It begins….

The reason the dollar has managed to stay as strong as it has — despite the combination of large trade deficits and low interest rates — is that Asian central banks have been buying up greenbacks. The big question that watchers of global finance have been asking in recent years is: what happens when the Asian central banks stop buying dollars? Steve Johnson and Andrew Balls of the Financial Times suggest that we’re about to find out:

The dollar could slide still further, in spite of hitting an all-time low against the euro last week in the wake of George W. Bush’s re-election, currency traders have said. The dollar sell-off has resumed amid fears among traders that Mr Bush’s victory will bring four more years of widening US budget and current account deficits, heightened geopolitical risks and a policy of “benign neglect” of the dollar. Many currency traders were taken aback on Friday when the greenback fell in spite of bullish data showing the US economy created 337,000 jobs in October. “If this can’t cause the dollar to strengthen you have to tell me what will. This is a big green light to sell the dollar,” said David Bloom, currency analyst at HSBC, as the greenback fell to a nine-year low in trade-weighted terms…. [T]he market has been rife with rumours that the latest wave of selling has been led by foreign governments seeking to cut their exposure to US assets. India and Russia have reportedly been selling US assets, as well as petrodollar-rich Middle Eastern investors. China, which has $515bn of reserves, was also said to be selling dollars and buying Asian currencies in readiness to switch the renminbi’s dollar peg to a basket arrangement, something Chinese officials have increasingly hinted at. Any re-allocation could push the dollar sharply lower and Treasury yields markedly higher.

Brad DeLong has further thoughts on the matter. UPDATE: Do check out the Institute for International Economics web site as well — papers by Fred Bergsten, Catherine Mann, Morris Goldstein, and John Williamson address various aspects of the U.S. curent account deficit. ANOTHER UPDATE: DeLong says I’m oversimplifying things:

The strength of the dollar has been produced by (a) the willingness of someone (mostly Asian central banks) to buy and hold the flow of new dollar-denominated assets held abroad generated by our trade deficit, and (b) the unwillingness of private hedge funds, investment banks, and other investors to place large leveraged bets that the dollar decline has started for real. If the private market–which knows that the dollar is going down someday–decides that that someday has come and that the dollar is going down NOW, then all the Asian central banks in the world cannot stop it. You need both (a) and (b) to keep the dollar up. Just one of them won’t do.

Well, yes… except that the external pressures on a country to stop buying a foreign currency in order to prevent currency appreciation are much weaker than the external pressures on a country to stop selling a foreign currency in order to prevent currency depreciations. My guess is that (b) doesn’t take place until there’s some sign that (a) is about to happen. LAST UPDATE: Some of the commenters are wondering what the big deal is, since, “the value of the dollar remains about 10% ABOVE where it was during the halcyon days of Bill Clinton.” The answer is, possibly, nothing. If the dollar slowly depreciates by about 20-30% over the next year, there’s no reason for concern. And the administration deserves some credit for talking down the dollar while preventing a precipitous fall. The question is whether this will continue as Asian central banks stop buying the dollar in such large quantities.