Call In the Reserves

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 $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 1930’s, offers a whole series of painful, but important, lessons for the present.