James Turk: The truth behind the proposal to sell IMF gold

Section:

By William Pesek Jr.
Bloomberg News Service
Friday, February 25, 2005

http://www.bloomberg.com/news/commentary/wpesek.html

It's THE question in global currency markets: What force of nature
prompted South Korea suddenly to scrap plans to sell dollars?

On Tuesday, the dollar was plunging amid a comment by Asia's No. 3
economy that it would diversify foreign-exchange reserves into other
currencies.

By Wednesday, Korea's central bank said it had no such plan, leaving
traders scratching their heads.

Dumping dollars would be a logical move for the world's fourth-
largest holder of reserves after Japan, China, and Taiwan. Korea,
after all, is going against the tide in Asia, letting its currency
rise. It no longer needs so many U.S. Treasuries, nor does it want
to sustain huge losses as the dollar falls.

Korea's hasty and counterintuitive about-face makes you wonder if
U.S. Treasury Secretary John Snow himself made a call to Seoul. It's
hardly in the U.S.'s interest to see Korea pull the plug on
Treasuries. It could prompt other Asian central banks to do the
same, driving up U.S. debt yields.

Or maybe it was Japan, the biggest foreign holder of U.S.
Treasuries, pressuring Korea. Shortly after Korea's denial, Japan's
vice finance minister for international affairs, Hiroshi Watanabe,
referred to "wild" moves in the yen and said Tokyo "will act when
necessary" if its currency rises too rapidly. Asia hardly wants a
resumption of Japan's yen-selling campaign.

Conspiracy theories aside, markets could be excused for wondering if
Franz Kafka is roaming the halls of Korea's Ministry of Finance --
and whether the Czech writer is running its currency policies.

Kafka, of course, is famed for tales possessing bizarre, illogical,
and nightmarishly complex qualities. And there are some rather
Kafkaesque aspects to recent events, not only in Seoul but also on
currency policies throughout Asia.

Korea's retreat from dumping dollars shows the bind central banks
are in these days. This region's mercantilist tendencies have
manifested themselves in exchange-rate management efforts the likes
of which have rarely been seen before.

"Bretton Woods II" is what economists have dubbed the system that
unofficially replaced the original post-World War II currency
regime, which was based on a gold standard that collapsed in 1973.
In gold's place, many nations adopted the U.S. dollar as an anchor,
formally or informally pegging their currencies to it. We may be
seeing the demise of this new system, with Korea in the vanguard.

"The risk of a disorderly unraveling of Bretton Woods II -- a sharp
correction of the U.S. dollar and of the U.S. bond market, a surge
in U.S. long-term interest rates, and a sharp fall in the price of a
wide variety of risky assets such as equities, housing, high-yield
bonds, and emerging-market sovereign debt -- is growing," Nouriel
Roubini of New York University's Stern School of Business and Brad
Setser of Oxford University said in a research paper this month.

As their findings suggest, the current system is looking more and
more like a huge pyramid scheme. As long as Asian central banks
stick together and buy dollar-denominated securities, things are
fine. Once they start selling, virtually everyone loses -- central
banks experience capital losses and economies become less
competitive. Central banks have an interest in keeping the game
going and hoping others do too.

Yet this week's events underline "how vulnerable the dollar is to
negative news," says Carl Weinberg, chief global economist at High
Frequency Economics, referring to the dollar's biggest drop against
the euro in six months. The news, Weinberg says, "unwrapped a lot of
tightly-wrapped traders who were spring-loaded to sell greenbacks on
adverse news."

Sure, Korea's Treasuries holdings are much smaller than China's,
Japan's, or Taiwan's, but its $200 billion of reserves may be at the
forefront of trends to trim dollar holdings.

Central banks here don't buy U.S. debt out of altruism; it's to hold
down currencies to boost growth. Monetary officials find themselves
in the unenviable position of having to buy lots of dollar assets
they know are likely to lose value over time.

This may be as good a time as any for the region's monetary
authorities to avoid losses ahead of a possible surge in U.S. debt
yields. Investors won't ignore the record U.S. current-account and
budget deficits forever.

Yet it's a complex issue for Asian economies, which find themselves
in a "damned if you do, damned if you don't" situation.

Korea seems to have chosen to let the won rise, and it's a good
thing. Asia spends inordinate amounts of time weakening currencies,
worried about growth a quarter or two out. That distracts from
repairing structural problems. It's always easier to devalue your
way to growth than to reform financial systems, improve corporate
governance, and promote entrepreneurship.

Hopefully the rest of Asia will follow Korea's example. Rising
currencies are a sign of confidence in an economy, not a problem.
They lower bond yields and boost stock prices. Capital a hard money
brings in can be more important than increased trade attracted by a
softer one.

The Kafkaesque state of the global financial system may leave Asia
little choice in the matter.

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