As Central Banks Shun the Dollar

Action Economics' Ronald Simpson says the trend of diversifying reserves shouldn't hurt the greenback much in the near term

It was no surprise to foreign exchange market watchers when the South Korean central bank announced plans to switch out of U.S. dollars in its search for higher yields. In past months, other foreign central banks had expressed interest in similar plans. These institutions are seeking diversification in their official reserves, and that means looking at other currencies besides the greenback

The dollar sell-off after the announcement was likely a market positioning event rather than a foreboding sign of things to come. Even in the short term, the greenback will probably trade sideways, even as more central banks move away from dollar investments, according to Ronald Simpson, Action Economics' managing director of global currency analysis.

BusinessWeek Online reporter June Kim spoke with Simpson about the Korean central bank's move away from the dollar and what it means for interest rates and the currency in the long run.

Q: The South Korean central bank has plans to diversify its official reserves. Was this announcement expected?


When the South Korean central bank came out saying they were thinking of diversifying their reserves, in the scheme of things this isn't really anything new. As far as the foreign exchange market is concerned, there's been talk of this going on for many, many months now.

It has been an ongoing phenomenon really. In fact, in December, Russian officials were saying that they were thinking of diversifying reserves out of the dollar. As the euro has gained credibility, it makes sense for the central banks of the world to not put all their eggs in one basket basically.

In the big picture, the dollar has been in a downtrend for some time. Obviously, if you're a foreign central bank holding a currency, you don't want it to depreciate. It's just a similar approach as to diversifying your portfolio in the stock market -- you don't want to put anything in one instrument.

Q: Is this something that other foreign central banks are going to do?


I think diversification of reserves is going to be an ongoing issue in Asia and the Middle East. Bahrain came out today and said they saw a larger role for the euro as a reserve currency. That has been mentioned out of the Middle East for many months as well.

It's not going to be 1-2-3, everybody sell dollars and buy euros. But South Korea, for example, was looking for higher yields. The universe is rather limited for stable and liquid currency investment alternatives.

Q: So if this kind of move was expected, why was there such a dramatic dollar sell-off?


I think that a good deal of the dollar weakness seen on the back of the Korean central bank news was driven more by market positioning than anything else. The reaction that we saw today was exaggerated just from market positioning -- the market was looking for an excuse to sell some of their stale long dollar positions. And that's exactly what they did.

We've seen the dollar rally -- the so-called New Year's rally -- since January. The dollar has been higher since the first of the year. Using the euro against the dollar for example, we finished the year off virtually at all-time record highs against the dollar -- and lo-and-behold, on Jan. 1, we've seen the euro move from $1.37 to lows of $1.27 as little as two weeks ago.

I think if you look at the last quarter of 2004, the dollar overall got hammered. And a lot of that was unwound, and in the beginning of 2005 we saw profit-taking on that kind of exaggerated move that we saw.

I think the market has kinda got itself out of dollar-bearish mode for the first month and a half of this year. And as a result, the markets has gotten itself quite long of dollars -- the speculative element of the foreign exchange market, which is a huge part of the market.

Q: What does this mean for the dollar and interest rates in the big picture?


It will continue to put downward pressure on the dollar. And it could, in the longer run, have an impact on interest rates -- it could put upward pressure on interest rates.

Going forward, if foreign central banks reduce their holdings of dollars, [this] will thereby reduce their demand for U.S. Treasuries -- which is normally where foreign central banks park their dollar holdings. As the demand for U.S. Treasuries declines over time, that pushes up the yields of those treasuries and, therefore, could make the dollar more attractive to foreigners.

So it supports the dollar. Everything kind of comes to an equilibrium.

It's an unfolding story. As time goes on, it could have significant impact on the dollar, but at the pace and scope of reallocation of reserves that we see now, it should not in the foreseeable future have a significant impact on the value of the dollar.

Q: What do you see the dollar doing in the short term?


If you put U.S. growth and expectations for moderately rising interest rates on one side against the deficit picture on the other side, I see a potential for the dollar trading sideways over the next few months within the trading bands that we've seen over the past couple of months or so.

Edited by Tzyh Ng

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