Alan Greenspan on Currency Reserves

The following are edited excerpts from a speech given by Alan Greenspan before the World Bank Conference on April 29, 1999.

One way to address the issue of the management of foreign exchange reserves is to start with an economic system in which no reserves are required. There are two. The first is the obvious case of a single world currency. The second is a fully functioning, fully adhered to, floating rate world.  All requirements for foreign exchange in this idealized system could be met in real time in the marketplace at whatever exchange rate prevails. No foreign exchange reserves would be needed. 

If markets are functioning effectively, exchange rates are merely another price to which both public and private decision makers need respond. Risk-adjusted competitive rates of return on capital in all currencies would converge. Only liquid reserves, denominated in domestic currency, would be required by public and private market participants. And in the case of a central bank of a fiat currency regime, such reserves can be created without limit. 

Clearly the real world is not perceived to work that way. Even if it did, it is apparent from our post World War I history that national governments are disinclined to grant currency markets unlimited rein. The distributions of income that arise in unregulated markets have been presumed unacceptable by most modern societies, and they have endeavored through fiscal policies and regulation to alter the outcomes. In such environments it has been the rare government that has chosen to leave its international trade 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 trade surplus as somehow good, and deficits bad. Since in the short run, if not in the long run, trade balances are affected by exchange rates, few are allowed to float freely.  In a crisis, of course, monetary authorities are often overwhelmed and lose any control of the foreign exchange value of their domestic currency. For good or ill, most nations have not been indifferent to the foreign exchange value of their currency. I say most, but not all. 

Immediately following the dollar's float in 1973, U.S. authorities did not intervene and left it to others to adjust their currencies to ours. We did not sense a need to hold what we perceived to be weaker currencies in reserve because presumably we could always purchase them in the market, when and if the need arose. We held significant reserves in only that medium we judged a "harder" currency, that is gold. 

It has become a general principle that monetary authorities reserve only those currencies they believe are as strong or stronger than their own. Thus central banks, except in special circumstances, hold no reserves of weak currencies other than standard transaction balances that are not viewed as stores of values. 

The United States built up modest reserve balances of DM and yen only when the foreign exchange value of the dollar was no longer something to which it could be indifferent, as in the late 1970s when our international trade went into chronic deficit, inflation accelerated, and international confidence in the dollar ebbed. 

The choice of building reserves in a demonstrably harder currency is almost by definition not without costs in real resources. The budget cost of paying higher interest rates for the domestic borrowings employed to purchase lower yielding U.S. dollar assets, for example, is a transfer of real resources to the previous holders of the dollars. 

The real cost of capital is higher in a weaker currency country because of risk. Countries with weaker currencies apparently hold hard currency reserves because they perceive that the insurance value of those reserves is at least equal to their cost in real resources. Reserves, like every other economic asset, have value but involve cost. Thus the choice to build 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 perceived benefits of intervention in the foreign exchange markets. That would appear to require a successful model of exchange rate determination and a clear understanding of the influence of sterilized intervention. Both have proved to be a challenge for the economics profession. 

The two main policy tools available to monetary authorities to counter undesirable exchange rate movements are sterilized intervention operations in foreign exchange markets and monetary policy operations in domestic money markets. 

Empirical research into the effectiveness of sterilized intervention in industrial country currencies has found that such operations have at best only small and temporary effects on exchange rates. One explanation for the limited measurable effectiveness of sterilized intervention is that the scale of typical operations has been insufficient to counter the enormous pressures that can be marshaled by market forces.

Hence reserve assets do not, in a meaningful way, expand the set of macroeconomic policy tools that is available to policy makers in industrial countries. In addition there is scant evidence that the rapid development of new financial instruments and products has undermined the liquidity, efficiency, or reliability of the market for major currencies. 

While the stock of foreign exchange reserves held by industrial countries has increased over time, those increases have not kept pace with the dramatic increases in foreign exchange trading or gross financial flows. Thus in a relative sense, the effective stock of foreign exchange reserves held by industrial countries has actually declined. 

In recent years volatility in global capital markets has put increasing pressure on emerging market economies.  This has important implications for financial management in those economies. There have been considerable fluctuations in the willingness of global investors to hold claims on these economies over the last two years. Between 1992 and 1997, yields on a broad range of emerging market debt instruments fell relative to those on comparable debt instruments issued by industrial country governments. But this pattern reversed sharply with the onset of the Asian financial crisis in the second half of 1997, and again following the ruble's devaluation in August of 1998. 

These changes in foreign investors' willingness to hold claims on emerging market economies had a particularly severe impact on currencies operating under fixed or pegged exchange rate regimes. Accordingly, those countries' foreign exchange reserves and reserve policy played an important role in the recent financial crises. 

The Asian financial crises have reinforced the basic lesson that emerging market economies should pay particular attention to how they manage their foreign exchange reserves. But managing reserves alone is not enough. In particular, reserves should be managed along with liabilities and other assets to minimize the vulnerability of emerging market economies to a variety of shocks. In this context some simple principles can be outlined that are likely to be useful guidelines for policymakers. 

Pablo Guidotti, the Deputy Finance Minister of Argentina, suggested that countries should manage their external assets and liabilities in such a way that they are always able to live without new foreign borrowing for up to one year. That is, usable foreign exchange reserves should exceed scheduled amortizations of foreign currency debts without rollovers during the following year. 

This rule could be readily augmented to meet the additional test that the average maturity of a country's external liabilities should exceed a certain threshold, such as three years. The constraint on the average maturity ensures a degree of private sector "burden sharing" in times of crisis, since in the event of a crisis, the market value of longer maturities would doubtless fall sharply. If the preponderance of a country's liabilities are short term, the entire burden of a crisis 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 that is indeed the case, their economies are being exposed to too high a risk generally. For too long emerging market economies have managed their external liabilities to minimize the current borrowing cost. This short-sighted approach ignores the insurance imbedded in long-term debt, insurance that is often well worth the price. 

The essential function of an external balance-sheet rule should be to make sure that actions of the government do not contribute to volatility in the foreign exchange market. Consequently it makes sense to apply the rule to all of the government's foreign assets and all sovereign liabilities denominated in, or indexed to, foreign currencies. 

It is important to note that adherence to such a rule is no guarantee that all financial crises can be avoided. If the confidence of domestic residents is undermined, they can generate demands for foreign exchange that would not be captured in this analysis. But controlling the structure of external assets and liabilities could make a significant contribution to stability. 

A "liquidity at risk" standard could handle a wide range of innovative financial instruments -- contingent credit lines with collateral, options on commodity prices, put options on bonds, etc.  Such a standard would encourage countries to manage their exposure to financial risk more effectively. 

Clearly it would not be feasible at present for most emerging market countries to implement a policy regime based on liquidity at risk. It might not even be feasible for most emerging market economies to adhere to a more simple external balance-sheet rule, since many countries will require some time to build up foreign exchange reserves, and to adjust the structure of their external liabilities. It is almost certainly desirable, however, for countries to begin to think about managing their assets and liabilities, or just monitoring their vulnerabilities, in a more sophisticated way. An external balance-sheet rule is probably a good place to start.