South Korea diversifies

In late February, the foreign exchange market was shocked by the release of a South Korean report that its central bank might begin adding Australian dollars and Canadian dollars to its predominantly U.S.-dollar reserve holdings.

Not surprisingly, this unexpected report triggered knee-jerk dollar sales in trading centers around the globe as traders contemplated a widespread diversification away from dollar reserves by monetary authorities.

Fortunately, such action is highly unlikely, and South Korean authorities quickly attempted to quell market fears by indicating they had no intention of sharply reducing their dollar holdings. South Korea’s dollar holdings of $70 billion account for only about 4 percent of global dollar reserves. Nevertheless, the dollar dropped about 1.5 percent when the South Korean report hit the newswires as investors and dealers speculated that countries like Japan, China, and the United Kingdom — which hold sizeable amounts of U.S. Treasuries — might be contemplating similar diversification programs in response to a softening dollar.

Japan, whose dollar reserves exceed $700 billion, quickly attempted to reassure the financial community that it had no intention of shrinking the dollar percentage of its reserve holdings.

For decades, Japanese authorities have faithfully channeled dollars acquired through currency intervention activities into U.S. Treasuries, and there is no reason to believe they won’t continue to do so despite modest dollar weakness in recent years.

The Bank of China, whose dollar reserves exceed $200 billion, actively purchased Treasuries last year as it intervened to defuse revaluation pressures. The Bush Administration has recently stepped up pressure on Chinese authorities to allow the yuan to appreciate. Arevaluation this year is possible but not probable, so Treasury purchases by the Bank of China should continue. The Bush Administration believes Chinese trade surpluses with the U.S. will decline once the undervalued yuan is revalued, but the U.S. could also suffer some undesirable consequences if dollar-supportive Chinese purchases of Treasuries dwindle in the wake of a yuan revaluation this year.

The dollar has admittedly slipped about 30 percent on a trade-weighted basis in the past three years, but central bankers aren’t contemplating substantial reserve diversification programs, simply because there aren’t many attractive non-dollar instruments available at the present time.

U.S. interest rates are nearly 1 percent above rates in Europe and Asia, while rapid U.S. economic growth and sluggish growth in the Eurozone and in Japan doesn’t encourage central banks to avoid dollar assets.