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Korea To Limit Its Dollar Holdings

Central Bank's Plan Upsets Exchanges

By Paul Blustein
Washington Post Staff Writer
Wednesday, February 23, 2005; Page E01

Fears flared anew yesterday that the U.S. dollar might lose a crucial underpinning of support -- purchases by the world's central banks -- after South Korea's central bank said in a report that it plans to invest more of its holdings in the currencies of other countries.

News of the report by the Bank of Korea sent the dollar skidding on foreign exchange markets. The euro was trading at $1.3259 late yesterday, up from Monday's close of $1.3067. The dollar fell to 104.04 yen, from 105.64 on Monday; and the greenback also sank against the British pound, Canadian dollar and Swiss franc.

A clerk carries U.S. dollar bills at a bank in Seoul. South Korea's central bank says it plans to invest more of its holdings in currencies other than the dollar. (Kim Kyung-hoon -- Reuters)

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The dollar's slide, together with a rise in oil prices to more than $50 a barrel, drove stock prices sharply lower, with the Dow Jones industrial average falling 174.02 points, or 1.6 percent, to 10,611.20.

Analysts differed on the significance of the Korean report, which some said was neither new nor alarming. But the announcement, and the market's reaction, provided a potent reminder that the dollar's value has depended heavily in recent months on decisions taken by government officials managing their central bank's vast portfolios.

Those central banks, mostly in Asia, have become huge buyers of U.S. Treasury bonds and other dollar-based securities in the past couple of years, overtaking private foreign investors in some months. That in turn has aroused worries about how long such sources can be relied on to provide the billions of dollars that the United States, with a trade deficit of $617.7 billion last year, must effectively borrow from abroad each day to pay for imported goods. The ultimate nightmare scenario is that a plunge in the dollar would generate so much turmoil in global markets that it would threaten a world recession.

"One doesn't want to say the sky is falling, but this is a serious problem," said Desmond Lachman, an economist at the American Enterprise Institute. "What the Koreans seem to be saying is that they want to diversify their reserves [of foreign currencies] away from dollars in the future, which means they don't want to add a lot more dollars. But if foreign central banks decide they don't want to finance the U.S. trade deficit, who's going to finance it?"

The news from Korea, Lachman noted, was one of the most troubling in a series of similar statements by central banks because the Bank of Korea holds about $200 billion in foreign currency, the fourth-largest hoard of reserves. Russia's central bank said in November that it may increase its purchases of euros, which caused the dollar to sink, as did other recent reports of moves toward non-U.S. currencies by the central banks of oil-exporting countries.

With yesterday's drop, the dollar has lost a considerable portion of the gains it posted in the early weeks of 2005. The dollar's general trend since early 2002 has been down, as the greenback has fallen more than 15 percent against a basket of currencies of major trading partners. The decline has been uneven, however, with some of the steepest losses coming against the euro, British pound and the Canadian dollar. That is because many Asian governments -- anxious to keep their exports relatively cheap -- have bought dollars to prevent their currencies from rising too fast.

One result is the massive accumulation of U.S. securities, about $2 trillion worth, by Asian central banks. Although some of the biggest Asian holders, such as the Japanese, have averred that they have no intention of diversifying away from dollars, the huge sums, combined with the fall in the dollar's value, have raised the prospect that some big central banks will shift into euros and other currencies to avoid incurring losses on their portfolios.

Hence the reaction to the Korean announcement, which came in the form of a report to a parliamentary committee. "Korea's suggestion that it would consider a more active policy of diversification away from the dollar is a reflection of the understandable unease that Asian central banks are feeling, having built vast unhedged exposures to the dollar . . . in the past two years," JPMorgan Chase & Co. said in a report to clients.

The markets are probably exaggerating the importance of that problem, according to some experts. Edwin M. Truman, a scholar at the Institute for International Economics, said that although foreign central banks have been major buyers of dollars in recent months, sometimes accounting for the majority of the inflow of foreign capital to the United States, their holdings still total only about 12 percent of U.S. liabilities to foreigners.

"That's small, relative to other private holdings of U.S. assets," said Truman, the former top international staffer at the Federal Reserve. "So it can be blown out of proportion." Still, he said, "there's no denying the psychological impact" of the Korean news.

The dollar's drop helped fuel the rise in oil prices because oil is sold in dollars and traders fear that a falling greenback will prompt OPEC to cut production to drive up prices. Other factors included colder temperatures in parts of the United States and Europe, which increases demand for heating oil.

On the New York Mercantile Exchange, oil for March delivery closed at $51.15 a barrel, up $2.80 from Friday's close. The price is creeping closer to the recent high of more than $55 a barrel set in October, although when adjusted for inflation, the price remains well below the peak reached in 1981.

Staff writer Justin Blum contributed to this report.

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