Reserve and Foreign Exchange

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RESERVES AND FOREIGNEXCHANGE IN THE

MACROECONOMIC CONTEXT

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By

Anthony Kyereboah-Coleman (Ph.D)

Presentation at Regional Course onOptimising Reserves and ForeignExchange Management for IncomeGeneration organised by WAIFEM,

May 11 15, 2009, Accra, Ghana



OUTLINE

l Background to reserve and foreign exchange

l Why hold foreign reserve?

l What is the appropriate level of foreignreserve?

l Management of foreign reserves

l The place of foreign reserve in themacroeconomic arena.

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Background

l Conceptually, a unique definition of foreign

reserves is not available as there have beendivergence of views in terms of coverage of

items, ownership of assets, liquidity

aspects and need for a distinction between

owned and non-owned reservesNevertheless, for policy and operationalpurposes, most

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Background

l countries have adopted the definition

suggested by the International MonetaryFund (Balance of Payments Manual, andGuidelines on Foreign Exchange ReserveManagement, 2001);

l which defines reserves as external assetsthat are readily available to and controlled bymonetary authorities for

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Background

direct financing of external payments

imbalances, for indirectly regulating themagnitudes of such imbalances throughintervention in exchange markets to affectthe currency exchange rate, and/or for other

purposes.

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Background

l The standard approach for measuring

international reserves takes into account theinternational reserve assets of the monetaryauthority; however, the foreign currency andthe securities held by the public including the

banks and corporate bodies are notaccounted for in the definition of officialholdings of international reserves.

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Background

l Reserve management is a process that

ensures that adequate official public sectorforeign assets are readily available to andcontrolled by the authorities for meeting adefined range of objectives for a country or

union. In this context, a reserve managemententity is normally made responsible for themanagement of reserves and

associated risks.

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Background

The word union is used to represent monetary

or exchange management unions that alsoundertake reserve management.Among countries, and among monetary orexchange management unions, the entity

responsible for reserve management may be acentral bank or monetary authority acting eitheras a principal or as an agent for anotherrepository of reserves such as an exchangefund.

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Background

These entities may also have a range of policy

responsibilities and functions that extendbeyond their reserve managementresponsibilities. The term reserve manager isused to refer to the specific area within the

entity that performs the actual reservemanagement function.

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Why Hold Foreign Reserves?

l Technically, it is possible to consider three

motives i.e., transaction, speculative andprecautionary motives for holding reserves.

l International trade gives rise to currencyflows, which are assumed to be handled by

private banks driven by the transactionmotive.

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Why hold foreign reserves?

l Similarly, speculative motive is left to

individual or corporations. Central bankreserves, however, are characterizedprimarily as a last resort stock of foreigncurrency for unpredictable flows, which is

consistent with precautionary motive forholding foreign assets.

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l Precautionary motive for holding foreign

currency, like the demand for money, can bepositively related to wealth and the cost ofcovering unplanned deficit, and negativelyrelated to the return from alternative assets.

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Typically, official foreign exchange reserves

are held in support of a range of some otherrelated objectives, including to:

l support and maintain confidence in the policies

for monetary and exchange rate management,

including the capacity to intervene in support ofthe national or currency;

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l Limit external vulnerability by maintainingforeign currency liquidity to absorb shocksduring times of crisis or when access toborrowing is curtailed, and in doing soprovide a level of confidence to markets that

a country can meet its external obligations;

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l Demonstrate the backing of domestic

currency by external assets;assist the government in meeting its foreign

exchange needs and external debtobligations; and maintain a reserve for

national disasters or emergencies.

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Appropriate Level of ForeignReserve

l Country circumstances vary, and there is no

precise level of reserves universallyconsidered either sufficient or optimal.Advanced economies with highly liquid,floating currencies and stable financial

market access in domestic currency areunlikely to derive any significant value fromlarge precautionary reserve holdings.

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Appropriate Level of ForeignReserve

l Where currencies are less liquid and market

access less than assured, reserves mayreduce both the risk and impact of currentaccount shocks or capital account crises.There is an extensive literature that attempts

to define specific benchmarks for reserveadequacy. We discuss four simple andcommonly cited ratios.

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Appropriate Level of Foreign Reserve

l Reserves to short-term external debt:

The so called Greenspan-Guidotti rule namedafter Alan Greenspan and Pablo Guidotti, a

former Argentine finance official, who called

for developing countries to hold reserves

equal to all external debt coming due withinthe next year has become the most widely

preferred benchmark for measuring vulnerability

to capital account crises.

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l Reserves to M2 :

Countries facing a risk of capital flight may followmoney-based measures, as reserve balances heldagainst a portion of the monetary base can increase

confidence in the value of local currency.

Given the difficulty in measuring capital flight there isno conventional minimum adequate level ofreserves, but it has been suggested that reservesequivalent to 5-20% of M2, depending on theexchange.

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l Reserves to imports: Import-based measures

can be useful for low-income countrieswithout significant access to capital marketsand vulnerable to current account shocks,such as a fall in the price of a country s main

export or a drop in tourism receipts due tonatural disaster.

Reserves worth three to four months ofimports is perhaps the most frequently cited

benchmark.20



Appropriate level of foreign reserve

l Reserves to GDP:

This ratio is sometimes spuriouslycited as an adequacy measure, with

little theoretical or empirical justification.

GDP does not represent a vulnerability that

must somehow be covered in a crisis, andthere is little reason countries should aim for

reserves to match some proportion of it. We

do not consider this measure in our analysis

below.21



Management of Foreign Reserves

l In the recent years, for several reasons,

increasing attention is being paid tomanagement of

international reserves.

First, advent of the Euro as an alternate

currency to US dollar;Second, movement of many central banksout of gold;

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Third, changes in exchange rate regimes;

fourth, changing views on reserve adequacyand its role in crisis prevention; and

fifth, operational use of reserve targets incalculating financing gaps by IMF.

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The attention to the subject is evidenced by

l increasing emphasis on transparency,accountability in various fora, and morerecently, the issue of IMF guidelines on thesubject.

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Operationally, reserve management is a

process that ensures that adequate officialpublic sector foreign assets are readilyavailable to and controlled by the authoritiesfor meeting a defined range of objectives fora country. A reserve management entity is

normally made responsible for themanagement of reserves and associatedrisks.

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l Invariably, the reserve management entity is the

central bank and hence the objectives of reservemanagement tend to be critical as they would

encompass the objectives of the monetary authorityand the objectives of a portfolio manager or the

custodian of reserves.

As a monetary authority, a central bank s primaryobjective is to ensure macroeconomic financialstability in general and external stability in particular.

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l As a custodian, the central bank s main objectivesare to ensure liquidity, safety and yield on

deployment of reserves.l In considering management of reserves, the benefits

and costs of holding reserves are constantlyassessed. On the benefits, recent internationalfinancial crises have shown that holding andmanaging sufficient reserves and disclosingadequate information to markets helps a country toprevent external crises, especially those stemmingfrom the capital account.

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l The growing appreciation of the role o f

reserves in crises prevention and as a buffer tomanage exchange market pressures has givenreserve management a more central role, nowthan before, in national economic policies.

l Maintaining high level of reserves, however,involves opportunity cost.

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l The opportunity cost of holding reserves is

the foregone investment because resourceshave been used to purchase reservesinstead of increasing domestic capital. Themarginal productivity of domestic capital is

the opportunity cost of holding reserves andreserves management seeks to minimize theopportunity costs against the benefits thataccrue from holding reserves.

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l The objectives of reserve management vary

across countries, and a recent survey ofreserve management practices of selectcountries (IMF guidelines, 2001) providegood insights on the subject.

l First, most countries hold reserves to support

monetary policy. While ensuring liquidity inforeign exchange market to smooth outundue short-term fluctuations in exchangemarkets constitutes the primary objective.

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l Smaller countries, hold reserves mainly for

consideration of transaction motives to meetexternal payment imbalances as well as astore of wealth. Precautionary motive ofholding reserves to mitigate adverse external

shocks is implicit in most countriesobjectives though among a few.

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l Few countries explicitly use international

reserves as the backing for monetary baseand to maintain the stability and integrity ofthe monetary and financial system.

l From a policy perspective, the objective ofholding reserves to support monetary policy

is common to most countries and theobjective of holding reserves in regard tomany emerging economies is primarily tomaintain international confidence about its

short-term payment obligations as well as32




confidence in monetary and financial polices.

l

Secondly, most countries have informalcoordination between debt management andreserve management policies. As part ofinformal coordination, most countries takeinto account external debt indicators,particularly the maturity composition of short-term and long-term debt, as part of reserve

management.

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l Thirdly, in regard to transparency and

disclosure standards, many countries adhereto the IMF s Special Data DisseminationStandards (SDDS) requirement. Mostcountries publish data on external debt and

reserves on an annual basis in either theircentral bank annual reports or other reportsof Government.

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l Fourthly, liquidity and safety (low risks)

prevail upon reserve management entities inmost countries as part of the objectives ofreserve management.

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l Fifthly, most countries use benchmarks for

managing currency composition of reservesthough information to the public about thebenchmarks for the underlying currencycomposition of reserves is generally not

made available.

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The place of foreign reserve in the

macroeconomic arena.

l Export-led growth strategy

The potential opportunity cost of keepingexcess foreign reserve must be related topotential benefits. If the main purpose isexport-led growth, the potential benefits can

be large. Of course, currency undervaluationimpose an additional cost to trading partners,

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The place of foreign reserve in themacroeconomic arena.

but the cost-benefit balance may be

favorable for the country in question in thepresence of fixed costs, market distortions orincreasing returns in production. Thereseems to be no study that attempts to

measure the existence and extent of suchbenefits but the presumption must

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The Place of Reserves in theMacroeconomic Arena

be that that these benefits are real and

sizeable. A prime facie indication is that mostof the successful emerging market countriesof yesterday (Japan and Korea) and of today(Argentina, China) have adopted thisstrategy. Chile is an important counter-

example.It remains to determine how this strategy canwork. In principle, simply attempting to keepthe exchange rate undervalued cannot work

if markets operate reasonably freely.39




l Indeed, keeping a high level of external

demand for domestically produced goodmust inevitably lead to inflationary pressure.This, in turn, means an appreciating real

exchange rate. In order to maintain present

the real exchange rate undervalued, thecentral bank must them keep depreciating itsnominal exchange rate, which requires

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further reserve accumulation in an unending

process. Furthermore, to prevent inflationfrom catching up, the central bank must sterilizeits foreign exchange market

interventions, which then becomes increasinglycostly.

This shows that the export-led strategy goesmuch beyond exchange rate undervaluation.

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The Place of Reserves in the

Macroeconomic Arena

l It may involve price controls, but this is a

recipe to kill growth because it can leads to alarge misallocation of resources. A bettersolution is to compress domestic demand,i.e. to allow for a high saving rate. Whether

the high saving rate of Asian countries isspontaneous or the result of active policiesremains a controversial issue. Moregenerally,

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The Place of Reserves in the

Macroeconomic Arena

l our understanding of differences in saving

rates across countries is limited. The linkl The implication, that saving rates can be

changed by policy actions, remains an openquestion.

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Conclusion

l To conclude, the theory and practice of

foreign exchange reserves is as complex asany other contemporary economic issue.While it is not easy to provide answers to allthe questions raised in the recent debate on

foreign exchange reserves managementpolicy.

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Reserve and Foreign Exchange

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