South-Western College Publishing - Economics  
Dollar Fall Worries Central Bankers
Subject Depreciating Dollar
Topic International Finance
Key Words

Interest Rates, Government Debt, Appreciation and Depreciation

News Story

For many years now, the volume and dollar value of exports from Japan, China, South Korea, and Taiwan have far outstripped what these nations are buying from the United States. In the process, these Asian countries have accumulated huge quantities of foreign exchange. They have used their accumulating dollars to purchase American government securities.

The purchase of U. S. securities by foreign entities has helped keep U.S. interest rates low and the dollar relatively strong in America. Consequently, Americans have been able to borrow cheaply and fill their shopping baskets with more and more of the relatively cheaper products imported from Asia. Low interest rates have also enabled the federal government to readily finance the gaping budget deficit that has resulted since 911 and the wars in Afghanistan and Iraq.

As the dollar has slumped this fall, some investors are beginning to worry that Asian countries may begin to sell off their dollar-based holdings in favor of investments based on more highly-valued currencies. With the dollar trading around its five-year lows against the Japanese yen, Russia's central bank suggested that it was considering diversifying from dollars to euros.

Among countries that are accumulating foreign exchange, China holds about $600 billion and is catching up fast to Japan, whose total stockpile is the largest in the world at $817 billion. Most of the money in China's central bank has accumulated over the past four years and is related directly to the staggering export business the Chinese have developed. Japan has developed her holdings over a longer period of time, also by exporting huge amounts of manufactured goods.

Taiwan and South Korea are following along at $235 billion and $193 billion in foreign exchange holdings. Together, these four Asian countries are responsible for holding about 40 percent of the American government's public debt. The bulk of their reserves are in the form of Treasury bills, notes, and bonds that finance the federal budget deficit and leave American consumers and businesses free to spend their available funds on other things and invest in promising business ventures.

Even with the recent rumblings by Russia and to some extent by China, it is unlikely that these Asian countries will reduce their dollar holdings significantly anytime soon. In fact, Japan and China hold so much American debt that it would be very difficult for them to diversify their holdings discreetly. They have chosen instead to urge the Bush administration, in public and in private, to bring the American budget into better balance and to improve American savings rates.

"What China and Japan are trying to do is say, 'Please get back on track with fiscal reform,'" said Robert A. Feldman, chief economist for Morgan Stanley Japan.

(Updated February, 2005)

Questions
1.

Use supply and demand analysis to explain how the value of the dollar would change if Japan decided to unload some of its holdings of U. S. government securities.

2. Discuss why Japan and China are encouraging the U. S. government to provide corrective measures to stop the fall of the dollar rather than just dumping their dollar-denominated holdings.
3. How do foreign country purchases of U.S. securities help keep the dollar relatively strong?
Source James Brooke and Keith Bradsher, "Dollar's Fall Tests Nerve of Asia's Central Bankers," The New York Times Online. December 3, 2004.

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