Do Security Concerns Influence Asian Central Bank Holdings?

By Keith W. Rabin and Scott B. MacDonald

International currency markets remain on edge, worried about the future trajectory of the U.S. dollar and its impact on other major currencies and economies. This concern is compounded by apprehension over what is on the minds of Asian central bankers, who collectively held a combined $2.3 trillion in U.S. dollar reserves at the end of last year.

Announcements by the Bank of Korea and Japanese Prime Minister earlier this year conveying their intention to diversify reserves away from the U.S. dollar rang alarm bells in world financial markets. In recent weeks, however, this anxiety has declined, as the US$ has begun to strengthen, and Treasury Department data reveals that foreign investors bought $91.5 billion in Treasury notes, corporate bonds, stocks and other financial assets in January – nearly a 50% increase over December.

The concern over dollar holdings in any case should be surprising given that a move toward greater central bank currency diversification is inevitable over the longer term. Brazil, Russia, India, China and other emerging economies are expected to grow far more rapidly than the United States in coming decades. Therefore, the U.S. share of global GDP, and the relative importance of its economy, should decline over time. Furthermore, Japan, another mature economy, is likely to show less dependence and correlation to the U.S. moving forward. This is due to increasing demand from Asia as well as ongoing restructuring and the gradual awakening of the Japanese consumer.

While the possibility of a systemic shock cannot be dismissed, it is unlikely this will be due to an abrupt decline in Asian U.S. dollar holdings. The shift toward diversification is not likely to be as fast or traumatic as many forecasters indicate. For one thing, at the present time, it is unclear whether any alternative currencies have sufficient depth and liquidity to absorb inflows of such magnitude. In addition, any rapid move by Asian central banks to diversify from the US$ would serve only to strengthen their respective currencies against the dollar. Their export competitiveness would decline as a result – as would the large amounts of U.S. Treasury Agency securities already in their portfolios – when translated back into the domestic currency in question. As of last December, Japan alone held almost $712, China $194 and Korea $69 billion.

Even if one were to believe that Asian economies could withstand the significant financial ramifications of an overt move away from the U.S. dollar, it is doubtful they would move to do so. The alliances that bind the U.S. to playing a vital security role in that part of the world are becoming increasingly important – at a time when we are seeing increasing signs that the delicate balance that has kept the region relatively tranquil for several decades is starting to become undone. Chinese submarines off the coast of, territorial disputes with, and violent demonstrations against, a Japan more prone to asserting its military power, nuclear tensions with North Korea, several border disputes and saber rattling over Taiwan, are just a few of many issues rising in prominence.

This is not to suggest the existance of a strong quid pro quo, in which U.S. and Asian leaders are closely coordinating and linking economic with security considerations. Rather, as CLSA analyst Christopher Wood highlighted in a recent report, a recognition is developing that “there is clearly a ‘rearmament dynamic’ at work in the East Asian region in the sense that the post-1945 status quo is over”.

As China moves to augment, upgrade and flaunt its military capabilities and to achieve more economic and political stature, Japan, South Korea, and Taiwan, which depend on the U.S. as guarantors of their security, are unlikely to take any steps that might endanger Washington’s ability to sustain its treaty and alliance commitments. Nations such as Thailand and others in Southeast Asia, who also hold significant amounts of U.S. Treasury securities, also benefit from the ability of the U.S. to serve as a counterweight as China continues to transition into an increasingly powerful world leader.

One might also imagine China reluctant to see an economically weakened U.S., pressured to cut back on its security commitments. Such a move would create a number of extremely complicated diplomatic issues and dramatically raise anxiety levels throughout the region. That would make it far more difficult for China to maintain its focus on domestic development, as well as efforts to position itself as the focal point of an integrated, and more financially independent, Asia. To cite one example, a reduced U.S. security presence would increase pressure on China to lead in resolving an already intractable situation in North Korea, a responsibility it has been reluctant to assume.

The economic reasons why Asian central banks will refrain from abandoning the U.S. dollar will diminish over time as regional growth and integration accelerates. That will enhance domestic consumption and demand, as well as a greater emphasis on the services sector. This will serve to alleviate Asia’s traditional dependence on exports and create an increasingly vibrant and attractive new driver of global growth and development.

Economic progress in Asia, however, bolstered by regional integration, remains dependent on the shared sense of national security and confidence necessary to allow sufficient cooperation. Given the diverse range of interests, as well as the numerous wars, skirmishes, and power struggles that have held back development in Asia to the present time, the importance of a U.S. security presence should not be minimized.

The reluctance of Asian economies to abandon the U.S. dollar might be seen as a key reason why the U.S. bond market has been maintaining its strength, and the U.S. dollar -- which has been showing renewed strength in recent weeks -- may not be ready to reverse itself in a precipitous slide – despite renewed signs of weakness and the existence of numerous troubling indicators.

It should be emphasized, however, that the willingness of Asian central banks to maintain their U.S. dollar holdings does not offer a solution to growing fiscal imbalances in the U.S. and related distortions in the global financial system. At best, it only delays -- the risk of systemic shocks, as well as implementation of the structural adjustments necessary to resolve this situation.

Consequently, U.S. and Asian interests remain in lockstep and the status quo is likely to sustain itself for the foreseeable future. This is something nervous currency traders need to remember. At the same time, questionings of this reasoning promise periodic upsets and no end to market volatility. In addition, the potential for an abrupt end to this game of musical chairs should not be discounted. This is true regardless of whether Asian Central Banks maintain their ongoing love affair with the U.S. dollar.

Keith W. Rabin is President of KWR International

Scott B. MacDonald is Senior Managing Director at Aladdin Capital and a Senior Consultant at KWR International