The Great Depression's impact was accentuated in Europe by the hammering of the chief currency of the region at that time - the Pound-Sterling. The party to be majorly blamed in this regard - The Bank of France which mismanaged its reserves of the Sterling in the late 1920s and early 1930s. This resulted in large scale contraction of European economies that had a feedback effect on the US. The second crash of the world markets in 1933, post a nascent recovery period from 1929, can be in part attributed to this. Fast-forward to the 21st century, a crisis of similar proportions is unfolding, so is a recovery. Here too is a nation, China, an emerging superpower that has driven itself into a dollar trap and is on tenterhooks as to how to manage its reserves. What China does from here will have implications for the recovery from this crisis and the future of the international monetary system. Through this paper we seek to analyse factors that will influence China's decision making and address 3 key questions. How China can react to this situation and what will be its impact? What lessons can China learn from France's debacle? and What significance it holds for the nascent recovery from the global financial crisis of 2007?
"When you owe your Bank Manager a thousand pounds, you are at his mercy. When you owe him a million pounds, he is at your mercy" - John Maynard Keynes
Introduction
France's foreign reserve management - 1930s
The period during the late 1920s and early 1930s was a period where international cooperation was intertwined with conflict. During this period, the global superpowers Great Britain, the United States and France established a gold exchange standard. The re establishment of the gold exchange standard was discussed vehemently in the Genoa Conference of 1922 and it was taken by the above mentioned superpowers in the late 1920s. It enables central banks in these countries to hold foreign assets denominated in gold convertible currencies as part of their foreign reserves. In each country, parity was constituted between the prevailing currency and gold which was maintained through coordinated action on exchange markets. The gold exchange standard found its backing from the superpowers in order to prevent world deflation by reducing the risk of monetary gold scarcity (BIS 1932, Hawtrey 1922)
France's reserve policy in the gold exchange standard
The Bank of France was a private organization during this period and its motives outlining its reserve policy can be attributed to minimizing the risk of capital loss. Its foreign reserves were allocated between the sterling, dollar and gold. After the franc was stabilized in 1926, the French government mandated the Bank of France to buy foreign exchange on the market, in order to avoid excessive currency appreciation (Blancheton, 2001). Exhibit 1 shows the portfolio composition of the reserves held by the Bank of France. In the late 1920s Bank of France held more than half of the world's volume of foreign reserves.
However, there were some pressing issues with the gold exchange standard. The currency parity with gold established during the stabilisation years was a major cause for concern. It was believed that the sterling which was stabilised at its pre-war gold parity was overvalued compared to currencies like the franc and the reichsmark (Keynes, 1925). Moreover, France along with the United States were criticised for hoarding gold.
Bank of France anticipating a sterling devaluation started rebalancing its reserves portfolio by liquidating its sterling holdings for the dollar and gold. Many theories have been put across for this rebalancing. One clear aim of the rebalancing was to limit the risk of capital loss on its sterling holdings on the account of a highly probable sterling devaluation. Paul Einzig (1932) believed that French monetary authorities were using their reserves as a "fighting fund" in the financial war against Britain. On the other hand, Bouvier (1989) believed that the accumulation of large gold reserves were part of a holistic strategy employed by France to make Paris as a major financial centre. However, the Bank of France could not simply liquidate all its sterling holdings in one-go as it was concerned that its actions would have brought about widespread criticism as well as hastened the fall of the sterling. It started converting its sterling holdings to dollar and gold in the late 1920s at a temperate pace.
Sterling Trap
From 1929 onwards, it became clear that France was trying to offload its sterling holdings in favour of the dollar and gold. Exhibit 1 shows the variation in the portfolio composition of the reserves held by the Bank of France. Exhibit 2 shows decline in the Bank of France's sterling reserves during this period while Exhibit 3 shows the corresponding increase in the dollar reserves. The liquidation of France's sterling holdings expedited the fall of the sterling leading to its eventual devaluation in 1931. The major consequence of the sterling's devaluation was a capital loss of about 2.3 billion francs on the Bank of France's sterling holdings. This loss had a disastrous impact on the Bank of France and it required the support from the French Treasury to cover the losses (Moure, 1991). Furthermore, the Bank could no longer have autonomy over its foreign reserves policy.
One question which is relevant and concerns us in this paper is - If the Bank of France had expected a sterling devaluation, why did they still have to suffer a huge capital loss? This is the quintessential trap that a country which holds a large amount of foreign currencies as part of its reserves finds itself in when the currency is on the verge of devaluation. Any offloading of the currency holdings would hasten the process of devaluation thereby leading to large capital losses. In that scenario, what could a central bank do? Let us examine what the Bank of France did in the 1930s.
The Bank of France had started offloading its sterling holdings from the late 1920s as shown in Exhibit 2. However, it could not go all-out in its off loading for the fear of completing destroying the sterling, incurring massive losses and completely annihilating the international financial system. It had to be prudent in its offloading of its sterling holdings. It was carrying out its offloading in small measures and even had a change in attitude towards the sterling. As seen from Exhibit 2, between October 1930 and June 1931, it stopped offloading its sterling reserves and intervened in the exchange market in those early months to support the sterling. It also granted credit of 25 million pound-sterlings to the Bank of England in July 1931 (Moure, 1991). But all this was not done as a long term measure to prop up the sterling. Bank of France wanted to minimise its risk exposure and began offloading its sterling reserves as soon as the sterling strengthened.
This temporary support for the sterling is clearly in line with what can be expected from a large player in the foreign exchange market who possesses considerable sterling reserves. The Bank of France officials have been quoted as saying that "(we) seized every chance to liquidate our sterling pound holdings but circumstances were far from favouring full implementation of this policy". The Bank further said that it did not want to "provoke the depreciation of a currency in which it had considerable holdings". These responses show that the Bank of France was well and truly caught in the sterling trap and the only option was prudent support of sterling and consequent offloading of sterling reserves in order to limit the capital loss of its reserves.
The lack of cooperation between central banks of the industrialized powers was one of the key triggers of the sterling selloff by France. Central banks were driven by two motives - the first was to minimize capital loss on their positions and the second was a profit motive. The Bank of France's gold policy during times of Gold exchange backed currency has played an equal part in the monetary contraction of the great depression. The sterilization of these gold reserves without expanding money supply led to a sharp upward rise in the price of gold. This fuelled a bubble that very literally burst on the face of Europe deflating the price of the gold and also dragging down the value of the sterling with it. While these served the needs, in times of profit, a genuine value creation need during downturn was not understood. It is anybody's guess as to where the pound sterling may have headed post-the Great Depression. But the untimely hammering of the Pound Sterling by France not only resulted in loss of capital on its portfolio, but also effectively transferred the effect of the declining dollar to the pound and the great depression to the rest of Europe.
What France could have done
France could have obviously sought to reign in a control on the franc by paring it against the pound and rallying. Gold reserves should have been monetized to create money supply. However, this would have fuelled inflation in the short run but would have helped France realize its goal of minimized capital loss in the forex reserves as well as an appreciation of its gold reserves.
Chinese Dollar Trap and Impact on Global Trade
Extent of China's Dollar Reserves and rationale
From the year 2003, China has been accumulating its reserve of dollars by consistently devaluing the renminbi. Labour efficiency in china makes it an attractive destination for FDI and Chinese produce is price competitive thereby making it a highly export oriented economy with huge trade surpluses. This trade surplus allowed China to accumulate dollar denominated reserves and thus buy more political and economic clout in the asian hotch-potch. China's total forex reserves stand $2.5 tn. which is by a distance the largest in the world and more than 60% of this is dollar denominated. China's percentage of world reserves also rose considerably to rech nearly 5% of the entire world forex reserve, putting it in a vantage position. The Exhibits 5,6,7,8 and 9 succinctly sum up the situation of rising reserves, devaluation of the currency as well as the rise in gold prices.
Chinese Dollar Trap
In the early 2000's, China followed an aggressive export-led growth strategy. This was mainly a consequence of the increase in consumption patterns in the US and other Western countries, which led to the increasing demand for Chinese goods and services. As a result, China began accumulating large trade surpluses. This led to an increase in the inflow of foreign capital. Since China's Central Bank, the People's Bank of China (PBOC) decided to follow a fixed-exchange rate system and pegged the Yuan against the dollar, China had to buy out the dollars that were flowing in. This led to an accumulation in foreign exchange reserves to the tune of $2 trillion (around 1/3rd of China's GDP). This "Dollar Trap" offers a risky proposition as the safety of investing in US Treasuries has decreased after the credit crisis. Experts have suggested many ways to escape this dollar trap. China is considering offloading its foreign exchange reserves, but the inflow of such a large amount into the world economy might lead to the devaluation of the dollar, which again would affect China's reserves. In order to avoid this, China is pushing for an alternative form of reserve currency, namely, the SDR (Special Drawing Rights) (Krugman, 2009)
Impact on Global Trade
China has been trying out various escape routes to this dollar trap. This has resulted in a shift in the balance of worldwide trade and is leading to the creation of various imbalances.
World trade is declining at a faster pace, with constantly declining demands for exports. Wade quotes "As of May 2009, some 740 ships lie anchored in Singapore harbour, idle, unable to find cargo". There is a high risk of China dumping the dollar in the US. But, the US has problems of its own in struggling to meet the demand for foreign loans. As a result, the Fed might resort to printing dollars. This would lead to devaluation of the dollar, impacting China adversely. (Wade, 2009)
The credit crisis has affected other large economies as well. Increasing capital flows into China adversely affected trade patterns in Japan, the world's second largest economy. Japan's chief source of exports- the manufacturing industries, declined in growth in December 2008. It was a third lower in December 2008 than in December 2007.
The Chinese Government responded to the crisis by implementing a large stimulus package. Simultaneously, the PBOC brought about an expansionary monetary policy. The government introduced a stimulus package of 4 trillion yuan for 2009 and 2010. Apart from this, provincial governments were also asked to implement bailouts and packages of their own. Around 45% of this investment is in infrastructure. This is primarily in fixed assets and active promotion of public goods. But there is little incentive for local governments to invest in public goods and as a result, more new factories are being built to enhance China's manufacturing capacity. This would only attract more foreign investment into China and would not directly solve the dollar trap problem at hand. (Yu, 2010)
The dollar trap has also severely impacted Taiwan, as it faces further pressure to get incorporated with the Chinese mainland. The Chinese government is pressurizing the US to aid the incorporation of Taiwan in a deal which includes a promise not to dump dollars into the US.
One of the strategies adopted to escape the dollar trap has been promotion of outward FDI in developing countries. China has become the largest source for outbound FDI and it has been investing heavily in countries like Thailand and in Sub-Saharan Africa. The creation of the China Investment Corporation, a sovereign wealth fund to manage China's foreign reserves is seen as a positive step in this direction.
Apart from this, domestic Chinese industries continue to export large volumes of services like shipping and insurance. Large Chinese firms are actively taking part in Mergers and Acquisitions to strengthen their foreign portfolio. An example of this is Lenovo's acquisition of IBM's computing arm. Lastly, Chinese enterprises are seeking to move their factories to more labour intensive countries like Vietnam and Thailand. (Davies, 2009)
Global Imbalances created due to the dollar trap
China's investment of its foreign reserves in US Treasuries helped finance the "twin deficits" faced by the US, i.e. trade and capital deficits. Because of this, China became the largest creditor of the US. As a result, the fortunes of China's accumulating dollars and that of the US are completely intertwined.
In the US, unemployment and house foreclosures continue to rise, depressing the house prices further. As a result, the financial system of the US still remains fragile and there is hope that China would continue to buy US Treasuries, thus preventing the dollar from crashing. But the situation in China is completely contrary, with China looking to diversify its foreign reserves into other stable currencies.
Also, China is investing majorly in countries which provide a stable environment for FDI and have stable currencies. The sectors which it is investing are metal and energy. In the metals sector, China has invested $19.5 billion in the Rio Tinto group, in Australia. In the energy sector, it has signed a $25 million oil pipeline deal with Russia and has provided loans to Russian oil major Transneft. It has also signed a $10 billion agreement with Kazakhstan. (Jiang, 2009)
One way to tackle this crisis was the calling of the G20 summit in London in April 2009. The G20 summit arrived at a consensus on the need for tax havens and transparency in hedge funds. Much discussion took place on an alternate reserve currency, but nothing concrete was proposed in this area. Meanwhile, the US budget deficits continue to rise and China remains reluctant to fund these deficits by buying US Treasuries. This could lead to a great deal of discomfort between the US and China, especially if the US is at the receiving end.
Case for SDR as an International Reserve Currency
What is SDR?
SDRs or Special Drawing Rights are a form of international accounting unit created by the IMF and allocated to member countries. SDRs were initially created in 1969 and were based on gold, just as the dollar was based on gold back then. Currently, the SDR consists of a basket of 4 major currencies - the dollar, the yen, the Euro and the Pound. The SDR basked consists of 0.632 dollars, 0.41 euros, 18.4 yen and 0.0903 pounds. This unit of account is non-tangible and hence, transactions can be carried out in SDRs if both parties agree to it. (McCallum, 2009)
Each member country is allocated SDRs by the IMF. It can convert its available SDRs to currencies of other member countries at prevailing exchange rates. When it does so, it must pay interest to the country from which it is borrowing currency. So ideally, a lender would have SDR surplus while a frequent borrower would have SDR deficits. Presently, the interest rate is around 0.5% but it could vary depending on the financial conditions and interest rate on short-term debt on all the four basket currencies.
China's case for SDR as a reserve currency
In April 2009, Zhou Xiaochuan, Governor of the People's Bank of China issued an essay on "reformation of the International Monetary System". He basically called for the "establishment of a new and widely accepted reserve currency with a stable valuation" to replace the US dollar, the current reserve currency. The PBOC feels that the deficiencies present in a credit-based system such as the dollar would be solved using the SDR as it takes virtually no cost to create or allocate an SDR, while the price to issue and borrow international currency is high. (McCallum, 2009)
Governor Zhou also felt that the non-use of a particular country's currency as a global measure would help the exchange rate system of that particular country to adjust economic imbalances within the country. Apart from this, China also wants an international settlement system to carry out trade in SDR, without involving the concept of interest-rate payments, as these could vary depending on the financial situation. It also wants the IMF to actively promote SDR in trade and bookkeeping, essentially making it an official form of transaction so that most member countries will be pressured into following a similar pattern.
Lastly, it wants the valuation of SDR to be improved and managed by the IMF. This could be done by expanding the existing basket to include currencies of all major economies.
Why does the SDR present a strong case for an international reserve currency?
In the present system, countries without foreign exchange reserves have to accumulate reserves and the adjustment lies in the hands of the countries with a current account deficit. Developing countries would then borrow from developed countries with stable currencies at a higher interest rate. This leads to an increase in consumption in developed countries due to the increase in capital inflow .The instability of the system can be pointed out in the fact that the dollar can be devalued quickly as a result of dumping of excess dollars by countries which have them, like China. This rapid devaluation of the dollar could render the reserves of many countries worthless. (Yu, 2010).
One of the most important advantages of the SDR is the fact that it is low cost and doesn't exist as a tangible unit. Therefore, it would only require commitment from the Central Banks of member countries to accept it as a global currency. As a result, implementation of such a measure can be easily possible without any transaction costs.
Secondly, this would prevent the accumulation of US treasuries as the reserves of different countries. Developed countries would be spared the burden of having to accumulate US Treasury securities for protection.
The fact that a reserve currency exists puts pressure on countries to accumulate that currency. As a result, demand for that currency increases and this impacts its exchange rate. Currently, most of the world's trade is executed using the dollar and its demotion from reserve status would reduce the demand for the dollar drastically. As a result, this might impact the exchange rate value of the dollar and devalue it, which would certainly affect the US. (Smelt, 2009). Also, an international reserve system based on SDRs would allow countries to convert its existing dollar reserves into SDRs, in order to diversify exchange rate risks.
Lastly, in order for countries to place greater trust on SDR as a currency, the basket must be expanded to accommodate currencies of other large economies, in proportional weightage.
What are the factors that work against the SDR?
The SDR essentially is an accounting adjustment unit that allows banks to readjust their forex portfolio. For the SDR to become a vehicle of global investment and to function as a currency, a separate market must be created for the same. This requires the existing forex markets and banks to denominate trades in SDR and for the IMF to control it as a global currency issuing it in times of crisis, increase supply to manage liquidity problems - in short function as a global central bank. To put such measures into place will take a better part of the decade. (Eichengreen, 2009)
If we are to take the SDR's as a solution to the volatility in the dollar in the short run it will mean that nations apart from US and China will have to assume losses in capital value by investing in SDR and see the value of their dollar reserves dip. This may not be an acceptable for players with large dollar reserves - especially India and Brazil. (Yu, 2010)
Therefore, at least in the foreseeable future the replacement of the dollar as a global currency seems highly unlikely and
Lessons for China from France's debacle
The fundamental problem with the dollar trap lies in the fact that the reputation of US as a quality supplier of financial assets has been sullied and US looks to issue debt to the tune of $4tn. over the next few years. These combined effects have weakened the dollar as an investment destination.
The Bank of France, in the 1920s, without the cooperating with the other Central Banks resorted to dumping pounds in the international market in a stop-loss measure. China is in a similar position but there are some critical differences which may enable the Chinese to respond in a proactive fashion without dire consequences for the world economy.
China's trade forms close to 60% of its GDP and politically, the ruling CPC derives its power from the control of both trade and the currency - the weakening of either is detrimental to its state. The PBOC is the financial voice of the government. The PBOC has also signed significant swap deals especially with the Asian tiger economies allowing it to hedge its reserves. China has also realized its potential for expanding investment in strategic reserves of resources like minerals and oil and has taken steps to expand investment in developing nations in Africa.
In the case of France, this difference played a key role as the Bank of France was not under govt. control. The Bank of France looked only to hedge its capital loss and did not cooperate with other central banks to gradually off-load its pound sterling reserves.
If China is to go the route of France and resort to dumping its dollar reserves - it will definitely precipitate the second dip as during the great depression when in 1933 the markets crashed again after a nascent recovery period from 1929.
The chain of events post a dollar dumping by China may look like this: A dip in the value of US govt. securities followed by a general loss in faith in the US govt. to repay its borrowings. The chasm between debt issued and deficit will reinforce the same. This may prompt the US to lower the debt burden on by allowing inflation. Inflation will lead to higher cost of living prompting cuts in consumption. This will lead to a general GDP shrink and demand for imports. This will have a feedback effect on the Chinese economy which is highly dependent on trade to fuel its growth. This will also be couple with loss of capital value in its current forex reserves.
However, a nascent recovery has set in and liberal monetary policy of the Fed has begun fuelling consumption again. Although there is definitely a case for replacing the dollar with a more neutral and less volatile global monetary unit, the phasing out must be smooth.
China has already taken steps towards the same:
China has already drastically reduced its purchase of newly issued US govt. securities.
Is pushing to strengthen the Renminbi as a medium of transaction in trade especially with Asian and African nations.
China is investing its dollar reserves in strategic resources such as oil and minerals in Africa.
China is also pushing steadily for the SDR regime to come in - this will find voice with emerging powers India and Brazil.
China has also entered into numerous "swap deals" with Asian central banks to facilitate offloading US securities from its large SAFE reserves.
China at the moment is highly unlikely to take the route that France did during the 1920s and 1930s - thereby putting to rest fears of a double-dip arising from the Chinese side of the wall.
A question to ponder for China will be the way Japan went in the 1980s.
Japan was one of the largest trading nations with the US at the time. US pressurized japan into appreciating the yen so as to ease the concerns over the dollar valuation. Japanese exports started falling. In order to control the appreciation Japanese started a more liberal monetary policy by lowering interest rates in the system. This brought the exports back up but fuelled a property bubble, which then burst and resulted in the "lost decades". China already has a property bubble going and by not allowing the currency to appreciate it is fuelling domestic inflation. How this will pan out over the next 2-3 years will be crucial to the world recovery from the financial crisis.
Exhibits
Exhibit - 1: Currency composition of Bank of France's reserves (in millions francs)
Source: Bank of France archives
Exhibit - 2: Bank of France's sterling balances (in millions pounds)
Source: Bank of France archives
Exhibit - 3: Bank of France's dollar balances (in millions $)
Source: Bank of France archives
Exhibit - 4: France's Gold Reserves during the Great Depression
Exhibit - 5: China's Forex reserves trend
Source: Seeking Alpha, 2009
Exhibit - 6: China's purchases of US securities
Source: The Asia-Pacific Journal, 2009
Exhibit - 7: China's Forex reserves as a percentage of World Reserves
Exhibit - 8: Gold price trends in China
Source: Market Oracle, 2010
Exhibit - 9: Chinese exports and Imports Data
Source: Setser, 2009
Exhibit - 10: China's development of Steel capacity - overcapacity problem
Exhibit - 11: The "loss of faith" point in the dollar created by US deficit
Source: Yu Yongding, Third World Network.
