The Year of the Dollar

You have heard it a thousand times: diversify, diversify, diversify. It is a staple of investment advice columnists, and, as it applies to a personal portfolio, it probably makes good sense. But coming from the lips of a central banker, especially an Asian central banker, the mere mention of the word “diversification,” can cause all hell to break loose.

That’s what happened last week when the Bank of Korea, in a briefing distributed to members of the National Assembly, said that it plans to invest more money in higher-yielding securities than in U.S. Treasury bonds, such as Australian Canadian dollar assets. That sent the dollar tumbling and the euro (not to mention the Korean won) to new heights.

Of course, the Bank quickly issued a disclaimer insisting that it was not planning to sell dollars, which calmed the markets down somewhat. But it was more in the nature of a non-denial denial, since the Bank had never actually threatened to dump the greenback, only to adopt a more diversified investment strategy in the future. The Bank of Japan issued a similar statement.

They probably won’t actually sell any of their current dollar holdings. They just might not buy as many dollar assets in the future. That will become clearer over the next three to four months, when we can observe South Korea’s actual buying pattern. Once the dust settles, we’ll see the color of South Korea’s money.

In international finance circles the word “diversification” has become a scare word. It should be recalled that only last November the mere mention of the word from an obscure Chinese bank official at an investment seminar in Shanghai was enough to boost the euro to a record level.

That same month Fed Chairman Alan Greenspan, speaking at a banking conference in Frankfort, said, “The insatiable foreign demand for dollar holdings would eventually fall as investors diversify . . . away from U.S. assets or lead them to seek higher rates of return.”

Of course, Asian countries are stuffed with dollars because of America’s growing current account deficit. Asian countries now hold about $2 trillion in dollar-denominated assets. South Korea has about $200 billion in foreign currency reserves, including $69 billion in U.S. Treasury bonds. That makes Korea the fourth largest holder of foreign reserves and the fifth largest of Treasury bonds.

U.S. Treasury Bonds in Asian Banks (in $billions)

Japan $711.8
China $193.0
Korea $ 69.0
Taiwan $ 58.8
Hong Kong $ 52.7
Singapre $ 28.0
Thailand $ 15.0

One gets the impression that central bankers are panting to diversify their holdings out of the greenback. Then they get spooked when they see the market’s reaction to any hint of diversification, or perhaps they get a call from Washington or maybe even they look into the face of economic abyss and then they back down again. But eventually they may start doing what they say they want to do.

In previous periods of a weak dollar, the central bankers had little choice but to stick with the greenback, but this is no longer the case. With the advent of the euro, they have for the first time ever a choice to diversify into what is really a perfectly good alternative global reserve currency.

Today the euro is the world’s second-most widely traded currency and has become the offset currency to the dollar. It now captures a 31% share of the trade, compared with just 20 % in 1999. So there is a lot of room for growth. Even though the Eurozone economy is growing at a slower pace than the U.S., every time the dollar weakens one immediately sees that weakness offset by strength of the euro.

Looking back, the economic story of 2004 was the rise in petroleum prices. One could say that it was the Year of Oil. One can predict that economic news in 2005 will be the dominated by the dollar’s steady decline and its consequences. The Bank of Korea may be just a curtain raiser on The Year of the Dollar.