Periscope

It was just a subordinate clause in a dense 32-page report to a parliamentary subcommittee, but when the Bank of Korea last week indicated that it might begin to diversify its foreign reserves away from the dollar and into other currencies, traders around the world panicked. The dollar dropped 2 percent against the won in one day, and lost most of its gains against the euro so far this year. It ended the week down at $1.32 to the euro. And a big question hung over the markets: will China and Japan follow South Korea, leading to a plunge in the dollar? Short answer: no. "This is all overblown," says Morgan Stanley chief currency analyst Stephen Jen. "The whole mindset of how currency traders respond to and digest news is very unhealthy." The market reaction was based partly on the mistaken belief that Korea was preparing to dump dollars, rather than diversify future purchases of foreign currency. In fact, this is already happening. A Royal Bank of Scotland survey of 56 central banks, released in January, found that nearly 70 percent had increased exposure to the euro, and 52 percent had reduced dollar holdings. But that doesn't mean a destabilizing sell-off is coming. Japan and China together hold 60 percent of global foreign reserves, and have no intention of allowing a sharp fall in the dollar that would damage the value of their holdings. Moreover, as Tokyo is part of the G7 gentlemen's agreement not to sell one another's currency without permission, "Japan has made it very clear that diversification is not going to happen," says Jesper Koll, chief Japan economist for Merrill Lynch. China has been gradually diversifying over the past year or so, says Jen, but any big move is out of the question because that would disrupt what Koll calls the great vendor finance relationship: China finances Americans to buy Chinese products and create Chinese jobs. "And who gets hurt when that relationship gets broken? The guy who provides the credit," he says. Still, last week's panic was a reminder that markets are paying attention to the fallout from bad monetary policy that has kept interest rates low for a long time, fueling U.S. consumer spending, says GFC Economics' Graham Turner, calling it a "critical turning point." The United States is counting on a weaker dollar--but not too weak--to help balance out its boom and its current account deficit with the rest of the world. Jittery markets could trigger a sell-off that nobody wants.--Karen Lowry Miller