Brad Setser

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Korea, enough said

by Brad Setser
February 22, 2005

It looks the remarks of Korea’s Central Bank President last week were a leading indicator of today’s big news: Korea plans to diversify its reserves away from the dollar!

Bloomberg is right: the real question is who [formerly, how — oops] else follows suit — Thailand already has shifted out of the dollar (look at how its reserves moved in January, when the dollar rose v. the Euro), Russia too. But most central banks are still massively overweight dollars.

“The market will now be looking to other central banks and what they will be doing, including the European central banks and Middle Eastern banks,” said Mansoor Mohi-Uddin, head of currency strategy at UBS AG in London. “The market has got nervous and has continued selling the dollar.”

“Support for the dollar is quickly disappearing,” said Kenichiro Ikezawa, who manages $1 billion in overseas debt at Daiwa SB Investments in Tokyo. Korea’s report “feeds into suspicion that others are also seeking to cut their exposure to the dollar.”

It will be interesting to see how far Korea is willing to let the won appreciate. Diversification in the context of rapidly growing reserves is a bit different than diversifying your existing holdings. If a country’s reserves are growing faster enough, their dollar holdings can go up even as the share of dollars in their overall portfolio goes down. I suspect that is what happened with Russia last year, for example.

The other big question, of course, is how much additional pressure this all places on China: the Bretton Woods 2 system of central bank financing of the US current account deficit increasingly hinges on the People’s Bank of China’s willingness to keep adding to its dollar reserves at an accelerating rate.

The more other central banks shift out of the dollar, the weaker the dollar — and the weaker the renminbi. And the weaker the renminbi, the more reason to bet on its eventual revaluation …


  • Posted by General Glut

    The won is up 1.2% against the renminbi/dollar today. The tried this last year and eventually gave up the diversification strategy because they couldn’t stand the pain.

    How long can Seoul take it this time around?

  • Posted by Jesse

    Does this imply that the Treasury/Fed began to ‘monetize’ the Social Security Trust Fund ‘money’ beginning in 1995? There is a sea change in the growth of M3 that did begin at that time.

    Two quotes from Robert Rubin’s “An Uncertain World”

    “Without an increase, the federal government would hit the debt ceiling before the end of 1995, possibly as early as October. Default and the President being forced to sign an unacceptable budget were both untenable. We needed to find a way out, rather than simply hoping that at the last minute the opposition would blink and increase the debt limit.” p. 170

    “It was Ed Knight, our savvy chief Treasury counsel, who suggested borrowing from the federal trust funds on an unprecedented scale to postpone default.” p 172

  • Posted by brad

    Jesse — I am not folowing you here.

    If you plot M3 v. stock of treasuries (in market and in the trust funds), I suspect it would show that M3 spiked up, as in your graph, even as growth in the Treasury stock first slowed and then basically stopped (in 2000 I think the US G ran a surplus even without drawing on the social security system — i.e. the fall in debt outstanding exceeded the increase in trust fund debt.

    the end 95 debate on the budget really had nothing to do with this — borrowing from the trust funds was a short-term way to avoid default; am pretty sure the funds were repaid. it was not a sustained shift in policy –if anything, the confrontation in 95 helped set up the dynamic that brought the government into surplus in 99/00.

  • Posted by Andrew Boucher

    From the Bloomberg article:
    “Japan and China, the two largest holders of Treasuries, probably won’t shift out of the dollar, he said. They “cannot diversify while the dollar is under pressure.””

    This is a great game-theory problem. I presume both the Japanese and Chinese believe that if one begins to sell, so will the other. So there is no advantage to go first.

  • Posted by steve

    I’m not sure how these plans of the BoK square with what President Roh told his counterparts at the ASEAN meeting just two months ago.

    I sense that in all of these countries (Korea, Taiwan, China, perhaps Japan) there are technocrats from the MoF or central bank crying out for FX diversification, and many politicians who don’t quite get it, or value stability or exports more than some theoretical capital account loss.

    WSJ, Tuesday, November 30, 2004

    Meeting on the sidelines of a regional gathering in Laos, the leaders of South Korea, Japan and China agreed on the need for exchange-rate stability, according to a statement issued by the South Korean presidential office. A separate meeting of finance-ministry officials from the three countries to discuss the dollar’s decline led to an “understanding,” though no agreement on any concerted action, South Korean Deputy Finance and Economy Minister Chin Dong Soo told reporters in Seoul.

    …South Korean President Roh Moo Hyun met with his counterparts, Prime Minister Junichiro Koizumi of Japan and China’s Mr. Wen, on the sidelines of the Asean summit yesterday. A statement from Mr. Roh’s office quoted the Korean president as telling Messrs. Koizumi and Wen that “a dramatic change in exchange rates is not appropriate” and that “currency stabilization is important for the economies in this region.” According to the statement, Messrs. Koizumi and Wen agreed. The statement paraphrased Mr. Koizumi as saying there should be cooperation and joint efforts among the three countries to stabilize the currencies.

  • Posted by A.F.

    The perspective on the bond and foreign exchange markets is distorted by the smokescreen known as the yen carry-trade. The Japanese are printing yen, not to support productive enterprise but to finance speculation. The Fed obliges and prints dollars, again not to support productive enterprise but to serve as a drop-off point for speculators. Japanese interest rates being so low, speculators can borrow yens at around 1.5%, sell them for dollars to be invested in US Treasuries yielding 4 to 5%. The speculators pocket the difference without performing any useful service whatsoever. The yen carry-trade is firmly in place, allowing the US debt markets to defy gravity. Observers look at another key market, that of the dollar, and conclude that the obvious bear market will spell the end of the yen carry-trade. As the dollar falls, the Japanese and the Chinese may threaten to start dumping it and to put an end to its reserve currency status. Only a dramatic rise in interest rates may save the dollar as the world’s reserve currency.

    But the bear market in the dollar actually helps rather than hurts the yen carry-trade. The terms of trade for those who sell yens to buy dollars is improved immensely by the fall of the dollar. The yen carry-trade can be described as arbitrage with short leg in the yen bond market and long leg in the dollar bond market. Profits on the long leg increase far more than losses on the short as a result of the dollar-devaluation. The faceless bond speculators are sitting on a huge pile of profits already that have been accruing for a quarter of a century. They can well-afford to prevent Humpty-Dumpty (read: the dollar) from having a great fall from its perch as a reserve currency. This particular cash cow can be milked yet for quite a bit longer with careful husbandry. It would be a folly to let it be slaughtered just at the time when milk (and honey) output is at peak.

    What I am suggesting is that bond speculators are calling the shots, and central bankers willy-nilly play balls with them. The alternative is sudden death. Without bond speculation the regime of irredeemable currencies would have come to a sad end thirty years ago. Speculators well-understand the dynamics of competitive currency devaluations. The present round started ten years ago when the yen was devalued 50%. In the intervening years the ruble collapsed along with other Asiatic currencies. Right now it is the turn of the dollar. It will be interesting to watch whether and when the euro will succumb to the temptation, as I predict it will, in spite of the brave talk we are hearing from Brussels. This is just a replay of the 1930’s with the yen playing the role of the leading currency. If the yen carry-trade was profitable during the last ten years of a weak yen, then it would be a hundred times more profitable during the next ten years of a strong yen.

    It is a mistake to look at the falling dollar as the result of the profligacy of the American consumers, and a direct outcome of the American trade deficit. This is just a decoy. It is designed to diverts attention away from the real culprit, which is the yen carry-trade and its obscene profits. But let us not forget that at the same time it is a powerful booster for the yen carry-trade. Let the public buy Milton Friedman that the falling dollar is just the manifestation of the adjustment mechanism balancing the American trade account. Or let it buy the equally fallacious Quantity Theory of Money predicting that the dollar will be printed into worthlessness. The truth is that there is an insatiable demand for dollars, especially for falling ones, by bond speculators. In the present case what you see is the American trade deficit, which can easily be blamed on the appetite of the gluttonous American consumer. What you don’t see is the accumulating profits of the faceless bond speculators, sucking the life-blood from the world economy. This is exactly the same point that was missed in the Great Depression of the 1930’s by all economists. They are going to miss it again.

  • Posted by Jesse


    You’re right. For some time I have been looking for some reason for the very definite change in growth rate in M3 that occurred at the time on the graph.

    Someone had suggested those passages. I looked to see if there were any serious changes in the constituency of the Trust Funds about that time. I had trouble understand what Rubin meant by borrowing those funds, as they are really just debt instruements. What did they borrow? Might be just a bookeeping thing perhaps.

    Anyway it does not seem to be ‘the answer.’ Any thoughts on that change in growth besides Rubin’s ascendancy to the Treasury?

  • Posted by Billmon

    From Bloomberg this evening:

    South Korea’s central bank, which holds the world’s fourth-largest foreign currency reserves, said it has no plan to sell dollars from those holdings and no plan to change the current portfolio of currencies in its reserves.

    “The Bank of Korea will not change the portfolio of currencies in its reserves due to short-term market factors,” the central bank’s said in a press release e-mailed to all media this morning after the Korean won rose past 1,000 against the dollar for the first time since November 1997.

    Sounds like a classic non-denial denial to me — the ongoing U.S. current account imbalance, and the resulting mountain of dollars the ACBs are currently be forced to buy, certainly don’t seem to meet the definition of “short-term market factors.”

    It may be, as Steve above speculated, that the conflicting messages out of Korea reflect real conflict between the central bankacrats and the politicians behind the scenes.

    Or, maybe the Koreans were trying to send a message — to us, to the Chinese, to the world — roughly the same message Mr. Creosote delivered to the waiter in Monty Python’s The Meaning of Life: “We’re absolutely stuffed, and we could’t eat another bite.” But they didn’t expect to move the markets in such a brutal fashion, and so are now trying to walk everything back.

    In which case I suppose they really will try to eat just one more wafer thin dollar mint . . .

  • Posted by Jesse

    Here is the correct link for the SSA trust fund “holdings”

  • Posted by brad

    Billmon — nicely said, as usual. I suspect you and Steve are right, and there is growing tension, probably not just in Korea, between the central bank bureaucrats looking at their “stuffed” balance sheets/ trying to figure out how to sterilize another $10b and their political masters. In our paper, Nouriel and I tried to emphasize both the intrinsic instability of Bretton Woods 2, and our expectation that it would unravel in fits and starts as everyone stumbles toward a new equilibrium. The “fits and starts” may have started up a bit faster than even we expected, but I would be shocked if there is not an extended period of stumbling around.

  • Posted by glory

    Lex: Central banks

    Currency reserves are to central banks what spare tyres are for cars: a source of comfort in a crisis. But are South Korea’s threatening to create a market blow out? The dollar tumbled on Tuesday after signs that the Bank of Korea wants to diversify its reserves. Although the BoK on Wednesday denied it planned dollar sales, markets remain jittery.

    No wonder. Asian central bank reserves almost doubled to $1,900bn between 1999 and 2003, and swelled further in 2004, mostly in dollars. This is starting to resemble a pyramid scheme. If nobody dumps dollars, banks may avoid losses on these holdings, but if any bank tries to protect itself from possible losses by selling dollars, everyone will be hurt. The New York Federal Reserve, for example, estimates that Singapore would suffer a capital loss equivalent to a tenth of gross domestic product if its currency rose 10 per cent. For China and Korea, the hit would be 3 per cent.

    Right now, it is hard to see any central bank breaking rank. Japan does not wish to offend the US. China has a dollar peg. Meanwhile Korea’s comments describe an existing policy of slow, minor diversification not a U-turn. Its ratio of US Treasuries to all reserves, for example, is already falling. However, just because everyone has a tactical interest in playing the current game now, that does not make it structurally stable in the long term. If or when the distortions linked to these pumped-up reserves unravel, the “pop” will be painful.

  • Posted by glory

    Central Banks May Look Past Dollar

    Merrill Lynch estimates that global central banks’ excess funds currently amount to nearly $1.5 trillion (€1.2 trillion) — that’s trillion with a “t” — out of $3.4 trillion in total reserves.

    Backed by this huge pool of money, “a new class of foreign-exchange investor has emerged — central banks,” says Alex Patelis, a senior currency strategist at Merrill in London. Eager to reduce the opportunity costs of holding a huge pool of reserves and to generate superior returns, some “central banks are moving to separate a portion of their reserves and managing them with more explicit longer-term mandates,” he says.

    Recent examples, he points out, include South Korea, Taiwan and Russia, while longer-standing ones are Singapore, Norway and Abu Dhabi, capital of the United Arab Emirates.

    Some of that excess is bound to be invested in the world’s favorite securities market — the U.S. — where central banks already are major purchasers of Treasurys. But it’s also likely to find its way elsewhere in the search for superior returns and risk-spreading. Mr. Patelis says that a typical global stock and bond benchmark allocates 41.2% to dollar assets, or roughly a third less than the current central-bank average dedicated to dollar-denominated assets.

    Foreign-currency reserves are to a central bank what spare tires are to automobiles: back-ups to keep things running in an emergency. They can be deployed to defend a currency under attack, calm jittery financial markets and ensure that local banks have sufficient funds to meet demands. They also are used to alleviate economic shocks, make sure that companies have access to hard currency to pay for imports and bolster a country’s creditworthiness.

    There is no magic formula to determine how big a war chest individual central banks should maintain; each country has its own needs. By year-end 2003, total global foreign-exchange reserves had ballooned to almost 14% of world gross national product from less than 2% in 1960 and roughly 4% a decade ago.

    Part of this increase is in response to more numerous economic crises, part a reaction to the increasing mobility of global capital flows. But a hefty chunk also reflects central banks’ attempts to keep their industries competitive by preventing their currencies from rising against the dollar. They do that by creating local money that is then used to buy dollars. Those dollars in turn are then usually invested in relatively low-yielding Treasury securities, money-market instruments, U.S. agency securities and bank deposits.

    Lately, there’s been much chatter that central banks, disenchanted with the dollar’s weakness, are diversifying away from dollar assets. Indeed, a few are. For instance, Russia on Tuesday confirmed that about a third of its reserves are in euros. Yet Morgan Stanley and Dresdner Kleinwort Wasserstein, in recent reports, each found negligible evidence of dollar diversification. They said the dollar’s share of global official reserves actually may have risen a little since year-end 2003, when they stood at 63.8% — and the euro’s share equaled 19.7% — according to the International Monetary Fund.

    But that could change, if, as some analysts believe, more countries seek better returns on their hordes of cash. Two models are Singapore, which in 1981 created the Government of Singapore Investment Corporation, or GIC; and Norway, which in 1990 set up the Government Petroleum Fund to invest the country’s oil revenue. The former, analysts estimate, now has more than $100 billion in assets. The latter — which is run by Norway’s central bank, or Norges Bank — received its first funds in 1996 and has roughly $165 billion.

    Unlike most central banks, both organizations invest in long-dated bonds and stocks. GIC manages its own assets, whereas the Petroleum Fund has both its own staff and uses external managers.

    “The GIC and Norges Bank are at the leading edge of modern monetary-authority money management,” says Ronald Layard-Liesching, a partner at money managers Pareto Partners. “Before they used to just invest in short-term treasury instruments. Now they are moving further up the risk spectrum and becoming more like investment-management firms.”

    Others are catching on. South Korea, for instance, is setting up the Korea Investment Corp. to be funded with at least $100 billion by 2012. This year, the nation’s central bank, with $193 billion in reserves, also will award about $20 billion to external money managers. Meanwhile, Taiwan, with $239 billion, plans to use reserves to help local companies buy machinery and intellectual-property rights overseas.

    Even so, any major shifts won’t happen overnight. Central banks are conservative beasts; and to avoid triggering a dollar freefall, they will wait for a stronger dollar before selling, says Mr. Patelis. Thus, while the banks won’t exacerbate the dollar’s current problems, they probably will cap any rebound in the currency.