Mon, Dec 13, 2004 - Page 9 News List

Call in the reserves

Large holders of US dollar reserves, such as China and Japan, can learn a historical lesson from the nasty fate of big holders of British sterling in the 1920s

By Harold James


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 World War II) but in foreign exchange, especially in British 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 -- India, Egypt and 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.

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