South-Western College Publishing - Economics  
Is the Dollar Vulnerable?
Subject Value of the Dollar
Topic International Finance
Key Words

Account, Central Banks, and Reserves

News Story

The dollar's vulnerability was underscored recently by the currency's value plunging one day and rising the next. Speculation in currency markets can explain some of the volatility; speculators thrive on market volatility. Analysts' real worry, however, relates to whether or not Asian central banks may start converting their reserve holdings away from dollars and toward other currencies. The dollar plunged 1.5 percent against the euro and 1.4 percent against the yen on apparently false reports that the central bank of Korea was shifting some of its reserve holdings out of dollars and into other currencies.

Other nations' central banks are major contributors to the flow of funds from abroad to cover the U. S. current account deficit, which is the difference in trade and services between the U.S. and the rest of the world. This is where worries arise. If foreign central banks are not attracted to U.S. financial assets, the U.S. may not have enough funds to cover the current account deficit, which is expected to set a record of more than $600 billion in 2004.

Some compelling reasons indicate that a sell off of dollars is not in the interest of other countries. Especially in Asia, rapid selling of dollars would plunge the dollar's value further and cause major disruption to world financial markets. Additionally, Asian central banks will not want their currencies to rise further against the dollar, because Asian countries want to keep their exports and currency competitive with China's exports and currency, where the Chinese yuan's value is pegged to the dollar.

One analyst does not see the Asian central banks diversifying their reserves away from dollars. "I don't think they will be out there leading the charge in selling the dollar," said Steven Englander, chief foreign exchange strategist for the Americas at Barclays Capital. The Bank of Korea denied any plan to get out of dollars. In a statement the bank said, "Recent reports by the foreign media that the B.O.K. is selling U.S. dollars are not true". The statement did say that the bank was planning to "diversify investment targets," but did not specifically name the dollar.

In addition, according to Bloomberg News, the director of the foreign exchange markets division of Japan's ministry of finance said that Japan did not plan to shift its foreign currency reserves away from dollars. Likewise, the central bank of Taiwan reported that it was not selling dollars to obtain other currencies. Thus, although some fear that the dollar could fall further, sufficient reasons also seem to exist to believe that the situation will not worsen substantially unless a number of foreign central banks change their stance on holding dollar reserves and begin to trade them in for other currencies.

Questions
1.

Find a recent summary of the U.S. balance of payments and record the current account balance.

2. Why, with a negative current account balance, is it important for the U.S. to attract foreign investment?
3. Use a supply and demand graph to analyze the effect of a central bank selling off dollars in favor of other currencies.
Source Jonathan Fuerbringer, "a Currency Can Feel, the Dollar Feels Vulnerable," The New York Times Online, February 24, 2005.

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