Call in the reserves<\/p>\n
Harold James, Project Syndicate<\/p>\n
The People's Bank of China and the Bank of Japan -- as well as
\nother central banks in Asia -- are in trouble. They have
\naccumulated vast foreign exchange reserves, estimated at more
\nthan US$2 trillion. The problem is that almost all of it is in US
\ndollars -- a currency that is rapidly losing its value.<\/p>\n
All policy options for Asia's central banks appear equally
\nunattractive. If they do nothing and simply hold onto the
\ndollars, their losses will only increase. But if they buy more,
\nin an attempt to prop up the dollar, they will only have a bigger
\nversion of the same problem. If, on the contrary, they try to
\ndiversify into other currencies, they will drive down the dollar
\nfaster and create greater losses. They are also likely to
\nencounter the same sort of problem with other possible reserve
\ncurrencies.<\/p>\n
The euro has been touted as the replacement for or alternative
\nto the dollar. Some enthusiastic Europeans encouraged Asians to
\ndiversify their reserve holdings. But the same scenario might
\nwell be repeated with the euro in a few years. Large fiscal
\ndeficits and slow growth might convince foreign exchange markets
\nthat there is little future in the euro, fueling a wave of
\nselling -- and hence losses for central bank holders.<\/p>\n
There is a historical parallel to today's concern about the
\nworld's major reserve currency. The interwar economy, shattered
\nby the Great Depression of the early 1930s, offers a whole series
\nof painful, but important, lessons for the present.<\/p>\n
In the 1920s, the world economy was reconstructed around a
\nfixed exchange rate regime in which many countries held their
\nreserves not in gold (as was the practice before the First World
\nWar) but in foreign exchange, especially in British pounds
\nsterling. During the course of the 1920s, some of the official
\nholders of pounds grew nervous about Britain's weak foreign trade
\nperformance, which suggested that, like today's dollar, the
\ncurrency was over-valued and would inevitably decline.<\/p>\n
Foreign central banks asked whether the Bank of England was
\ncontemplating changing its view of the pound's exchange rate. Of
\ncourse they were told that there was no intention of abandoning
\nBritain's link to gold, and that the strong pound represented a
\ndeep and long commitment (in the same way that US Treasury
\nSecretary John Snow today affirms the idea of a \"strong dollar\").
\nOnly France ignored British statements and substantially sold off
\nits sterling holdings.<\/p>\n
When the inevitable British devaluation came on Sept. 20-21,
\n1931, many foreign central banks were badly hit and were blamed
\nfor mismanaging their reserves. Many were stripped of their
\nresponsibilities, and the persons involved were discredited. The
\nDutch central banker Gerard Vissering resigned and eventually
\nkilled himself as a result of the destruction wrought on his
\ninstitution's balance sheet by the pound's collapse.<\/p>\n
Some countries that traded a great deal with Britain, or were
\nin the orbit of British imperial rule, continued to hold reserves
\nin pounds after 1931. During World War II, Britain took advantage
\nof this, and Argentina, Egypt, and India, in particular, built up
\nhuge claims on sterling, although it was an unattractive
\ncurrency. At the war's end, they thought of a new way of using
\ntheir reserves: Spend them.<\/p>\n
Consequently, these reserves provided the fuel for economic
\npopulism. Large holders of sterling balances -- Nehru's India,
\nNasser's Egypt, and Peron's Argentina -- all embarked on major
\nnationalizations and a public sector spending spree: They built
\nrailways, dams, steel works. The sterling balances proved to be
\nthe starting point of vast and inefficient state planning regimes
\nthat did long-term harm to growth prospects in all the countries
\nthat took this course.<\/p>\n
Could something similar be in store for today's holders of
\nlarge reserves? The most explicit call for the use of dollar
\nreserves to finance a major program of infrastructure
\nmodernization has come from India, which has a similar problem to
\nthe one facing China and Japan. It will be similarly tempting
\nelsewhere.<\/p>\n
This temptation needs to be removed before the tempted yield
\nto it. Reserve holdings represent an outdated concept, and the
\nworld should contemplate some way of making them less central to
\nthe operation of the international financial system.<\/p>\n
To be sure, reserves are important to smooth out imbalances in
\na fixed exchange rate regime. But the world has moved since the
\n1970s in the direction of greater exchange rate flexibility.<\/p>\n
Reserves are also clearly important for countries that produce
\nonly a few goods -- especially commodity producers -- and thus
\nface big and unpredictable swings in world market prices.
\nDependency on coffee or cocoa exports requires a build-up of
\nprecautionary reserves. But this does not apply to China, Japan,
\nor India, whose exports are diversified.<\/p>\n
Today's big surplus countries do not need large reserves. They
\nshould reduce their holdings as quickly as possible, before they
\ndo something really stupid with the accumulated treasure.<\/p>\n
The writer is Professor of History at Princeton University and
\nauthor of The End of Globalization: Lessons from the Great
\nDepression.<\/p>",
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