Questions in reserve

Indian Express, 8 November 2011

International reserve holdings by all countries put together have risen rapidly since 2000. They did not go down during the crisis as few countries used reserves in the crisis, allowing their currencies to depreciate in response to capital outflows as they also faced declining export growth. Post-crisis, there are new reasons for central banks to build reserves. We should expect to see a rise in international reserves in the coming decade. As a consequence, despite all its debt difficulties, the US government it likely to continue see demand for its bonds rising.

The original intent of holding reserves was to provide insurance to countries. The opening up of their trade and capital accounts can often bring unexpected pressures on the currency. As a rule of thumb, dollar reserves worth 3 months of imports, and adequate to cover one year of all short term liabilities of a country were held by the central bank.

However, after 2000 when capital flows to emerging economies rose rapidly, one big reason for the rise in reserves was the mercantilist policies of China, and following it many emerging economies, including India, who did not let their currencies appreciate in response to higher capital flows. China and the fuel exporters are today among the biggest international reserve holders.

Allowing their currencies to depreciate during the crisis was consistent with the policies of export promotion, and it is therefore not surprising that reserves were not "used" or sold, to prevent currency depreciation. The countries with the biggest reserves were not the ones which used them the most in the crisis as the preferred weak currencies.

The global crisis this time was different from previous currency crisis, which had often involved attacks against specific weak currencies. This time dollar liquidity in international financial markets dried up. During the crisis, interbank money and swap markets suddently froze and some central banks stepped in to provide dollar liquidity to their banking systems. The US Fed offered swap lines to some countries to allow their central banks to provide this facility.

This has created a new breed of reserve builders. Advanced economies with floating exchange rates, who did not intervene in foreign exchange markets in the 2000s, and who did not see a reason to hold reserves for insurance earlier, as they would have allowed their currencies to depreciate, are now building up reserves. One such example, is the Swedish central bank that has increased its reserve holding after the crisis in which it lent USD 30 billion to its banking sector. The calculation to be made for such countries is how much might the banking sector need in times of crisis, how much can the government borrow in a stressed situation, and what is the difference between these two. The last figues gives an estimate of what should be held by the central bank as reserves.

There are considerable technical difficulties in estimating how much the banking sector might need, or how much the government may be able to borrow in a crisis. A conservative banker may hold much more than if he had been accurately able to estimate the country's needs. Moreover, holding dollar reserves by the central bank will increase moral hazard, the risk banks are wiling to take if they know there is a lender of the last resort available. This will increase the amount the central bank has to hold, in contrast to what the earlier need may have been if it held no reserves.

However, holding reserves as a form of self-insurance is costly of each country. A pooling of risks may be a cheaper arrangement. In response to the need felt by countries to hold international reserves after the crisis, the IMF has proposed a new credit arrangement. A Flexible Credit Line (FCL) is offered to a country if it should choose to apply and pay for it. No conditionalities are involved. The credit line is provided for a fixed period of time, one to two years, and can be renewed upon reapplication.

So far, only three countries have signed up for the IMF's FCL: Poland, Mexico and Columbia. Among the rest, some feel they do not want to be bracketed with these countries. Still others feel that to qualify they need to build up reserves, as that is one of the parameters the IMF looks at to determine the strength of the economy before giving it a credit line. Further, signing up means that the pressure to build reserves remains high as market confidence would be undermined if the country was rejected for an FCL upon reapplication. Comparison with other countries in the region, and of similar size both by rating agencies, and the IMF often adds to the pressure to build reserves. This suggests that the FCL has not been able to substitute for reserves accumulation by individual country central banks.

Hans Genburg of the Independent Evaluation Office of the IMF pointed this out in a recent lecture. He concluded that these factors suggest that the demand for international reserves will keep rising. Demand from advanced countries who now feel the need for reserves during a financial crisis is has added to the earlier demand for reserve accumulation from emerging economies. At the same time the FCL has not been able to offer an alternative to reserve accumulation by individual countries.

This suggests to us that demand for US government bonds will remain high. Higher uncertainty in the world is often accompanied by investors reducing their holding of emerging country assets, and buying dollar bonds. This is holding up the demand for dollars today. Even when this uncertainty subsides, if central banks continue to build up reserves, whether for mercantilist reasons in emerging economies, or for insurance for their banking systems in advanced countries with floating exchange rates, there will be adequate demand for dollar bonds.

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