China's monetary authorities at the People's Bank of China (PBC) are well aware of the "dollar trap". Its huge foreign exchange reserves at US$2.65 trillion are the largest in the world. At least one-third of that is denominated in U.S. Treasury Securities as shown in the graph below.

If the PBC decided to rapidly unwind its U.S. dollar position it would result in a "mass depreciation" reminiscent to that experienced by the Banque de France in the 1930s when it held half of the world's foreign exchange reserves.

Chinese officials have made a series of tentative steps towards diversifying out of the U.S. dollar. They have:

• Called for replacing the U.S. dollar with a "super sovereign reserve currency" comprised of a basket of national currencies.
• Increased the gold reserves of the PBC to 1054 tonnes becoming the seventh largest single holderof bullion.
• Made announcements indicating a continuation of the policy to buy gold from domestic producers and hinted at the possibility of making open market purchases.
• Domestically encouraged the citizens of China to purchase gold and silver.
• Stopped increasing its exposure to U.S. treasury securities since July 2009 (see chart above).
• Replaced expiring long-term U.S. securities with those with a shorter term.
• Arranged six bilateral currency swap agreements worth 650 billion yuan.

Foreign exchange reserves were initially proposed as a means to address the perception of the quantity of gold being insufficient for supporting global trade. The U.S. dollar is the preferred currency of the world for both historical and practical reasons. It was the last currency to remain on the gold standard and, through the spectre of the Bretton Woods Agreements of 1944, the majority of international transactions remain U.S. dollar denominated.

Since the mid-1970s the United States has exported its dollars for goods and incurred a negative balance of payments year after year for nearly four decades. Under the classical gold coin standard (pre-1914), a negative trade balance would have depleted domestic gold holdings. As a result of domestic gold becoming more scarce, its value increases, resulting in lower prices. Through this process, the citizens of the United States would have found it agreeable to increase the amount of exported goods in exchange for gold due to its increased purchasing power. However, because the dollar is a fiat currency, made legal tender by government decree, the U.S. Federal reserve is simply able to print more currency and the imbalances are allowed to continue.

Every economic boom born from an expanding money supply proceeds this way until an inevitable collapse of confidence occurs and the public rushes for value. In the 1930s, when the Bank of England repudiated its obligation to redeem pound sterling in gold, the value of the British currency fell violently and those who held onto sterling-denominated holdings suffered greatly.

In the 1970s when the United States stopped honouring the convertibility of dollars into gold at the rate of $35/oz, the cost of its default was carried by the public in the form of rapidly escalating prices for goods and services, which continued well into the 1980s.

Foreign exchange reserves, often promoted as a stabilizing factor, are in actuality, a destabilizing force. A large accumulation of any fiat currency becomes a burden to the holder as it cannot be quickly unwound without driving the value of the currency down and precipitating the loss of capital that the holder is trying to avoid.

To accumulate a large foreign exchange requires a persistent surplus of goods being exported to the country issuing the reserve currency. This results in a lower standard of living for the citizens of the country producing the goods for export, as they do not enjoy the fruits of their labour. This would not necessarily be such a problem if the money received for these goods represented real wealth which could be used to purchase different goods at a later date. However, in today's world of fiat currencies, where paper money can be printed without limit, the analysis of trade becomes a bit more convoluted.

The holder of the foreign exchange reserve must act at some point to capture the saved purchasing power of the accumulated currency while it still has a measure of purchasing power.

Otherwise, they will be left holding on to worthless, coloured pieces of paper.

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© 2009 DollarDaze

ABOUT THE AUTHOR

Mike Hewitt is the editor of DollarDaze.org, a website pertaining to commentary on the instability of the global fiat monetary system and investment strategies on mining companies. His website also provides a no-cost market data feed service with up-to-date quotes on currency exchange rates, commodity prices and major indices. Mike can be emailed at mikehewitt@hotmail.com.

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Posted in Monetary Commentary, Mike Hewitt