Dollar scare highlights
cracks in the U.S.
currency policy

NEW YORK » Most American investors have never heard of Park Seung, but he might have more influence over your portfolio than you think.

He's the governor of the Bank of Korea -- the Alan Greenspan of Seoul -- and a line from a statement issued by his office this past week helped send U.S. stocks to their biggest one-day plunge since May 2003. The suggestion that South Korea might diversify its currency holdings away from the greenback -- later retracted -- also rattled the bond market, sending interest rates higher and the price of dollar-denominated assets like gold and oil soaring.

The incident underscored the vulnerability of the dollar and exposed cracks in the U.S. currency policy, an issue analysts say is getting harder to ignore. It also suggests that if current conditions persist, more rough trading days lie ahead.

"It's the butterfly effect. All these markets are very intertwined, and events you think should have no impact on your portfolio suddenly do," said Kenneth McCarthy, chief economist at the Center for Innovative Entrepreneurship, a non-profit group.

The dollar has served as a reserve currency for much of the world since World War II, but its nearly three-year decline has led many central banks to consider diversifying into other types of money, especially in the face of a more valuable euro. What's stopping them, analysts say, is that a sharp decline in the dollar would have a cataclysmic effect on the U.S. economy, which could dry up the market for Asian-made goods.

"I think this question of diversifying out of the dollar is on the minds of many central banks, but they don't want to say it," McCarthy said. "The last thing you want to do is trigger a sell-off of the dollar. Nobody wants to do that."

For America, a hearty foreign appetite for U.S. assets and debt is critical to help cover the record-high current account deficit.

Some 43 percent of all U.S. Treasuries and bonds are held by foreigners. But economists, even Greenspan himself, have worried that at some point the central banks -- particularly those in Asia, the biggest investors in U.S. debt -- might start selling U.S. dollars.

This isn't a new concern. But when South Korea, with the world's fourth-largest foreign exchange reserve, said in a parliamentary report it might consider diversifying its currency holdings, it caused "a panic in the markets," McCarthy said, as large hedge funds and other powerful speculators rushed to take advantage of the situation.

In the resulting frenzy Tuesday, the dollar, which had been on the rise and seemed to be stabilizing, plunged, giving incentive to anyone who wanted to sell, and launching programmed trades for those who had shorted it.

Oil prices surged as market participants bet the Organization of Petroleum Exporting Countries might cut production at its meeting next month to raise crude prices and offset the decline of the dollar.

The cartel's president has said this is unlikely; oil prices are already 50 percent higher than they were a year ago, despite the fact that domestic fuel supplies are well above last year's levels.

South Korea's central bank governor attempted to clarify his country's position in the ensuing days, saying it had no plans to sell existing dollar assets, though it might use new reserves to diversify into British pounds or Canadian dollars. Japanese finance officials said they weren't planning major changes to their currency asset mix, either.

The bottom line, analysts say, is that Tuesday's trading was mostly driven by speculation. But while the panic has subsided, and stocks have recouped some of their losses, the event has resonated among market watchers. Some economists say that even if Korea makes only marginal changes, it could have significant ripple effects. The market's reaction on Tuesday serves as a further signal that the current arrangement -- relying on Asian central banks to forestall the dollar's slide -- is unsustainable.

If central banks in Japan, Taiwan and Korea all made changes at once, some analysts argue, it could cause China to re-evaluate its currency policy, because it would wind up having to buy even more dollars than it does now to maintain the yuan's peg to the U.S. currency. In this regard, China has "painted itself into a corner," said Peter Morici, a business professor at the University of Maryland.

What makes China "the kingpin," in the situation, Morici said, is that it has been the most active in buying U.S. debt. As of last year, China was spending 12 percent of its gross domestic product on foreign securites -- much of it U.S. assets.

It's unlikely China will dump its dollar reserves, Morici said, because that would cause a financial crisis that would disrupt its trade with the United States, cause massive unemployment in China and ultimately threaten the stability of the communist regime. But sooner or later, China will have to take steps to revalue its currency.

Over the long term, that could bring higher interest rates in the United States, and in turn, declines in the housing market. In the short term, speculation about what lies ahead will likely mean more volatility in stocks. For small investors, the best way to deal with it is to stand firm, McCarthy said.