Testing, testing…. one, two, three
February 25, 2005
“Maybe it was all just a misunderstanding,”
said the Wall Street Journal on Thursday after South Korea’s
central bank denied reports that it may diversify its dollar-dominated
foreign exchange reserves.
The dollar dropped to a seven-year low against the
South Korean won on Tuesday after a single sentence in a thirty-two
page report from the Bank of Korea to the National Assembly stated
that it would “expand investment into non-government bonds,
which have relatively higher yields, and diversify the currencies
in which it invests.” The dollar fell 2 percent against the
won and 1.4 percent against both the yen and the euro in response
to the news and, as a result of the fall in the dollar, gold rose
by about 1.7 percent in dollar terms.
Seoul quickly came out with a denial that they intend
to sell any of their dollars, and the market stabilized.
The rapid decline in the dollar illustrates how nervous
foreign exchange traders are about the greenback’s fundamentals.
Any indication that foreign central banks will reduce their purchases
of US Treasury securities ignites fears about the US budget and
trade deficits. For most of last year I wrote about the twin deficits,
explaining that the budget deficit puts upward pressure on interest
rates and the trade deficit puts downward pressure on the dollar.
When the United States buys goods from China, Japan,
South Korea, and others, it pays with US dollars. If these countries
were not trying to keep the dollar strong -- and their own currencies
weak relative to the dollar -- they would turn around and sell those
same dollars into the foreign exchange markets. But they didn’t.
In order to keep the dollar strong, they used the
dollars they received for their goods to buy US Treasury securities.
This reduced the amount of dollars that would otherwise have flooded
foreign exchange markets but it also caused serious distortions
in their foreign exchange portfolios. China, Japan and South Korea
together own just under one trillion dollars’ worth of US
It really doesn’t matter whether they sell any
of their existing dollars or not. The US trade deficit is pumping
hundreds of billions of additional dollars into their coffers every
year. Even if these countries keep all the dollars they currently
own but just not keep as high a percentage of the new dollars they
continuously receive, the dollar will plummet.
There really isn’t any way around it.
Either the dollar falls sufficiently to eliminate the trade deficit,
or the trade deficit will continue to put pressure on the dollar.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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