IT HAS BEEN a turbulent week in Asia's foreign exchange markets. Rumours, hastily denied, that Asian central banks were planning to sell US dollars sent the American currency into a tail-spin on Tuesday.
Then, news leaked out of a closed-door meeting in Bangkok of something called the Asian Bellagio Group, a secretive gathering of regional finance ministry officials and central bankers.
For many foreign exchange dealers, this seemed to confirm their worst fears: a sinister conspiracy among Asian governments to manipulate the world's currency markets. Rumours swirled: some claiming Asia's central banks were collaborating to support the US dollar, others that they had agreed to let the greenback slide.
As usual, almost all the talk was baloney. There is no sinister conspiracy and no wholesale desertion of the US dollar. For the time being regional central banks will go on resisting the appreciation of their own currencies. They will continue to accumulate foreign reserves - adding to the US$3.8 trillion worth they already have - and they will continue to hold almost all that money in US currency.
It is true that the Bank of Korea said it had plans to diversify its US$200 billion of reserves, and it is also true that the Asian Bellagio Group met in Bangkok, but neither of these events means much. However, it says a lot about the jittery state of financial markets that a few lines in the annual parliamentary report of the Bank of Korea and an obscure economics discussion group can trigger a rout in the currency of the world's richest economy.
The cause of the jitters is the huge pot of foreign exchange reserves that Asia's central banks have accumulated since the regional crisis of the late 1990s. In the face of weak demand at home, regional governments have sought to generate jobs by encouraging exports. To keep their exporters competitive, central banks have bought the dollars their exports earn, selling their own currencies in return. Until now, the policy has worked a treat.
Increasingly, however, the central banks are facing the problem of what to do with all that stockpiled money. Traditionally, central banks have parked their reserves in the safest of all havens, US Treasury bonds. In the past few years, massive buying of US government debt by Asian central banks has been instrumental in funding the budget deficit run up by Washington.
That demand has also helped keep a lid on long-term US interest rates, which in turn has encouraged US consumers to max out their credit cards on Asian-made goods, exacerbating the US$2 billion-a-day US current account deficit.
In return, Asian central banks earn a measly 4.25 per cent yield. Their reserve managers would dearly love to diversify away from US federal debt, both to enhance returns and spread risk, but diversifying is far more difficult than most foreign exchange dealers believe.
When the Bank of Korea said it wanted to diversify, it was talking mainly about buying US 'agency debt' - bonds issued by bodies such as mortgage lender Freddie Mac, which are perceived to carry a federal guarantee.
Asian central banks have bought a lot of agency debt over the past couple of years, and even some bonds issued by the most credit-worthy US blue-chip companies. According to some estimates, they now hold between 15 per cent and 20 per cent of their reserves in such debt, which earns them a small yield pick-up over government paper. What they have not done is buy much debt denominated in currencies other than the US dollar.
Although foreign exchange traders live in perpetual fear that Asia's central banks will switch their reserves from dollars into euros, the truth is that they cannot, at least not in major amounts. There simply is not enough high-grade European debt out there to satisfy Asian demand, and with German government bonds yielding below 4 per cent, the returns are hardly attractive. Asia's central banks have bought some euros in recent years, helping to push the European currency higher. But they still hold almost all their reserves - between 70 per cent and 90 per cent - in greenbacks, and that will not change any time soon.
One day, Asian central banks will have to stop accumulating reserves at such a furious pace and allow their currencies to rise. To carry on buying US dollars and in return creating domestic liquidity in their own currencies risks fuelling inflation, as is emerging in India, or asset bubbles, as in Shanghai property or the Korean stock market.
But the crunch point is a long way off, and one theme highlighted at the Bellagio meeting was that there is little appetite yet for an agreement among Asian policymakers to allow their currencies to rise in concert against the US dollar. Such an agreement may be struck one day, but not until China is prepared to let its own currency rise significantly, and there are no signs that will happen this year.