The BoK's Announcement & the US$
John Mauldin's Outside the Box

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Introduction

This week we will turn once again to a group headquartered in Hong Kong called GaveKal Research Limited. Louis Vincent Gave's GaveKal Ad Hoc Comments for Wednesday, February 23, 2005 looks at the possible implications of the recent announcement by the Bank of Korea to diversify their holding away from the US dollar.

He uses the term "sterilize" a lot, and it is important to understand this process. Countries sterilize their currency to maintain fixed exchange rates and Investopedia.com defines "sterilize" as "using offsetting open market operations to prevent an act of exchange market intervention from changing the monetary base." If the country does not sterilize the incoming currency, it will "infect" the money supply and could cause inflation. Basically it does this by buying or selling bonds in the local currency.

Gave goes on to discuss the explosion in foreign central banks US dollar reserves and suggests that the dollar will strengthen in the future rather than fall. This idea is at odds with my longer term forecast of a weaker dollar and that is why it made this week's Outside the Box. (Of course, I did note in my annual forecast that I thought the dollar could strengthen in the short term.)

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The BoK's Announcement & the US$

February 23rd, 2005
by Louis-Vincent Gave

Yesterday's announcement by the Bank of Korea that it was looking to diversify its foreign exchange reserves from US$ into other currencies has renewed the selling pressures on the US$. In 24 hours, the US$ has lost - 1.4% against the Euro, -0.7% against the Yen and Sterling, the NZ$ is making all time highs etc...

So what should we make of the BoK's announcement? Will this decision be a heavy burden for the US$? Will it be the proverbial straw that breaks the US$'s back? Or are the markets over-reacting? In the following few pages, we aim to answer some of the questions posed by the BoK's announcement, and the consequent market reaction.

1- How Big of An Impact Would BoK Selling Have?

As anyone involved in the financial markets knows, prices are made at the margin. Consequently, the news that the Bank of Korea will become a seller of US$, instead of a natural buyer, can hardly be perceived as good news for the US$. But having said this, the question then becomes how much of a seller of US$ the BoK will become. And on that point, the announcement was very vague.

Looking at the growth in reserves of the Bank of Korea, last year saw record inflows of over US$40bn, bringing the BoK's total reserves to US$200bn.

 
Chart 1

Now undeniably, these are not small amounts; and backed by these reserves, the BoK could be a major player in the foreign exchange markets. But having said this, the amounts moved around by the BoK are still dwarfed by the amounts of the BoJ [Japan], and the PBoC [China]. In the world of central bank forex intervention, the BoK is still a second division player!

More importantly, looking at the above chart a question needs to be raised: are investors betting on big sales of US$ from the BoK's not simply projecting the recent past into the future? After all, the annual growth of Korean reserves has not been a steady affair. Some years (1988, 1991, 1997, 1998) have seen a contraction in reserves, while others (1989, 1999, 2001) have seen the growth in reserves fall abruptly. And when that happens, the Bank of Korea does not go out and sell US$ in the open market. Quite the contrary!

Over the past year, the BoK has been accumulating reserves at a record pace. But is this pace likely to continue? As is visible from the chart, the past year's growth seemed to be somewhat of an anomaly... and betting on the BoK's ability to sell US$ in the market could be betting on a continuation of the past year's anomaly.

2- Haven't Asian Central Banks Been Diversifying Anyway?

Last November we wrote a lengthy piece entitled "What Investors Should Know About the US Current Account Deficit" in which, amongst many other things, we attempted to uncover how reserves of central banks all over the world (but especially in Asia) could have risen so much faster than their underlying countries' current account surpluses? And the explanation we found was simple enough: a massive game of double counting on reserves was taking place. We wrote:

"Central banks like to keep enough US$ at hand to cover at the very least three months worth of imports, and usually six. Once that is achieved, then local government debt denominated in foreign currencies usually starts to get repaid (i.e.: Thailand, Indonesia, Malaysia... 1998-2001). Once both the reserves are secure, and foreign currency debts have been repaid, the central bank will then usually look at the countries against which it runs a current account deficit, and start accumulating reserves in that currency.

To take an example: once the People's Bank of China is secure with its US$ holdings, it will most likely decide to start buying some Yen (to cover the cost of its imports from Japan).

Usually, those reserves are deposited at the central bank of the surplus country (Japan, in our example above) and appear as liabilities in the balance sheet of that central bank (assets held at the BoJ for the account of foreign central banks).

Which then implies that the country at the receiving end of these transfers (i.e.: Japan) now has two kinds of reserves:
  1. The "earned reserves", which are more or less equal to the sum of the current account surpluses over the year. These reserves are, by their very nature, very stable.

     
  2. The "unearned reserves", which are the sum of the net private and public (central banks) capital flows. These reserves are, by their very nature far more unstable.
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And unfortunately, it seems that most of the growth in reserves over the past couple of years has been of the latter, unstable kind. As highlighted in the chart below, while historically the difference between Japan's current account surplus and its annual growth in reserves has been a negative US$140bn, in the past year, it has grown to a positive US$200bn!

The above facts lead us to the conclusion that a massive game of "passing the hot potato" is currently taking place amongst the world's central banks. And in this game, the "hot potato" is US$ reserves (or trying to show that one doesn't have too much to an increasingly uneasy US administration) and the main players are the US, China, Japan and Asia ex Japan, ex China. The other players (Europe + OPEC) are simply on the receiving end of the game.

 
Chart 2

And the direct result of this game of hot potato is massive double counting of reserves.

Staying with the same example as above: if China changes some of its excess US$ for JPY and places the Yen for deposit with the BoJ, then overall Chinese reserves will not change. However, if the BoJ turns around and buys back the US$ that the Chinese have sold (to prevent the Yen from rising), then Japanese reserves will go up-by the amount invested by China in Japan. Importantly, a lot of these reserves do not belong to Japan, but to China...in the official statistics, these reserves will appear as Japanese reserves, because Japan does not give a breakdown of its reserves. But these reserves could melt away like snow in the sun, if, for some reason or other (i.e.: a trade deficit, the purchase of weapons system, a really bad harvest, etc...) the PBoC decided it no longer wants to hold Yen but needs US$ (or Euros, AU$, etc...).

Worse yet, if the reserves are kept at the People's Bank of China, and deposited with commercial banks in Japan, the BOJ may not even know that this is taking place...

Summing up the above, we can conclude that when a country (i.e.: China) runs a current account surplus, and wants to maintain a fixed exchange rates, it must first decide whether it wants to sterilize its FX intervention, or not. In turn, the US$ bought on the market (whether sterilized or not) can be used to buy Yen (or AU$, KRW etc...). This then pushes the BoJ to intervene in the FX markets and either sterilize, or not.

We therefore have four possibilities:
  1. China sterilizes and Japan sterilizes (2002 and early 2003, see An Important Change in China): this is very deflationary for the world and very positive for US Treasuries.

     
  2. China sterilizes, Japan does not: this is most unlikely but would lead to a rapid fall in the Yen and an out-performance of Japanese equity markets.

     
  3. China does not sterilize, but Japan does (situation prevalent today): the Yen rise and Japanese equities underperform.

     
  4. Nobody sterilizes and money supplies accelerate rapidly: asset prices go through the roof (this is what happened in 2003).
In any event, we would like to reiterate that the current situation is highly unstable. The impressive growth in reserves shows that there either exists a massive short US$ position in the system, or that central banks around the world, but especially in Asia, have been double counting their reserves. When reserves start to shrink, central banks will first liquidate their third party currencies (mostly Yen and possibly AU$). And this could add volatility in the financial markets at the worst possible time."


So given the above, we can draw two possible conclusions:

Conclusion #1: The Bank of Korea has already been diversifying its reserves (in Yen, Euros, AU$...) and this recent announcement is a typical central bank announcement; i.e.: the BoK is just stating the obvious.

Conclusion #2: While every single central bank in Asia (PBoC, BoJ, MAS...) has been busy diversifying away from the US$ (hence the double-counting of reserves), the BoK is finally waking up to the game that everyone else has been playing and is hoping to get in on the action. In other words, the growth in reserves of the BoK is not really linked to Korean trade, but to the fact that other Asian central banks have been buying Won...and the BoK now wants to send this money elsewhere!

Our experience of central bankers in general, and of Asian central bankers in particular, would lead us to chose the former over the latter. But in this decision, we truly show our prejudices: after all, the solid rise in the Korean Won last year (from 1200 to 1050) and so far this year (from 1050 to 1004) would seem to indicate that, unlike other Asian central banks, the BoK has not been extremely deft at manipulating the value of its currency lower; last year, the Won was the world's best performing major currency.

 
Chart 3

3- A Different Trend in Reserves in 2005

The most interesting part of the BoK's announcement is that, on aggregate, the growth in foreign central bank reserves has started to decelerate. This means that we are moving from an environment of plentiful, and weak, US$ to an environment where US$ aren't as plentiful (and weak) as they once were. So anyone who has borrowed in US$ could be scrambling to meet its obligations.

 
Chart 4

 
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4- Conclusion

The recent announcement by the BoK has knocked the wind out of the sails of the US$. But beyond that the announcement is a non-event which does not alter an important reality: today, the growth rate of US$ deposited at the Fed by central banks is decelerating rapidly. And this argues for a stronger, not a weaker US$. The US$ might test its December lows, but we doubt it will pass them.

 
Chart 5

Conclusion

You can find out more about GaveKal Research by going to www.GaveKal.com.

Your still seeing a weaker dollar in the long term analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

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Posted 02-28-2005 3:34 AM by John Mauldin
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