Marion V Williams: Foreign exchange reserves - how much is enough?
Text of the Twentieth Adlith Brown Memorial Lecture delivered by Dr Marion V Williams, Governor of
the Central Bank of Barbados, at the Central Bank of the Bahamas, Nassau, 2 November 2005.
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Mr. Master of Ceremonies, Governor of the Central Bank of The Bahamas Mrs. Wendy Craigg, former
Governor of the Central Bank of Barbados, Sir Courtney Blackman, Deputy Governors, Central
Bankers, distinguished guests.
I would first like to thank the Central Bank of the Bahamas and the Centre for Monetary Studies for a
well-organized Monetary Studies Conference and I wish also to extend my appreciation for the many
courtesies extended to us.
It is indeed an honour to have been invited to deliver this year's Adlith Brown Memorial Lecture. The
list of speakers who have done so before me is indeed distinguished and Adlith herself was a
consummate economist who was dedicated to uplifting the level of scholarship on monetary and
central banking matters in the Caribbean. I think this series attempts to do just that. I cut my teeth in
monetary matters at the Regional Programme for Monetary Studies, the precursor of CCMS, as a
rapporteur at the first meeting held in Barbados under Mrs. Pat Robinson who was the Research
Director at the Central Bank of Trinidad. That was many years ago. I hope that today, I can add
something to the body of knowledge on the subject, more particularly, on considerations surrounding
the holding of an adequate level of foreign exchange reserves, as I address the topic "Foreign
Exchange Reserves: How much is enough?" I will discuss why countries have varying views on what
is adequate, why countries aim to have levels which are more than adequate, and what factors must
be considered in arriving at internationally-accepted criteria without having a one-size-fits-all formula,
how we can develop such formulae, and whether countries are likely to cease accumulating foreign
exchange reserves.
In the Caribbean, almost any one who is an occasional reader of the newspaper knows that foreign
exchange reserves are characterized primarily as a last resort stock of foreign currency for the
financing of foreign currency outflows. Reserves help to maintain confidence in the currency, and allow
central banks to intervene in the market in order to influence the exchange rate. They also permit
central banks to limit the vulnerability of the country to external shocks, give confidence to the public
and reassure credit rating agencies and international financial institutions about the soundness of the
economy.
Traditionally, the control and management of foreign exchange reserves have been the preserve of
central banks. However, the accumulation of foreign exchange reserves depends not on the central
bank directly, but on the structure and vibrancy of the economy, the split between the share in GDP of
the traded and non- traded sectors, the level and rate of capital inflows and outflows, and on the
attractiveness of returns offered in other currencies. Reserve accumulation can be built from strong
performance of the economy and from current and capital account surpluses, or it can be
supplemented by external borrowing.
All these factors taken together influence the level of foreign exchange reserves. Since the holding of
reserves, which by definition is denominated in other countries' currencies, generally means that the
home country is financing investment and development of other people's countries, then on the basis
of pure arithmetic, countries should hold no more foreign exchange reserves than they think is
necessary. However, most countries tend to do the reverse; they tend to accumulate as much foreign
exchange as possible. Why do Central Banks then defy mathematical laws and consistently incur
greater costs by holding increasingly higher levels of foreign exchange reserves. Admittedly, if a
country is earning foreign exchange at a rapid rate, it generally has little option but to hold its assets in
foreign assets, since the alternative of spending it on the imports of goods and services which are
superfluous to its needs, can create inflationary pressures. However, countries which have difficulties
in accumulating reserves, through normal transactions activities, will make vigorous attempts to
increase their holdings.
Why we need foreign exchange reserves
Though traditionally, foreign exchange reserves were used to intervene in the foreign exchange
markets, over the years the frequency of intervention by central banks in developed hard currency
markets has waned. Few central banks in developed countries have actively intervened in the past
decade, since for the most part, financial markets in developed countries are sufficiently deep to
absorb and manage most shocks. However, intervention still frequently occurs in emerging market
economies, but intervention in developed countries, if and when it takes place, is often limited to
ensuring orderly conditions for the movement in exchange rates. Indeed, increasingly, intervention is
seen as having little lasting power to influence the real exchange rate and thus competitive conditions
for the tradable sector. Intervention can be used, however, to supply liquidity to the foreign exchange
markets or to influence the level of foreign exchange reserves.
When foreign exchange reserves are not needed
A country with a hard currency, such as the US dollar, sterling or the euro, has little need to be
concerned about the level of foreign exchange reserves. Their currencies are acceptable across the
globe. However, very often, non-US dollar currencies are acceptable largely because the countries
involved have substantial foreign exchange reserves. In recent years China has built up substantial
reserves in US dollars, as have Japan and some other East Asian countries. Mervyn King in an article
in the Central Banking Quarterly Journal of May 2005 observes that for most of the post-war period,
the quantity of reserves held by Asian central banks was of the same order of magnitude as that of the
central bank reserves held by the G7 countries. The example of South-East Asia in the mid-1990s
showed that for developing and newly industrializing countries, even when foreign exchange levels are
huge, they can be eroded rapidly if there is loss of confidence. Since then, in Asia and more recently in
a number of Latin American countries, central banks have embarked on deliberate policies of reserve
accumulation. By the middle of 2005, Japan and non-Japan Asia held reserves nearly 10 times larger
than the combined reserves of the rest of G7 countries. Indeed the People's Bank of China's Monetary
Policy Report for the second quarter of 2005 states that at the end of June official foreign exchange
reserves had reached US$711 billion, and more importantly, had grown by US$101 billion over the
end of 2004. It is clear therefore that there has been acceleration in the pace of reserve accumulation
by China.
Indeed, some Asian countries have kept their currencies undervalued in an effort to maintain external
competitiveness, attract foreign direct investment and boost exports and growth. Dooley et al (2004)
argue that the resulting accumulation of foreign reserves can be seen as collateral, which is being
used for attracting foreign investment.
Increasing levels of reserves
Without doubt, global reserves have increased rapidly over the past decade, principally as a means of
combating financial market turbulence. Between 2001 and the end of 2004, global foreign exchange
reserves grew by over US$1600 billion, reflecting reserve accumulation by emerging market
economies in Asia. In a survey on "How Countries Manage Reserve", editors Pringle and Carver
(2003), note that between 1975 and 2001, just after the move to generalized floating by major
industrial countries, official holdings of reserve assets as measured by the IMF increased by more
than ten times, (or about 10.2% per year). The same study reports that there are only a few years in
which reserves did not rise and that these reflected years of acute crises in the system, sharp falls in
the market price of gold or changes in the outstanding holdings of IMF related assets.
Foreign Exchange Reserves and Hard Currency Areas Versus Soft Currency Areas
In the case of hard currencies such as the US dollar, the value of the currency is less dependent on
the volume of foreign exchange reserves and more on the strength of the economy. The value of
these currencies rarely rises or falls on the basis of how much foreign exchange reserves the Central
Bank has accumulated, but rather on corporate indicators, economic fundamentals and capital market
movements.
Some central banks, through open market operations aimed at preventing their currency from
appreciating, can at the same time build substantial reserves. For many years Japan engaged in a
programme of buying US dollars in order to keep the yen/US dollar rate down so as to make its
exports more competitive. This also led to a massive build up in foreign exchange reserves in the
Bank of Japan. In these circumstances, the level of foreign exchange reserves is a secondary
consideration. Canada did the same in the 1980s and its reserves rose steadily, reaching US$18
billion in 1990 compared to an average of US$2.5 billion between 1975 and 1986.
In small developing countries the reverse is the case. Intervention is usually intended to stop the rate
from falling rather than to stop it from rising, so open market operations usually take the form of selling
foreign exchange; and the level of foreign exchange reserves to support interventions is a much more
important factor.
Foreign exchange reserves: oil economies versus non-oil economies
Oil exporting countries are able to build reserves much more easily, while non-oil exporting countries
have to continuously concern themselves with replenishment of foreign exchange reserves. This gives
oil exporters much more flexibility in adopting a floating exchange rate regime, as they are able more
easily to defend the rate. Indeed, in some oil exporting economies where there are large revenues
from such exports, the Central Bank engages in passive intervention to prevent the foreign currency
from reaching the market. Moreno (2005) notes that in Mexico, the Mexican oil company Pemex can
only acquire pesos by depositing its dollars in the central bank.
Foreign exchange reserves: politically vulnerable economies and politically correct economies
The political correctness of an economy influences what it considers to be an adequate level of foreign
exchange reserves. A centrally planned economy like China is not a politically correct economy. Nor,
today, is Venezuela. Such countries see themselves as needing to avoid placing themselves in a
position where they are forced to change their regimes. This comment is not in any way intended to be
judgmental about any regime, but it is interesting to note that it was not until Indonesia came close to
running out of foreign exchange reserves in the mid nineties that it was forced to change its regime
from the family-run government system which had been in place for several decades. They had to
privatise a number of family businesses, many of which were owned by the government in power.
While this is not to condone their system, it is quite likely, that had they not come close to running out
of foreign exchange reserves, they would have been able to continue with that system of government
for many years.
There is evidence from the case of China that substantially high levels of foreign exchange reserves
add political clout. Robert Pringle in reporting on the growth of China's reserves, notes that its
economic dynamism and vast foreign reserves meant that its views needed to be listened to more
respectfully than had been the case in the past. He notes that China's reserve accumulation has not
only secured insurance against shocks but also the world's respectful attention. However, though
accumulation of reserves adds confidence, over-accumulation in a single currency can in itself bring
vulnerability. It is argued that massive US payments deficits are beginning to undermine confidence in
the dollar and for large dollar holders there may be a point beyond which there is over exposure to the
dollar and therefore vulnerability can set in. This introduces issues of currency composition, portfolio
management and duration, which need to be taken into account but are not intended to be the subject
of this presentation, as that constitutes a different subject in itself.
Guaranteed security and foreign exchange reserves
While reserves add to financial security, there is the political security which can result from where
foreign exchange reserves are placed. In the BIS, for example, access to foreign reserves is
guaranteed. According to its post-war Charter, foreign reserves placed with the BIS cannot be
impounded or frozen, as happened in the case of Panama, several years ago. So, depending on one's
political vulnerability, it is not only important to have large reserves, but it is also important to be
mindful of where they are held.
Capital account liberalization and reflows of foreign exchange reserves
The level of foreign exchange reserves is heavily influenced by the extent to which the capital account
is liberalized. In strong competitive economies where capital inflows are vibrant, the liberalization of
the capital account can lead to continued inflows of foreign exchange. In less competitive economies,
particularly where there is the expectation that the exchange rate cannot be maintained, liberalization
of the capital account can lead to outflows of foreign exchange. Jamaica experienced this for several
decades. Indeed, following the South-East Asian crisis of the mid nineties, Malaysia re-imposed
exchange controls in order to pre-empt short term outflows, to staunch the outflow of capital and to
rebuild reserves. From all reports this appears to have worked and though this is not a
recommendation, it is one of the few cases where re-imposition of exchange controls has been
successful.
In a BIS study on foreign exchange markets, it was observed that in EU accession countries a higher
level of foreign exchange reserves helped mitigate an increase in external vulnerability stemming from
liberalization of capital flows - in particular short term flows.
Rebuilding reserves under liberalized systems
Though the adequacy of foreign exchange reserves is closely related to capital inflows and the extent
of foreign borrowing, and though foreign borrowing can be an important method of rebuilding reserves,
it cannot be a substitute for autonomous inflows based on the proceeds of export of goods and
services and foreign direct investment.
However, borrowing to supplement reserves is an appropriate method of ironing out difficulties if those
difficulties are just short term. If difficulties are chronic, then foreign borrowing will not be sustainable
over the long term, even though the level of reserves, when borrowed, will help to add confidence to
the public and to investors, in the short and sometimes even the medium term.
Sustainability of reserve levels
While the level of foreign exchange reserves is influenced by the way in which reserves are managed,
it is the underlying strength of the economy, and the ability to earn foreign exchange which are vital. In
the Caribbean many countries consistently post current account deficits and rely on capital inflows to
offset these deficits. However, where current account deficits become very large, dependence on
capital inflows can be precarious as experienced in the nineties by Latin America. Perversely,
because Caribbean capital markets are not yet very deep, capital flows tend to be less volatile, so for
the time being, there is no evidence of excessive volatility in the capital markets of most of the
Englishspeaking Caribbean, though there is greater volatility in Jamaica than in the rest of the Caribbean. The
prognosis therefore, would tend to indicate that as the Caribbean deepens its capital market - which it
is making every effort to do -Central Banks in the region may need to hold higher levels of foreign
exchange reserves in order to deal with the volatility which can result unless they are willing to let the
exchange rate depreciate.
Interest rates and reserve levels
While the level of foreign exchange reserves is influenced by economic fundamentals, interest rates
can influence reserve stocks at the margin. Where interest rates are lower than metropolitan rates
foreign exchange holders are likely to go in search of higher returns and may be slow in repatriating
export proceeds and other funds earned overseas. Where interest rates are high relative to foreign
rates, there is a greater likelihood that foreign exchange earners will keep funds at home. There is
therefore pressure to keep interest rates competitive in order to discourage capital outflows, and low
enough as not to adversely affect the cost of operations of business or precipitate outflows and hence
a loss of foreign exchange reserves.
Cost structures and reserve levels
The country's cost structure, by influencing the competitiveness of its products also influences the
profitability of businesses and the growth of its exports of goods and services. Countries with high cost
structures will therefore have greater difficulty in building foreign exchange reserves through exports.
Indeed, the United States has been adversely impacted in this way, particularly with respect to the
export of vehicles and electronics goods and similar types of products.
In the final analysis, the competitiveness of the economy is the most important determinant of a
country's ability to build reserves. While some capital may flow into the country on bases unrelated to
competitiveness, it is the competitive ability to earn one's way in the world that leads to the most
sustainable means of building foreign reserves.
Surplus reserves
Significant accumulation of reserves, as in the case of China and at one time Japan, can lead to calls
for foreign exchange rate appreciation in some international quarters. This has been the argument
made principally by the US and some European countries as to why China should revalue its
exchange rate. This new dimension - too much foreign exchange reserves - is really, not so much
about reserves as about the fact that the country has been able to out-compete so many other
developed countries through the tremendous performance of its export sector.
However, there are the cases of Mexico and Chile where approaches to controlling foreign reserve
accumulation have been adopted. These recent measures in Chile and Mexico to reduce foreign
reserve holdings and to limit foreign exchange growth suggest that in some Latin American countries
the cost of holding additional foreign reserves may be exceeding the benefits. Mexico, for example has
put in place a policy to limit the growth of foreign exchange reserves by selling foreign currency
according to a pre-determined formula.
Impact on other economies of holding surplus reserves
The argument against countries holding too large a stock of reserves has another dimension. It is
argued that struggling economies with high levels of foreign exchange reserves are really financing the
development of other large economies by holding their government securities.
This argument has not been sufficiently persuasive as to stop reserve accumulation, simply because
most developing countries generally do not find themselves in a position where they hold such
excessive stocks of reserves. Even in Botswana, a diamond rich country, where reserves are
equivalent to over 3 years of imports, it is debatable whether this is excessive given how rapidly
fortunes can change.
The greatest risk to the holding country of holding excessive reserves is depreciation of the currency in
which the reserves are held. Where large reserves are held then the impact of the risk of depreciation
of the currency is greater. By buying other hard currencies one can hedge against depreciation, since
the depreciation of one hard currency is often matched by appreciation of others. Without getting too
deeply into currency diversification issues, this makes the point that countries can hold large stocks of
reserves and yet reduce their exposures through currency diversification.
G7 countries are beginning to argue that the counterpart to the Asian Bloc's current account surpluses
and acquisition of dollar reserves - which has been large current account deficits in the United States
- could, in due course, cause investors to start to worry about the US' ability to repay. This, it is
suggested, could then contribute to potential instability of the international financial system. However,
the international system is already taking corrective measures. Data already show that the share of US
dollars in the official holding of global foreign exchange reserves has declined from 71% in 1999 to
65.9% in 2004,mostly reflected in a shift to the euro.
Reserves and their impact on government spending
It is sometimes argued that high levels of foreign exchange reserves allow the borrowing country to be
less circumspect in assuming debt where they are a good credit risk, as financing is always available.
There is a disadvantage here for prudent macroeconomic management. It is suggested that if foreign
exchange reserves are highly visible and easily available, some governments may be encouraged to
spend on public works and other similar activities. Aizenman and Marion (2004) even suggest that it is
optimal to hold lower foreign reserves if the government is more inclined to spend them.
Non-reciprocity in investing and borrowing
It is however noteworthy, that while foreign assets are held mostly in government securities, borrowing
is from the private sector. Invariably, developing countries have no direct access to borrowing from the
governments in whose securities they invest and whose economies they therefore support.
Increasingly however, as credit ratings become more widespread, central banks will be positioned to
place their reserves in issues of highly rated developing country issues. This should lead to a situation
where developing countries use their reserves to help each other without exposing their assets to too
much risk. Unfortunately, current data indicate that while there has been an increase in the holding of
developing countries assets in global reserves, it has been through increased holdings by
industrialized countries.
Opportunity cost of holding reserves
The matter of the opportunity cost of holding reserves is always a consideration, but becomes more of
an issue where holdings reach significant levels. The opportunity cost of holding reserves is the
foregone investment of resources which have been used to purchase reserves rather than towards
building domestic investment capital. One could argue that the marginal productivity of domestic
capital is the opportunity cost of holding reserves.
The optimal level of reserves has been indicated as the level where marginal productivity of reserves -
including exchange rate stability, confidence factors, risk mitigation factors, insurance against capital
flight and similar benefits, plus interest earned on reserves, equals the marginal productivity of real
resources were they otherwise employed. Clearly, an attempt to quantify these costs and benefits is
challenging. In reality therefore, most central banks do not calculate explicitly such costs and benefits,
but instead use several indicators of foreign exchange adequacy, none of which by itself is sufficient.
Where domestic rates are kept high and US rates are low, the carrying cost of holding reserves
increases. A consideration in any decision affecting reserve levels is therefore the marginal cost of
holding reserves against the marginal benefits. Moreno (2005) suggests that if the impact on
competitiveness is not a consideration, the marginal benefit of an additional dollar of reserves could be
estimated as the expected reduction in the cost of a currency crisis based on early warning system
estimates (i.e the change in the probability of a crisis associated with an increase in reserves, times
the cost of a crisis) while the marginal cost is the opportunity cost of holding reserves (e.g. the
sovereign spread - which assumes reserves are financed by foreign borrowing) times the change in
reserves. Research suggests (Moreno and Turner (2004), that higher foreign reserves can reduce
sovereign spreads as well as improve credit ratings. Thus the cost of holding reserves can be
narrowed as reserve holdings rise. Accordingly, the greater the quantum of reserves, the lower the
cost of borrowing and the greater the benefit of holding reserves.
Currency boards: foreign exchange reserves to broad money and base money
Some developing and newly industrialising economies opt for a currency board system where
currency board principles require that changes in the monetary base can only be brought about by
corresponding changes in foreign exchange reserves. This is intended to place a known cap on
outflows. Hong Kong, the OECS and some former USSR countries and Pacific islands are examples.
It is argued that in this way all claims on local currency can be met by foreign exchange. In reality,
there are several modifications to this and varying percentage coverage used in different jurisdictions.
Generally, it is felt that a sizeable money stock in relation to reserves puts the monetary authority in a
weak position to deal with possible capital flight. However, international crises in the past 10 years are
not able to point to a high money base and low reserves as the cause of the crises, though low
reserves do result from crises. In addition, where capital markets are open, currency boards no longer
provide the insurance they once appeared to offer.
Reserve levels and access to capital markets
Uncertainty about access to capital markets also influences the level of reserves which Central Banks
hold. Access to capital markets can be cut off because a country's credit rating falls or because the
market itself is short of liquidity. In addition, access may be so costly as to be prohibitive. In these
circumstances, central banks can be pressed into drawing on international reserves. Though building
foreign exchange reserves by way of foreign borrowing is not the optimum approach to foreign
exchange accumulation, in some circumstances countries may need to resort to the capital markets in
order to boost reserves, in order to fund foreign currency payments and to boost confidence in the
economy. In some developed countries, foreign borrowing is only undertaken to meet government's
foreign currency liabilities and not for funding of private sector payments. Several central banks
(among them the Bank of Canada) do not therefore provide foreign currency to the commercial
banking system to fund private sector transactions balances.
Reserve accumulation needs in fixed and floating rate regimes
In a fixed exchange rate regime ideally, commercial banks should finance transactions from their own
foreign exchange resources before approaching the central bank. However, they can, and do,
approach the central bank to purchase foreign exchange for transactions purposes. It is expected,
however, that central banks will provide foreign exchange to fund only those private sector foreign
payments which cannot be met from the system, but it is sometimes difficult to confirm that banks
have tested the interbank market first. Consequently, unless central banks in fixed exchange rate
regimes can get commercial banks to use their foreign exchange resources, and we have in
Barbados, been trying to do this (Trinidad and Jamaica operate that way all the time), fixed exchange
regimes will find it necessary to hold higher levels of foreign exchange than their counterparts in
floating rate regimes where the exchange rate is not sacrosanct.
Foreign exchange reserves and support for exchange rates
Foreign exchange intervention aimed at preventing currency depreciation requires high levels of
foreign exchange reserves. In some floating rate economies regimes, authorities often worry that a
steep depreciation of the currency could have political and credit risks and will intervene in order to
support the rate or to slow its depreciation. Foreign exchange intervention is defined here as any
operation that has the effect of altering the net foreign position of the public sector. Paul Moser Boehm
(2005) in BIS papers on "Foreign Exchange Intervention in Emerging Markets" notes that there is a
limit to intervention. If the exchange rate is depreciating as a result of weak fundamentals, intervention
would not help to stabilize it for long unless the central bank raises interest rates, and even then
stabilization is not assured. Likewise, trying to reverse depreciation by intervening in the foreign
exchange markets can be ineffective in the face of chronically large budget deficits.
Where central banks take foreign currency directly from public or private entities outside the market, in
some cases as a result of surrender requirements, termed "passive interventions", this can
supplement reserves. These are direct dealings of the Central bank with the private sector - where the
private sector borrows or otherwise obtains foreign exchange and sells the foreign exchange directly
to the central bank - and while used in some Latin American countries, it can sometimes be less than
transparent.
Sterilized interventions are transactions that are offset by central bank transactions which nullify any
impact on domestic money creation while unsterilized interventions are included as part of a deliberate
monetary policy.
Intervention is prompted by the view that if a country can keep its exchange rate relatively steady there
is likely to be a greater likelihood of capital inflows. In order to support its exchange rate, a country
must, however, have a healthy level of foreign exchange reserves so as to position itself to support the
rate where it deems it necessary for the achievement of macroeconomic stability.
Indeed, in floating rate systems in developing countries, the quantum of foreign exchange reserves
aimed for by the central bank depends to a large extent on the objectives of the Bank. If the country
wishes to keep its exchange rate stable, a higher quantum of reserves is required than if it is prepared
to allow the rate to depreciate. If it is prepared to allow it to depreciate at a controlled pace, it can
suffice on somewhat less, but still substantial reserves; but if it is prepared to let the rate go altogether,
less reserves are required.
In floating exchange rate regimes, particularly in hard currency areas, authorities seem more inclined
to allow the rate to go where it will. This permits the central bank to hold on to its foreign exchange
reserves. The decision not to intervene and so conserve reserves can also be influenced by the extent
to which the central bank feels that its intervention can or cannot make a difference. Sometimes the
cost in terms of likely foreign exchange loss is too high and the central bank may opt to hold on to its
foreign exchange reserves and allow the rate to depreciate.
Foreign currency accounts and the impact on foreign exchange reserves
Globally, there has been an increase in the holding of foreign currency accounts, principally in dollars,
by resident account holders in non-dollar countries. While this may be advantageous to the holder, it
removes large sums from the pool of foreign exchange reserves which can be made available to the
general public, and creates foreign assets which are blocked by the banks who hold such accounts for
particular customers, whether or not the customer needs the funds for current use. This portion of
funds, which would otherwise have been available to a greater number of users, reduces the pool of
reserves and slows the pace of accumulation of official foreign exchange reserves. However, there is
increasing pressure on central banks to allow the free holding of foreign currency accounts - this
involuntary dollarization is represented as part of the liberalization process. This too, and it is
increasingly the case, pushes central banks into holding more foreign exchange reserves, and also
undermines the effectiveness of monetary policy. The ratio of foreign currency deposits to total
deposits in the Caribbean ranges from a low of under 15% in Barbados and the OECS to close to 40%
in