Mr Greenspan discusses recent trends in the management of foreign exchange reserves  (Central Bank Articles and Speeches, 29 Apr 1999)
Central bank: fed | Type: speech | Date: 1999-04-29

## Mr Greenspan discusses recent trends in the management of foreign exchange reservesSpeech by the Chairman of the Board of Governors of the Federal Reserve System, Alan Green at the World Bank's conference on Recent Trends in Reserves Management, Washington, D.C., on April 1999.One way to address the issue of the management of foreign exchange reserves is to start economic system in which no reserves are required.

There are two.

The first is the obvious single world currency.

The second is a more useful starting point: a fully functioning full floating rate world.All requirements for foreign exchange in this idealised, I should say, hypothetical; syst met in real time in the marketplace at whatever exchange rate prevails.

No foreign exchange would be needed.If markets are functioning effectively, exchange rates are merely another prices to whic makers--both public and private--need respond.

Risk-adjusted competitive rates of return on all currencies would converge, and an optimised distribution of goods and services enhan nations standard of living would evolve.Public and private market participants would require only liquid reserves denominated in currency.

And in the case of a central bank of a fiat currency regime, such reserves can without limit.But, clearly, the real world is not perceived to work that way.

Even if it did, it is app post World War I history, that national governments are disinclined to grant currency unlimited rein.

The distributions of income that arise in unregulated markets have been unacceptable by most modern societies, and they have endeavoured, through fiscal polici regulation, to alter the outcomes.In such environments it has been the rare government that has chosen to leave its internat and finance to what it deems the whims of the marketplace.Such attitudes very often are associated with a mercantilist view of trade that perceives as somehow good, deficits bad.

Since in the short run, if not in the long run, trade b affected by exchange rates, rates that are allowed to float freely are few and far between. course, monetary authorities are often overwhelmed, and lose any control of the foreign value of their domestic currency.

Most nations, for good or ill, have not been indifferent t exchange value of their currency.

I say most, but not all.Arguably, immediately following the dollar s float in 1973, U.S. Authorities did not interv it to others to adjust their currencies to ours.

We did not sense a need to hold what we pe weaker currencies in reserve because presumably we could always purchase them in the ma when, and if, the need arose.

We held significant reserves in only that medium we judged a currency that is gold.It has become a general principle that monetary authorities reserve only those currencies t are as strong or stronger than their own.

Thus, central banks reserve balances except circumstance hold no weak currencies of which I am aware, other than standard transaction that are not viewed as stores of values.We in the United States built up modest reserve balances of DM and yen only when we perceive the foreign exchange value of the dollar was no longer something to which we could be indifwhen, in the late 1970s, our international trade went into chronic deficit, inflation accelera international confidence in the dollar ebbed.The choice of building reserves in a demonstrably harder currency is almost by definition not wi costs in real resources.

The budget cost of paying higher interest rates for the domestic borr employed to purchase lower yielding U.S. dollar assets, for example, is a transfer of real resou the previous holders of the dollars.

The real cost of capital because of risk is higher in currency country.

Countries with weaker currencies apparently hold hard currency reserves becau they perceive that the insurance value of those reserves at least equal they re cost in real r Reserves, like every other economic asset, have value but involve cost.

Thus, the choice to reserves, and in what quantities, is always a difficult cost-benefit tradeoff.In general, the willingness to hold foreign exchange reserves ought to depend largely on the perc benefits of intervention in the foreign exchange markets.

An evaluation along these lines w appear to require a successful model of exchange rate determination, and a clear understanding o influence of sterilised intervention.

Both of the above have proved to be a challenge for the eco profession.The two main policy tools available to monetary authorities to counter undesirable exchange movements are sterilised intervention operations in foreign exchange markets and monetary poli operations in domestic money markets.Empirical research into the effectiveness of sterilised intervention in industrial country curre found that such operations have at best only small and temporary effects on exchange rates. explanation for the limited measurable effectiveness of sterilised intervention is that the typical operations has been insufficient to counter the enormous pressures that can be marshall market forces.

In one sense, this is true by definition.

Another is that the assets bought and intervention operations are such close substitutes in the minds of investors that they willingl changes in the currency composition of their holdings without compensating changes in asset pri or exchange rates.

A more recent strand of research into this topic claims that intervention ope can be effective when they signal future monetary policy operations, which are perceived to be effective in altering asset prices, including exchange rates.

The problem with this view is that that sterilised intervention is not an independent tool that can be used to influence exchange needs a supporting monetary policy stance to be effective.We are left with the conclusion that foreign exchange market-sterilised intervention by itself h a limited impact on exchange rates.

This is underscored by the reported purchase by Japane authorities of roughly $20 billion against yen in April of last year that barely budged the do exchange rate.Hence, reserve assets do not expand, in a meaningful way, the set of macroeconomic policy tools is available to policy makers in industrial countries.

In addition, there is scant evidence that development of new financial instruments and products has undermined the liquidity, efficiency, reliability of the market for major currencies. U.S. monetary authorities have intervened only o foreign exchange markets since August of 1995.

It seems likely that industrial countries official for foreign exchange reserves is more likely to have declined over time, than to have increased.The introduction of the Euro is clearly going to significantly alter reserve holdings.

As mark Euro-denominated assets develop, the Euro should become increasingly attractive as a world rese currency.

The bid-ask spreads on average of, say, the separate currency government bonds of Euro-11 countries before January 1, were wider than the spreads on average that should eventua emerge for new Euro-denominated issues.

Such increased liquidity should reduce the cost of hold reserves, though conceivably the credit risk of bonds, not denominated in a currency fully cont by a domestic central bank, would rise.

To some extent the increased attractiveness of the Euro sreduce the demand for dollars.

But history suggests that this effect is likely to be evolutionary.While the stock of foreign exchange reserves held by industrial countries has increased those increases have not kept pace with the dramatic increases in foreign exchange tradin financial flows.

Thus, in a relative sense, the effective stock of foreign exchange rese industrial countries has actually declined.In recent years volatility in global capital markets has put increasing pressure on emer economies and this has important implications for financial management in those economies have been considerable fluctuations in the willingness of global investors to hold claim economies over the last two years.

Between 1992 and 1997, yields on a broad range of em market debt instruments fell relative to those on comparable debt instruments issued by country governments.

But this pattern reversed sharply with the onset of the Asian financi the second half of 1997, and again following the ruble's devaluation in August of 1998.These changes in foreign investor's willingness to hold claims on emerging market economie particularly severe impact on currencies operating under fixed or pegged exchange rate Accordingly, those countries foreign exchange reserves, and reserve policy, played an impor in the recent financial crises.In both Thailand and Korea the monetary authorities allowed their foreign exchange reserve forward contracts and other obligations, to fall almost to zero.

Once this became obvious participants, subsequent downward pressure on the baht and the won intensified substant contrast, a number of countries (Taiwan and Singapore, for example) introduced greater excha flexibility without exhausting their foreign exchange reserves.

These countries did not suf violent downdrafts in their foreign exchange markets.

In recent years Hong Kong and China accumulated substantial stocks of foreign exchange.

While the motives for these buildups we economic, they may have helped these economies to weather recent financial turbulence at l than other emerging market economies in the region.The Asian crisis has focused attention on the adequacy of information about official re Thailand and Korea, in particular, limited disclosure of these data by the authorities co misperceptions by market participants of resources available to the authorities to ma prevailing exchange rate regime.

Moreover, once the crisis broke, inadequate data undermine by the international financial community to resolve the situation.In response, the G-10 central banks initiated an effort to establish standards for disclosu off-balance-sheet foreign currency activities of the public sector by countries that pa aspire to participate, in international capital markets.

The focus of this work was the foreign currency liquidity position, which consists of foreign exchange resources that ca mobilised, adjusted for potential drains on those resources.While greater disclosure is not a panacea for international financial crises, adherence to developed in the wake of the 1997 crisis would go a long way toward preventing future stre facilitating responses to those that do occur.

Some have argued that an equally important disclosure standard for private participants in international capital markets, especi leveraged entities.

Such disclosure could be useful, and work on this topic is proce progress on official disclosure should not be delayed pending the outcome of these efforts.The Asian financial crises have reinforced the basic lesson that emerging market economie pay particular attention to how they manage their foreign exchange reserves.

But managing alone is not enough.

In particular, reserves should be managed along with liabilities--and -to minimise the vulnerability of emerging market economies to a variety of shocks.

In thsome simple principles can be outlined that are likely to be useful guidelines for policymakers. also be useful to consider somewhat more nuanced approaches to this problem.Considerable progress has been made in recent years in developing sophisticated financi instruments.

These developments create added complexity that all financial market participan including policymakers from emerging market economies, must manage.

However, they also create opportunities that emerging market economies should seek to exploit.

In doing so there are les they can learn from advances in risk management strategies developed by major financial institutiIn his remarks at the recent G-33 Seminar in Bonn, Pablo Guidotti, the Deputy Finance Minister Argentina, proposed a simple guideline for policymakers in emerging market economies that a number of my colleagues at the Federal Reserve believe is worth considering.

Guidotti suggested countries should manage their external assets and liabilities in such a way that they are always live without new foreign borrowing for up to one year.

That is, usable foreign exchange rese should exceed scheduled amortisation's of foreign currency debts (assuming no rollovers) during following year.

This rule could be readily augmented to meet the additional test that the av maturity of a country s external liabilities should exceed a certain threshold, such as three y constraint on the average maturity ensures a degree of private sector ' burden sharing' in crisis, since in the event of a crisis, the market value of longer maturities would doubtless fal Short-term foreign creditors, on the other hand, are able to exit without loss when their inst mature.

If the preponderance of a country s liabilities were short term, the entire burden of would fall on the emerging market economy in the form of a run on reserves.Some emerging countries may argue that they have difficulty selling long-term maturities.

If th indeed the case, their economies are being exposed to too high a risk generally.

For too long eme market economies have managed their external liabilities so as to minimise the current borrow cost.

This shortsighted approach ignores the insurance imbedded in long-term debt, insurance th often well worth the price.The essential function of an external balance-sheet rule should be to make sure that actions government do not contribute to volatility in the foreign exchange market.

Consequently it ma sense to apply the rule to all of the government s foreign assets and all sovereign lia denominated in, or indexed to, foreign currencies.

Forward foreign exchange transactions should recognised, as liabilities, while such things as contingent credit lines, if they are truly av demand, should be counted as foreign currency assets.

In addition, key contingent liabilities sho included.

This means that the foreign currency assets and liabilities of financial intermediar have access to the safety net--e.g. banks--probably ought to be included in the scope of the analIt is important to note that adherence to such a rule is no guarantee that all financial cris avoided.

If the confidence of domestic residents is undermined, they can generate demands for for exchange that would not be captured in this analysis.

But controlling the structure of external and liabilities could make a significant contribution to stability.The adoption of any rule is not a substitute for appropriate macroeconomic, exchange rate, financial sector policies.

Indeed, the endeavour to substitute such a regime for the more di fundamentals of sound policy will surely fail.Countries that choose to follow this simple rule may reduce their vulnerability to financial cris minimum this framework can highlight signs of vulnerability.

For example, Korea s short-term deb including those of Korean banks, were more than three times its foreign exchange reserves December of 1996.An external balance-sheet rule could generate substantial benefits for the international communi well.

If followed, it would likely limit the size of future international rescue packages, sincof such packages is often related to the size of a country s short-term liabilities less applying any simple rule, it is important to anticipate endeavours to get around it.

For IMF has identified more than $30 billion in outstanding emerging market debt instruments options.

This suggests that maturity calculations ought to eschew notional maturities that prevail in times of crisis.In any event, it would probably be desirable to move beyond simple balance-sheet rules and towards a standard that is stochastic, i.e., that takes into account the foreseeable risk face.

One approach would be to calculate a country s liquidity position under a range outcomes for relevant financial variables (exchange rates, commodity prices, credit spread might be possible to express a standard in terms of the probabilities of different out example, an acceptable debt structure could have an average maturity--averaged over es distributions for relevant financial variables--in excess of a certain limit.

In addition, be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowi year with a certain ex ante probability, such as 95 percent of the time.Such a ' liquidity-at-risk' standard could handle a wide range of innovativ instruments--contingent credit lines with collateral such as the one maintained by Argenti on commodity prices, put options on bonds, etc.--in an appropriate manner.

Such a standar encourage countries to manage their exposure to financial risk more effectively.

For exampl standard could force countries to think realistically about the cost of selling put opti bonds.Of course, this approach will not work if policymakers are committed to the letter, but no of the exercise.

There is no credible way to fully preclude a counterproductive effort to benefits with new financial products that convert long-term liabilities to short.Clearly it would not be feasible at present for most emerging market countries to implemen regime based on liquidity at risk.

It might not even be feasible for most emerging market ec adhere to a simpler external balance-sheet rule, since many countries will require some ti up foreign exchange reserves, and to adjust the structure of their external liabilities certainly desirable, however, for countries to begin to think about managing their assets an or just monitoring their vulnerabilities, in a more sophisticated way.

An external balanceprobably a good place to start.Over the medium term, it would be desirable for emerging market economies to develop a sophisticated approach to the problem of managing their liquidity.

There is an obvious c between ' value-at-risk' techniques used by large financial institutions to manage to risk and the liquidity-at-risk approach proposed here.

It would be productive were t financial institutions to play a role in helping countries develop their own capabilities this approach, perhaps with technical assistance from G-7 supervisory authorities and int financial institutions.