Call in the reserves

Call in the reserves

Harold James, Project Syndicate

The People's Bank of China and the Bank of Japan -- as well as
other central banks in Asia -- are in trouble. They have
accumulated vast foreign exchange reserves, estimated at more
than US$2 trillion. The problem is that almost all of it is in US
dollars -- a currency that is rapidly losing its value.

All policy options for Asia's central banks appear equally
unattractive. If they do nothing and simply hold onto the
dollars, their losses will only increase. But if they buy more,
in an attempt to prop up the dollar, they will only have a bigger
version of the same problem. If, on the contrary, they try to
diversify into other currencies, they will drive down the dollar
faster and create greater losses. They are also likely to
encounter the same sort of problem with other possible reserve
currencies.

The euro has been touted as the replacement for or alternative
to the dollar. Some enthusiastic Europeans encouraged Asians to
diversify their reserve holdings. But the same scenario might
well be repeated with the euro in a few years. Large fiscal
deficits and slow growth might convince foreign exchange markets
that there is little future in the euro, fueling a wave of
selling -- and hence losses for central bank holders.

There is a historical parallel to today's concern about the
world's major reserve currency. The interwar economy, shattered
by the Great Depression of the early 1930s, offers a whole series
of painful, but important, lessons for the present.

In the 1920s, the world economy was reconstructed around a
fixed exchange rate regime in which many countries held their
reserves not in gold (as was the practice before the First World
War) but in foreign exchange, especially in British pounds
sterling. During the course of the 1920s, some of the official
holders of pounds grew nervous about Britain's weak foreign trade
performance, which suggested that, like today's dollar, the
currency was over-valued and would inevitably decline.

Foreign central banks asked whether the Bank of England was
contemplating changing its view of the pound's exchange rate. Of
course they were told that there was no intention of abandoning
Britain's link to gold, and that the strong pound represented a
deep and long commitment (in the same way that US Treasury
Secretary John Snow today affirms the idea of a "strong dollar").
Only France ignored British statements and substantially sold off
its sterling holdings.

When the inevitable British devaluation came on Sept. 20-21,
1931, many foreign central banks were badly hit and were blamed
for mismanaging their reserves. Many were stripped of their
responsibilities, and the persons involved were discredited. The
Dutch central banker Gerard Vissering resigned and eventually
killed himself as a result of the destruction wrought on his
institution's balance sheet by the pound's collapse.

Some countries that traded a great deal with Britain, or were
in the orbit of British imperial rule, continued to hold reserves
in pounds after 1931. During World War II, Britain took advantage
of this, and Argentina, Egypt, and India, in particular, built up
huge claims on sterling, although it was an unattractive
currency. At the war's end, they thought of a new way of using
their reserves: Spend them.

Consequently, these reserves provided the fuel for economic
populism. Large holders of sterling balances -- Nehru's India,
Nasser's Egypt, and Peron's Argentina -- all embarked on major
nationalizations and a public sector spending spree: They built
railways, dams, steel works. The sterling balances proved to be
the starting point of vast and inefficient state planning regimes
that did long-term harm to growth prospects in all the countries
that took this course.

Could something similar be in store for today's holders of
large reserves? The most explicit call for the use of dollar
reserves to finance a major program of infrastructure
modernization has come from India, which has a similar problem to
the one facing China and Japan. It will be similarly tempting
elsewhere.

This temptation needs to be removed before the tempted yield
to it. Reserve holdings represent an outdated concept, and the
world should contemplate some way of making them less central to
the operation of the international financial system.

To be sure, reserves are important to smooth out imbalances in
a fixed exchange rate regime. But the world has moved since the
1970s in the direction of greater exchange rate flexibility.

Reserves are also clearly important for countries that produce
only a few goods -- especially commodity producers -- and thus
face big and unpredictable swings in world market prices.
Dependency on coffee or cocoa exports requires a build-up of
precautionary reserves. But this does not apply to China, Japan,
or India, whose exports are diversified.

Today's big surplus countries do not need large reserves. They
should reduce their holdings as quickly as possible, before they
do something really stupid with the accumulated treasure.

The writer is Professor of History at Princeton University and
author of The End of Globalization: Lessons from the Great
Depression.