reserve and foreign exchange
TRANSCRIPT
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RESERVES AND FOREIGNEXCHANGE IN THE
MACROECONOMIC CONTEXT
1
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
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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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Why Hold Foreign Reserves?
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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Why Hold Foreign Reserves?
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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Why Hold Foreign Reserves?
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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Why Hold Foreign Reserves?
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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Appropriate Level of Foreign Reserve
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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Appropriate Level of Foreign Reserve
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
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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
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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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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
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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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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Management of Foreign Reserves
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
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The Place of Reserves in theMacroeconomic Arena
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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The Place of Reserves in theMacroeconomic Arena
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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