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Wednesday November 24, 2004 - 15:00:44 GMT
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Will Asia dump the dollar?

The ever-rising level of dollar reserves held in Asia poses a significant threat to the global stability. The US and Asia both have a powerful interest in avoiding a destabilising plunge in the dollar and a gradual adjustment is still realistic, especially if there is a US commitment to budget adjustment. The net dollar risks have, however, risen and could increase further, especially if individual central banks start to sell dollars more aggressively. The risks of a destabilising dollar collapse have, therefore, risen and must be taken seriously, particularly by the US. Benign neglect by the US administration is increasingly untenable.

Dollar fears increase

The issue of rising dollar reserves held by Asian central banks has been an underlying market concern for the past two years at least as intervention has pushed up Asian reserve levels, but the issue has received greater prominence over the past few weeks. The concerns have been brought into focus by the weak US dollar and by the reports of central bank reserve selling.

Scale of the problem

Asian central banks have been intervening heavily over the past year to prop up the dollar. During the first quarter of 2004, for example, Japan bought over US$300bn to stem yen appreciation. There has also been consistent and heavy intervention by the Chinese central bank to maintain the yuan peg and there has been consistent buying by other Asian banks. Chinese and Japanese central bank reserves have both increased to over US$500bn and total Asian reserves have increased to over US$2.2trn with around US$1.4trn of these denominated in dollars. Some of the increase in dollar terms has been due to a revaluation impact of non-dollar reserves, but the increase has still been very substantial.

There has been increased concern over the implications of a switch out of the dollar. Currently over 60% of reserves are still held in dollars and a reduction to around 50% would be likely to put an additional US$300bn into the global market. With dollar sentiment weak, it would be very difficult to absorb these dollars without a further significant US currency decline.

Complex relationship

There are, therefore, significant risks to the US economy as the dollar could weaken sharply. The relationship is, however, more complex than that as Asian economies are also dependent on strong US demand to support their export sectors. If there is a very sharp dollar decline, the risk of a US recession would increase as US Treasury yields rise and this would hurt Asia. There is, therefore, a strong incentive to maintain the uneasy balance that has existed over the past year. Asian central banks will also be happy to hold dollars if they can secure attractive returns in the US Treasury market.

Game theory

Students of game theory will watch the Asian situation closely. The Asian economies in general want to remain competitive and they will, therefore, not want the dollar to depreciate rapidly. It is therefore, in their interest to continue dollar buying in order to support the US currency. There will, however, be significant economic benefits to individual countries if they can quietly reduce their dollar reserves while other countries keep on buying. Such action would increase the risk of other countries following suit as they will not want to be left holding all the risk. This scenario could quickly develop into a cascade of dollar selling.

US needs to respond

The risks of China and Japan pursuing such a policy are still fairly low, but there will be a high risk in countries such as India. Reports of Russian central bank dollar selling will also increase tensions. In this context, it will be important for the US administration to make constructive proposals for correcting the US budget and trade deficits. A rise in US bond yields and narrowing of the current and budget deficits would allow a gradual market adjustment. The overall message is that dollar neglect by the US will be increasingly untenable.

The central banks will also be careful to avoid selling the dollar at its weakest point as this would compound capital losses and this suggests that they are more likely to sell into dollar strength rather than sell when the US currency is already under pressure. Sharp dollar depreciation could, however, force panic selling.

 

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