And the dollar watch starts for 2006

The Financial Times has two reports that provide contradictory signals on what the Pacific Rim economies will be doing about the dollar. On the one hand, Geoff Dyer and Andrew Balls report that China is planning on diversifying its foreign reserve holdings away from the dollar -- really: China indicated on Thursday it could begin to diversify its rapidly growing foreign exchange reserves away from the US dollar and government bonds ? a potential shift with significant implications for global financial and commodity markets. Economists estimate that more that 70 per cent of the reserves are invested in US dollar assets, which has helped to sustain the recent large US deficits. If China were to stop acquiring such a large proportion of dollars with its reserves ? currently accumulating at about $15bn (?12.4bn) a month ? it could put heavy downward pressure on the greenback. In a brief statement on its website, the government's foreign exchange regulator said one of its targets for 2006 was to ?improve the operation and management of foreign exchange reserves and to actively explore more effective ways to utilise reserve assets?. It went on: ?[The objective is] to improve the currency structure and asset structure of our foreign exchange reserves, and to continue to expand the investment area of reserves. ?We want to ensure that the use of foreign exchange reserves supports a national strategy, an open economy and the macro-economic adjustment."Here's a link to China's State Administration of Foreign Exchange, but damn if I can find the announcement in question. On the other hand, Song Jung-a reports that South Korea is moving in exactly the opposite direction: South Korea?s finance ministry said on Friday it would mobilise all possible means to curb the won?s recent sharp appreciation against the US dollar. The statement came a day after the currency hit an eight-year high against the greenback, intensifying concern among government officials that the stronger won could hurt exports, which account for more than a third of Asia?s fourth-largest economy. ?We?re deeply worried about moves in the foreign exchange market that can?t be seen as normal,? said Kwon Tae-shin, a vice finance minister, after chairing an emergency meeting with central bank and trade ministry officials and other regulators. ?The market has seen an excessive herd mentality because of speculative forces.? Mr Kwon said the government would look into speculative trading forces and further ease regulations on overseas investment as part of efforts to spur dollar outflows from the country. The government will immediately raise the ceiling on individual overseas investment from US$3m to US$10m and double the amount that individuals can spend to buy overseas property to US$1m, with an aim to completely abolish the ceilings within this year. ?In case the market fails to return to normal on its own, we will seek stability through cooperation with relevant government agencies,? the finance ministry said in a statement. China's dollar position is more significant than South Korea's, but my bet is that Beijing will move as slowly as possible in its diversification -- which means that South Korea's move in the opposite direction could leave the dollar pretty much where it is now. This, by the way, is the dream scenario for China -- it can comply with U.S. requests, diversify away from an asset that will fall in the future, and still have the dollar be relatively strong against the yuan in the short term. Click over to Brad Setser for more dollar analysis -- but be sure to read his list of what he got wrong (and right) about the dollar last year.