Asia may diversify reserves in face of global imbalance

Asia may diversify reserves in face of global imbalance

Agence France-Prese, Tokyo

South Korea's plan to diversify its huge holdings of U.S. dollar assets highlights concerns that Asia needs to reduce its over exposure to the dollar in the face of the global imbalances caused by the massive U.S. current account and budget deficits.

Asian central banks are denying they are ready to reduce their dollar assets given the risks of sparking a wholesale retreat out of the U.S. currency which could have potentially disastrous consequences in the shape of much higher U.S. interest rates.

At the same time, however, they have to face up to the fact that these assets -- estimated to be well over a combined US$2 trillion -- could be a wasting asset if the dollar weakens under the weight of the massive U.S. current account and budget deficits.

Analysts say that everyone knows that the United States has to remedy the deficit problem and that that probably involves a lower dollar but no one is exactly sure how to get there without totally upsetting the apple cart.

Reflecting the sensitivity of the issue, the dollar hit a one- month low against the euro Tuesday on reports that South Korea, which has the world's fourth largest forex reserves, planned to cut its holdings of the U.S. currency.

The dollar later steadied at least on Wednesday after the Bank of Korea issued a denial. Taiwan also felt obliged to follow suit after reports that it too was going to sell down its US dollar holdings.

The Bank of Korea said instead that it planned to diversify its foreign reserves into non-state bonds but had no plans to sell and convert dollar-denominated U.S. currency reserves into other international currencies.

In practice, that means South Korea will likely decrease the allocation of new reserves to the dollar, which will change the overall dollar weighting, said Callum Henderson, head of forex strategy at Standard Chartered Bank in Singapore.

Foreign reserve holdings in East Asia rose substantially in 2004 to around $2.3 trillion from $1.8 trillion, with China and Japan accounting for three quarters of the gain, according to Standard Chartered Bank.

"There has been a general trend in Asia and the Middle East to look at, first of all, the issue of how to manage their reserves," said Henderson.

"And secondly, what currency to consider if indeed they are looking at diversification, pretty much focusing on the dollar weight in new reserves rather than selling off their existing reserves," he said.

However, too quick a move by Asian countries to diversify their reserves could backfire, said Woo Chull Chung, resident director general at the Asian Development Bank in Tokyo.

"If the dollar tumbles, it will reduce the value of their dollar portfolios as well," he said. "They will perhaps do this more gradually and in a more calculated way.

"Asia needs a better developed bond market, through which large amounts of savings available in Asia can be channeled within Asia to finance projects," Chung said.

"They have been dependent on the U.S. dollar bond market too long and too much."

Naoyoshi Noguchi, director of the Asia Oceania division of the overseas research department at the Japan External Trade Organization (JETRO), said the Asian crisis of 1997-98 had supported the idea that the region needed its own bond market.

"Asian countries want to support one another in case of a crisis and that has led them to consider diversifying their reserve currencies," he said.

Currently, the Asian countries are simply recycling their trade and savings surpluses into U.S. dollar assets. As they do so, they cover the U.S. current account and trade deficits and so help keep U.S. interest rates at moderate levels in what has become a closed circle but a potentially vicious one if it is unwound.

"It's completely linked to the U.S. markets so if they hurt the US markets, it will hurt their investment portfolios too," Noguchi said.

"That's why Asia wants to create a regional bond market to keep the money from leaving for the U.S. ... it will be problematic to sell dollar assets just because the U.S. economy is slowing or the dollar is weaker," he said.

As for Japan, which holds the world's largest foreign reserves of $841 billion at the end of January, its dollar-holding policy is unlikely to change any time soon, analysts said.

"Japan is unlikely to adopt a policy of diversifying currencies in its reserves for now because the finance ministry would be too concerned about a plunge in the dollar against the yen," said Tomoko Fujii, director on foreign exchange at Nikko Citigroup Securities.

A weaker dollar would only cut Japanese export earnings at a time when they are still the main driver for the country's faltering economy.