China’s huge volume of dollar reserves is now at the centre of serious concerns about the future of the US currency. The origin of this situation dates back to the early 2000s, after the East Asian and Russian crises. At that time, accumulating foreign reserves was considered benign policy. Developing and emerging countries were encouraged in this way in order to insure against sudden reversals of capital inflows. China was pegging its currency against the dollar and, due to the US trade deficits, started acquiring US assets.
Ten years on, the People’s Bank of China (PBOC) has an extraordinary stock of dollars, and one pressing question: “What to do out of them?” Increasing political tensions have given rise to fears that it might get rid of this huge bulk of securities and precipitate a dollar crash. In August 2007, a Chinese official indeed reminded that Beijing was in a position to provoke a “mass depreciation” of the dollar if it decided to do so. Recent suggestion by Zhou Xiaochuan that China’s central bank might shift from the dollar has put the issue on newspapers’ headlines once again.
But bold statements are one thing, and actual policy another. Up to now, China’s authorities have shown few signs of attempting to weaken the dollar. The reason for this seems straightforward. After all, China is the world’s largest dollar investor, and no one else would have less interest in seeing the value of the US currency plummet. The PBOC might be the promptest to support the dollar, not least because it would suffer a huge capital loss in the event of a dollar depreciation. In a recent New York Times column, Paul Krugman argues that China has “driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”
This situation might appear unprecedented. But in truth, all this is not brand-new.
French foreign reserves policy during the Great Depression
Economic history offers one striking example of a country being trapped by the huge volume of its foreign reserves. This country was France, the period was the early 1930s, and the currency at stake the pound sterling. The episode ended up dramatically. Sterling suffered a major currency crisis, French authorities lost a lot of money, and their subsequent policy largely contributed to the Great Depression.
The origin of the problem lay in the government’s decision of 1926 to peg the franc to the sterling and dollar, two years before re-establishing the gold standard. Since the trade balance was in surplus and capital was flowing into the country, this goal was achieved through public purchases of foreign exchange. The Bank of France therefore accumulated a bulging portfolio of foreign holdings. At the end of the 1920s, the country held more than half of the world’s volume of foreign reserves.
French policy over subsequent years has been heavily criticized for being destabilizing. British contemporaries, like Paul Einzig, accused France of using its reserves in order to weaken the pound before the sterling crisis of September 1931. Others have noted that French conversions of foreign assets into gold after 1931, by imposing constraints on their money supplies, put intense deflationary pressures on other countries on the gold standard.
France’s Sterling Trap in 1931
Why did France engage in a policy that had such dramatic consequences? In a recent work, I explore the motivations behind the French reserves policy of this period. Spending time in the archives, I was able first to reconstitute the evolution of the reserves currency composition, and second, to identify the reasons invoked for the allocation decisions. Last, I have combined this information with market indicators of the perceived risk of reserves currencies.
France’s problems were similar to those of China today. The Bank of France was a private institution and its primary objective was to avoid capital losses. Its reserves were allocated between sterling and dollar. From 1929 to 1931, there were fears that the pound might be devalued and the Bank started shifting to the dollar (figures 1 and 2).
Figure 1. Bank of France’s Sterling Reserve (in millions of pounds sterling), 1928-1936
Figure 2. Bank of France’s Dollar Reserve (in millions of US dollars), 1928-1936
Source: Bank of France’s archives.
However, in implementing this policy, the Bank was also constrained by its position as a large player on the exchange market. So, as sterling’s weakness worsened at the end of 1930, the Bank was in a trap: it could not continue selling pounds without precipitating a sterling collapse and a huge exchange loss for itself. The only workable option left was to support the pound. French policy therefore suddenly turned cooperative. The Bank halted the sterling liquidations, and even intervened on the market in order to support the British currency.
When the pound eventually collapsed, the Bank of France was put into a state of technical bankruptcy. It was only able to survive thanks to a state’s rescue, obtained under tough conditions. Moreover, there were now rising fears over the dollar. The will to avoid further losses therefore led authorities to convert all their dollar assets into gold (figure 2), a policy that heavily contributed to the global monetary contraction of the 1930s.
Lessons for today?
What are the lessons for today? China’s objective function today certainly differs from those of France in the interwar years. But French experiences in the early 1930s are a reminder that when there is growing risk on reserves currencies, foreign reserves can be both a source of instability for the international monetary system, and a burden for large holders.
Accominotti, O., 2008, “The Sterling Trap: Foreign Reserves Management at the Bank of France, 1928-1936”, forthcoming European Review of Economic History.
Einzig, P., 1932, Behind the scenes of international finance, London: Macmillan.
Krugman, P., “China’s Dollar Trap”, New York Times, 2 April 2009
“China threatens nuclear option-of-dollar-sales”, Daily Telegraph, 10 August 2007