"It's a Trap" Part I - Sterling Trap

Admiral Ackbar where are you when the world needs you? China has increased their foreign reserves to over $2.4 TRILLION at the end of 2009 up from $1.9 TRILLION dollars on September 2008 (over half in US Dollars). The Financial Times claims this partly comes from the Euro and Yen declining. Nevertheless, this is shocking.

China previously has called for a new international currency reserve to replace the dollar, and yet, continues to acquire dollars (Treasury Bills) to increase reserves. A March 23, 209 NY Times article articulated Chinese concerns:

"Nicholas Lardy, an economist and China specialist at the Peterson Institute in Washington, said that through its proposal, China was indicating that the dollar’s long dominance was unfair, allowing the United States to run huge deficits by borrowing from abroad, and that the risks to holders of Treasuries were growing.

'Chinese are quite concerned that the large U.S. government deficits will eventually lead to inflation, which will erode the purchasing power of the dollar-denominated financial assets which they hold,' Mr. Lardy said. 'It is a legitimate concern.' "

Paul Krugman (not necessarily my favorite economist) provided some background in an April 3, 2009 NY Times Article:

"In the early years of this decade, China began running large trade surpluses and also began attracting substantial inflows of foreign capital. If China had had a floating exchange rate — like, say, Canada — this would have led to a rise in the value of its currency, which, in turn, would have slowed the growth of China’s exports.

But China chose instead to keep the value of the yuan in terms of the dollar more or less fixed. To do this, it had to buy up dollars as they came flooding in. As the years went by, those trade surpluses just kept growing — and so did China’s hoard of foreign assets."

I wish there was an example from history we could examine to enlighten us all. Teh internets (sic) save the day once again!

Post WWI was a time with great economic uncertainty. Governments were mostly adhering to a gold standard for their currency valuations and France's goal was to become a financial power house. Some guy named John Maynard Keynes in "Essays of Persuasion- Open Letter to the French Minister of France" noted that France was experiencing a large trade outflow and foreign investment inflow. France's government was artificially keeping internal prices low. France achieved this by diversifying reserves with foreign currency focused on dollars and the sterling.

France accumulated over half of the world's reserves by the 1920's. Confidence in the Sterling and, later, the dollar eroded forcing France to attempt to diversify their reserves, converting into gold assets. Because reserves were concentrated in these two particular currencies at such magnitudes, France could not diversify without accepting a huge loss and crippling other currencies (oh yeah and eventually it's own). IT WAS A TRAP!

If you have dusted your statistic skills off lately, please read Olivier Accominotti's paper "The Sterling Trap Foreign reserves management at the Bank of France, 1928 – 1936"

It explains The Sterling Trap in great detail and makes my skin crawl.

Let's examine the best investment strategies during the depression:

Pay down debt

Investments during German hyperinflation

Stocks

We'll look at Japan's Trap in Part II

Now for some Admiral Ackbar outtakes: