Foreign Exchange Market

Central bankers caught in a trap of their own making

PUBLISHED : Friday, 23 May, 2008, 12:00am
UPDATED : Friday, 23 May, 2008, 12:00am

At some point this month, and very likely today, the foreign reserves of the East Asian region will cross the US$4 trillion mark.

This event will not be marked by a big bang; there will be no fireworks and no sudden cheering. None of these things happened when this figure first crossed the US$1 trillion mark seven years ago and they will not happen now. The occasion will go entirely unremarked.

But in years to come people may look back and say, 'What was in their minds to take such a vast amount of their money for which there were plenty of good uses at home and invest it all abroad in countries that had much less need of it, mostly in the United States, which just wasted it on military adventurism?'

The answer to this question is that conceited finance ministers and central bankers in much of Asia think that they are stronger than the immutable laws of the workings of the balance of payments and can do with money what no-one has done before them.

Their predecessors thought so too in the early 1990s. For various reasons they wanted their currencies to be strong against the US dollar, stronger than the underlying performance of their economies warranted or than normal trade and investment pressures would otherwise have permitted.

They succeeded for a while in rigging the exchange value of those currencies and collecting the usual plaudits for economic miracle from the international agencies that specialise in this form of flattery.

But they couldn't keep it up and when investment speculators finally swooped in the certainty that their prey was much weakened, we had the 1997 Asian financial crisis with currency collapses across the region and much financial distress.

The speculators were blamed for it of course and the finance ministers and central bankers set to making sure it couldn't happen again. As they weren't ready to concede why it had happened in the first place, however, they made much the same mistakes they had been made before.

First of all, they were determined that they would build up foreign reserves to unprecedented levels as a defence against speculators, which they indeed have done, as the chart and table make apparent.

They were helped by the fact that the entire region embarked on an enormous trade boom shortly afterwards. The net export proceeds were quickly sterilised, mostly with the issuance of local currency debt instruments, and then sent back abroad as foreign reserves.

But these proved to be the wrong defence for the new circumstances. Rather than come under pressure to weaken, most Asian currencies came under pressure to strengthen from 2002 onwards as the US dollar began to show its own distinct weaknesses. Big foreign reserves help as a defence only when defending against currency weakness.

And this time the central bankers actually wanted currency weakness against the US dollar. They were worried that currency strength would sap their export industries. They wanted to follow the US dollar down.

But there was not much they could do. They had to continue piling up foreign reserves or their currencies would begin to strengthen against the dollar. What is more, as these reserves built up, any currency strengthen would give foreign exchange losses on their foreign currency holdings.

And this is the fix they are still in. The export boom is still on across the region, the reserves are still mounting, to enormous levels now, and central bankers are pondering how they got into this dilemma and how they can possibly get out.

They probably cannot. Their conceits about their own powers led them into the trap. If they want to act like big swinging dealers instead of careful monetary authorities this is the price they pay.