Foreign exchange reserves are a critical component of global financial systems. They play a pivotal role in ensuring economic stability and safeguarding against currency crises. As economies become increasingly interconnected, the role of foreign exchange reserves has become even more critical. EGROW Foundation organised a webinar to discuss the nature of reserves, reasons for their accumulation, and their impact on global trade and financial resilience.
Over the past two decades, reserves have experienced significant growth in parallel with the expansion of global liquidity and trade. However, recent observations suggest a stagnation in their accumulation, prompting a closer examination of the factors at play. The webinar discussed the needs for foreign exchange reserves, such as the need for market interventions to stabilise volatile exchange rates and the role of reserves as a safety net during financial crises. The speakers discussed the evolving role of international reserves in the context of the dominance of the dollar and the emergence of alternative currencies in global trade.
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Lull after boom in foreign exchange reserves
Professor Hans Genberg, Professor of Economics, Asia School of Business
To understand the significance of foreign exchange reserves, we must examine them in relation to global trade and liquidity. It will help explain why the measure of total reserves should be linked to the number of global exports or imports. Data clearly illustrates that reserves have experienced rapid growth in relation to global liquidity and trade since the early 2000s but have, more recently, stagnated.
Reserves serve multiple purposes, one of which is intervention in the foreign exchange market. Many emerging markets intervene in the forex market to stabilise or modify exchange rate volatility, and the International Monetary Fund recognises this as a legitimate policy tool. However, given the substantial volume of foreign exchange markets and trade, reserve holdings must be relatively large to exert any significant impact on the exchange rate.
High-reserve countries suffer less from major shocks
Reserve accumulation provides some support for trade
Countries have several reasons to intervene in foreign exchange markets and accumulate reserves. The central bank of a country acts as a lender of last resort in foreign currency, which proves crucial during financial crises or when banks in other countries require liquidity in a foreign currency.
For instance, the Swedish Central Bank holds reserves in dollars to provide liquidity to Baltic banks, and the Korean Central Bank receives a swap line in dollars from the Federal Reserve to cater to American banks in Korea. Another reason for accumulating reserves is to stabilize exchange rates in the face of large current account surpluses or capital inflows, as demonstrated by China and Switzerland. In both cases, failure to intervene could have detrimental effects on the economy due to currency appreciation.
As of 2022, China ($3.5 trillion) holds the highest amount of foreign exchange reserves, followed by Japan ($1.4 trillion) and Switzerland ($1.0 trillion). However, determining whether global reserves are adequate remains a difficult question to answer precisely. The distribution of reserves among central banks is one factor that may impact their adequacy. While some countries like China and Switzerland possess excessive reserves, others such as Sri Lanka have none and rely on the IMF for loans.
However, being deficient in reserves does not always entail a temporary problem that can be solved by acquiring more reserves; it signifies persistent balance of payments deficits, which may necessitate fundamental policy changes. The cost of holding reserves and the trade-off between safeguarding against balance of payments problems and the potential returns of utilizing reserves for other purposes are crucial considerations. Addressing this issue calls for the establishment of larger global and regional safety nets, such as the Chiang Mai Initiative Multilateralisation in Southeast Asia.
Although international safety nets, like the IMF and regional counterparts, exist, central banks often prefer to maintain their own reserves due to the potential difficulty in accessing these safety nets or fulfilling the associated borrowing conditions. It is essential to examine Special Drawing Rights (SDRs), which were allocated in small amounts until the 2009 financial crisis when a significant allocation of around $300 billion was made. Another substantial allocation was made in 2021.
However, the total value of outstanding SDRs remains relatively small compared to the overall reserves being held. This may be attributed to challenges in obtaining larger SDR allocations approval or the preference of central banks to retain their own reserves. Analysing the currency composition of reserves reveals that 60% of allocated reserves are held in dollars. Nonetheless, there has been a gradual diversification of reserves among an increasing number of countries, rather than a decline in the importance of the dollar in the international monetary and trade system.
Although the Renminbi has been considered a potential replacement for the dollar as a reserve currency, several obstacles impede this transition, such as the Chinese capital account’s lack of openness. Despite this, certain countries in Southeast Asia and Russia hold a larger proportion of their reserves in renminbi due to sanctions imposed on the Russian economy. However, the dollar is expected to remain the dominant international currency for trade and capital flows.
India follows safety first approach
Dr. Charan Singh, CEO, Foundation for Economic Growth and Welfare
International reserves comprise foreign currency assets (FCAs), gold, and other components such as SDR and reserve positions in the IMF. China holds the highest number of international reserves, followed by Japan, Switzerland, and other countries. Data illustrates a significant increase in reserve holdings during times of crisis, such as the Asian crisis of 1995-96.
Sufficient reserves are vital for dealing with economic shocks, including volatile capital flows, and ensuring financial stability within a country. The Asian crisis highlighted the importance of holding large reserves. The adequacy of reserves can be measured by the reserves-to-GDP ratio, which has shown an increasing trend for India.
In the past, gold held significant importance, and some central banks are considering purchasing gold again in the current period of de-dollarisation. Furthermore, India’s experience in 1991, when it had to seek resources from the IMF and the Bank of England due to a reserve shortage, emphasizes the importance of maintaining sufficient reserves.
India adopted market-based exchange rates in 1993 and achieved current account convertibility in 1994, but capital account convertibility has not yet been implemented. The formation of a high-powered committee on Foreign Exchange Management in 1993 recommended that a country’s reserves should be able to cover one year of imports and short-term debt.
If other countries had followed this rule, crises could have been prevented. Import cover of reserves, which reached 17 months in 2021 and has remained at a comfortable level since, is another measure to understand the adequacy of foreign exchange reserves in India. Additionally, short-term debt as a percentage of reserves has never been a major concern in India.
Several indicators are related to a country’s financial stability. Reserves as a percentage of external debt have been found to be sufficient for India. Similarly, exports as a percentage of reserves are also considered adequate. In the past, Korea had to rely on a line of credit from the Fed Reserve to rescue American banks, raising questions about its claims of maintaining a clean float in the exchange rate market.
The rapid depreciation of the Indian currency and the corresponding decline in foreign exchange reserves suggest a decrease in the funds used to support the currency and manage volatility. The objectives of Foreign Exchange Management in India, developed in response to the country’s experience in 1991, highlight the importance of liquidity and the need for India to be prepared for capital movement volatility.
Foreign exchange reserves, primarily invested in safe and liquid assets such as foreign government securities and the Bank for International Settlements, have not been channelled into sovereign wealth funds for an extended period as returns were not a priority. The focus has been on safety and liquidity, aiming to build confidence in international rating agencies and markets, which has positioned India well.
Foreign exchange reserve management in India has prioritized safety and liquidity, with returns on foreign currency assets averaging around 2%, competitive with the rest of the world. The adequacy of reserves is a sensitive issue and depends on the specific needs of the country. Utilizing reserves can help build and maintain market confidence.
As volumes increase, adopting the Singaporean model of Sovereign Wealth Funds is recommended for higher returns. Additionally, de-dollarisation in the future may be observed not only due to increasing bilateral trades in national currencies but also due to decreasing confidence in the dollar as a result of the Federal Reserve’s unconventional monetary policy.
Multiple dominant currencies emerging
Dr. Sweta C. Saxena, Chief of Staff, United Nations Economic Commission for Africa
Currency crises in emerging markets have evolved through various stages. Initially, they involved fixed exchange rates and significant fiscal deficits, which depleted foreign exchange reserves and led to currency devaluation. However, during the Asian financial crisis, there was a shift as the crisis was triggered by private sector borrowing rather than fiscal deficits.
As a response to this crisis, emerging markets started accumulating foreign exchange reserves as a preventive measure against future crises. This change in behaviour may have been driven by the fact that these countries had to rely on IMF loans, which motivated them to build reserves to avoid similar situations in the future. The lasting impact of the Asian financial crisis on countries like Korea is significant, as it is still referred to as the “island of crisis” even after 25 years.
The Reserve Adequacy Ratio, initially introduced by the IMF, aimed to determine the appropriate level of foreign exchange reserves for countries. At that time, countries were being criticized for accumulating excessive reserves. In the current context, the cost of a currency crisis is substantial, and each shock has a lasting impact on output. Consequently, countries tend to accumulate foreign exchange reserves as a precautionary measure due to the fear of volatile floating exchange rates.
The dominance of the dollar as the global currency for trade and borrowing has repeatedly come to the forefront. Countries require dollars to pay for imports and service their debts. However, the speaker questions whether the dollar will maintain its dominant status in the future, given the emergence of local currency bond markets in emerging economies and the increasing use of non-dollar currencies in bilateral trades. In a multipolar world, there is a possibility of multiple dominant currencies emerging.