Moves to calm markets as Koizumi comments send dollar falling

Financial Times ^ | 11MAR05 | David Pilling in Tokyo and Song Jung-a in Hong Kong

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Japan's finance ministry moved swiftly to calm markets yesterday after the dollar tumbled and Treasury yields climbed on comments made by Junichiro Koizumi, prime minister, about diversification of the country's foreign currency reserves.

Asked by a parliamentary committee about government policy on Japan's $840.6bn of foreign reserves, Mr Koizumi said: "I believe diversification is necessary." Markets reacted sharply to his comments, sending the euro to a two-month high of $1.3456 against the dollar.

Ten-year Treasury yields reached a seven-month high at 4.57 per cent on the news. Japan holds massive amounts of Treasuries as a result of its currency interventions and any diversification of its reserves is likely to involve scaling back its holdings.

Investors fear this would weaken bond prices and lift yields, raising US borrowing costs. Peter McTeague, strategist at RBS Greenwich Capital, said trading volumes of US Treasuries jumped and investors suffered a "wild ride" in Asian trading hours.

Japan's finance ministry was swift to quash any suggestion that policy had changed.

Mastatsugu Asakawa, director of the foreign exchange division at the ministry, denied Japan's policy had shifted. "We have never thought about currency diversification," he said, adding that Mr Koizumi was referring to asset-class diversification within a particular currency.

"The prime minister's response was very clear. He did not say anything about his intention to diversify our foreign reserves in terms of currency," said Mr Asakawa. "He said something in general - that, from a risk management perspective, obviously diversification is needed."

However, the episode emphasised market sensitivity to any hint that Asian central banks are considering diversifying their massive dollar holdings, which have built up after unprecedented levels of intervention.

Last month currency markets were sent into a spin and Treasury yields rose after officials in South Korea suggested it might be contemplating a more diversified foreign currency strategy. Yesterday Park Seung, governor of South Korea's central bank, underlined Seoul's concern about dollar weakness when he called for international action to counter a sharp appreciation of the won.

Although the market remains sceptical of imminent Japanese diversification, Tony Norfield, global head of foreign exchange strategy at ABN Amro, said any debate in Japan about its reserves would "put the spotlight on the dollar".