Readers of this blog are by now quite familiar with these issues. The US is running unsustainable current account deficits. Asian central bankers are supporting the dollar with massive purchases of Treasury debt (see Brad Setser's blog for detailed analysis), in the interest of protecting their own export-driven economies. (Also see Nouriel Roubini's blog for game theoretic discussion of the world currency regime and "mutual assured destruction" if China and Japan stop buying Treasuries.)
Analysts have often discussed the tremendous paper losses faced by countries like China and Japan if their dollar-denominated FX reserves (approaching the trillion dollar range) were to fall in value. I'm not quite sure how to think about these losses. Take China as an example: dollars repatriated to China by companies are converted back into renminbi, and the PBOC has to issue renminbi-denominated debt to remove the excess currency from the money supply ("sterilization"). This leaves the PBOC with renminbi debt and dollar assets, so dollar devaluation relative to the renminbi makes it hard for the central bank to meet its obligations. Clearly bad for them. As a last resort, though, I suppose dollar reserves can still be used to buy US assets - including technology or natural resources.
In the aftermath of the Plaza Accord of 1985 (see figure) the Yen appreciated by over 100 percent. I would be very interested to know what the consequences were for the BOJ.
