TECHNOCRATS in emerging market countries have typically viewed foreign exchange reserves as money in the bank, the more, the better. Over the past three decades, a shift to flexible exchange rate regimes and an ability to borrow in domestic currency eased pressure on industrial countries to accumulate reserves.
Meanwhile, emerging market and developing countries continued to struggle with maintaining adequate reserve levels. Only recently has the large scale of reserve accumulation in emerging markets raised questions about its necessity and even its wisdom.
The most obvious reason for an emerging market economy to hold a stock of foreign exchange reserves is to insure against currency crises. But there are a number of other reasons as well. Central banks can use reserves for intervention in non-crisis times. Economies with rigid declared exchange arrangements such as pegs or crawling bands and in fact, many countries with flexible declared exchange arrangements intervene to reduce volatility or maintain a target exchange rate such as in Malaysia.
If the currency is fundamentally near equilibrium but volatility remains high, intervention may be in two directions, resulting in little net change in reserve holdings.
Intervention can also act as a tool against deflation, both by mitigating nominal appreciation, and unsterilised, by expanding the money supply. Central banks in dollarised financial systems on the other hand may need foreign exchange reserves to serve as a lender of last resort to banks with high levels of foreign currency liabilities.
Central banks may desire to provide liquidity to banks in foreign currency outside periods of systemic crisis, due to the unique nature of the risk of bank runs, the mere presence of reserves may ensure that the need to use them never arises. Reserves are also used for day-to-day transactions such as purchases of foreign goods or payment of obligations to international organisations.
Reserve growth of the largest holders has significantly accelerated from previous patterns of accumulation, and in nearly all instances exceeded standard benchmarks for reserve adequacy. But there is a cost to holding large amount of reserves. These include sterilisation costs, risk to the Central Banks Balance sheet and false sense of security costs.
Sterilisation neutralises the inflationary monetary impact of reserve accumulation by offsetting the associated increase in money supply with a domestic money market operation, typically domestic debt issuance. Two costs of sterilisation merit concern, the direct fiscal cost to the monetary authorities and the indirect systemic cost of preventing current account adjustment, with the direct cost being the most commonly considered. Fiscal cost represents the difference between what the central bank earns on international reserves and what it pays on the domestic debt issued to sterilise the reserves. By stifling the monetary impact of foreign exchange intervention, sterilisation allows a central bank to influence the real exchange rate.
The practice of preventing upward real exchange rate adjustment, made feasible through sterilisation, can be harmful by distorting the price signal for resource allocation.
It can lead to overinvestment in tradable sectors at the expense of non-tradables, thus exacerbating the pain in particular for resource cursed economies.
Central bank balance sheet risk
Foreign exchange reserves, just like any other foreign currency asset, can lose their value in local terms when the exchange rate appreciates. In cases where foreign assets form a large share of a central bank’s balance sheet, the institution faces the risk of significant losses.
Of course, a central bank may account for these losses over several years, depending in part on the maturity profile of its foreign assets and on the pace of appreciation. Furthermore, as long as interest margins and cash flows remain positive, it may be feasible for central banks to operate with negative capital for a considerable period.
However, leaving itself undercapitalised could in time jeopardise the central bank’s credibility and ability to target price stability, to intermediate government foreign borrowing, to act as lender of last resort, or to maintain a domestic payments system. This represents a particular risk for central banks with expectations of high future expenses, such as large interest-bearing liabilities or a potential bank bail-out.
False sense of security costs
Reserve accumulation may render a false sense of security, delaying necessary reforms. While reserves may provide some protection against external crises, otherwise unsustainable policies could cause undesirable distortions even when they do not end in crisis. Large fiscal deficits, for instance, may crowd out private sector investment or create debt overhang problems. And these vulnerabilities, if allowed to grow too large, may overwhelm the insulating effect of reserves and surprise a country previously considered secure.
Bottom-line, too large an international reserve, could be poisonous. The rule of thumb in evaluating an optimum level of reserves is to look at reserves to short-term external debt, which is also known as the Greenspan-Guidotti rule, named after Alan Greenspan and Pablo Guidotti, a former Argentine finance official, who called for developing countries to amass reserves equal to all external debt coming due within the next year.
This rule has become the most widely preferred benchmark for measuring vulnerability to capital account crises. An alternative would be to use the reserves to M2 ratio, whereby economies facing a risk of capital flight may follow money based measures, as reserve balances held against a portion of the monetary base can increase confidence in the value of local currency.
- Suresh Ramanathan is an independent interest rate and foreign exchange strategist who has spent 20 years in several onshore and offshore financial institutions. He can be contacted at email@example.com