April 2nd, 2013
by Linda Goldberg, Cindy E. Hull, and Sarah Stein - Federal Reserve Bank of New York
That central banks should hold foreign currency reserves is a key tenet of the post–Bretton Woods international ﬁnancial order. But recent growth in the reserve balances of industrialized countries raises questions about what level and composition of reserves are “right” for these countries. A look at the rationale for reserves and the reserve practices of select countries suggests that large balances may not be needed to maintain an effective exchange rate policy over the medium and long term. Moreover, countries may incur an opportunity cost by holding funds in currency and asset portfolios that, while highly liquid, produce relatively low rates of return.
Governments around the world hold ofﬁcial foreign exchange reserves, which consist of foreign currencies, foreign government securities, and other foreign currency assets. Most often these reserves are held by central banks, although in some cases they may be held by ﬁnance ministries or sovereign wealth funds. To date, the foreign exchange reserves of major industrialized economies have received relatively little attention in public policy circles, with few questions posed regarding their optimal size, composition, and use. Instead, discussion of foreign exchange reserves tends to center on the large holdings of emerging market countries—including China, whose reserves reached about $3 trillion in mid-2012. Foreign currency reserves are also overshadowed in public discussion by the much larger external imbalances that countries amass in the form of trade deﬁcits and surpluses.
While industrialized countries have not accumulated the high level of reserve balances held by some emerging market countries, they have, in a number of cases, seen their reserve balances grow over the past decade. Some industrialized countries have built reserves in periods of current account surpluses or as part of their efforts to resist the appreciation of their currency. In the case of others, the growth of reserves has been more passive—the accrual, over time, of investment returns on a pre-existing stock of reserve assets. Even these gradual gains, however, can add up, producing a signiﬁcant increase in reserves. The possibility of such signiﬁcant accumulations raises some fundamental questions for industrialized countries: Are high reserve balances desirable? How effectively do such balances serve the purposes that the countries have assigned to them? And how can reserve balances be reduced if they have grown to undesirable levels?
This edition of Current Issues provides a conceptual treatment of the size and composition of industrialized countries’ foreign exchange reserves.We consider why countries hold such reserves, and argue that while the scale of international ﬁnancial and currency transactions has grown tremendously over time, it does not necessarily follow that the reserve balances of industrialized countries should expand correspondingly. Higher reserve balances have opportunity costs: most notably, they may yield lower returns than some alternative uses of these funds. Moreover, it is not evident that large foreign exchange reserve balances are needed for effective policy over the medium and long-run horizons of countries.
To place the discussion of these issues in context, we turn in the second half of the article to the experiences of six industrialized countries—the United States, the United Kingdom, Switzerland, Japan, Canada, and the euro area [For expository purposes, we refer to the euro area as a “country” because foreign exchange reserves in the euro area are held at the European Central Bank. While some of the central banks in the euro-area member countries also have foreign exchange reserves, these funds are generally not used in foreign currency interventions and are therefore excluded from this discussion.] — in acquiring and holding foreign exchange reserves.
Why Do Industrialized Countries Hold Foreign Exchange Reserves?
Industrialized countries hold foreign exchange reserves as a tool for inﬂuencing their exchange rates. Under a fully ﬂexible exchange rate system, the price of a country’s currency—the exchange rate—appreciates or depreciates so that the supply of the currency equals the demand for it. In such an environment, countries seldom use foreign exchange reserves. But suppose instead that a country wishes to resist the movements in the exchange rate of its currency. A change in the price of the country’s currency can be averted if the excess demand for, or supply of, the currency is absorbed by the foreign exchange balances in the portfolio of the central bank. For example, consider a country that is running a balance of payments deﬁcit—meaning that cash outﬂows exceed inﬂows on all transactions between that country and the rest of the world. To avoid a depreciation of the currency, the central bank can sell foreign exchange reserves and buy up the excess supply of the country’s currency.Alternatively, in a balance of payments surplus environment, a central bank can avoid a currency appreciation stemming from excess demand for the country’s currency by selling domestic currency and accumulating foreign exchange reserves. These actions by the central bank—accumulating or selling off foreign exchange to control the exchange rate—are termed ofﬁcial foreign exchange interventions.
Countries may also hold foreign exchange reserves in the expectation that the reserves might be used to calm disorderly markets. For example, the threat of intervention by the central bank may restore a perception of two-sided risk to a market in which speculators are betting that the exchange rate will move exclusively in one direction, toward depreciation or appreciation.
A third reason that countries may maintain reserve balances is to insure against liquidity losses and disruptions to capital market access.Aizenman (2008) argues that this self-insurance motive drove the rapid accumulation of reserves in Asia in the early 2000s, in the aftermath of the East Asian crisis.
What Is the “Right” Level of Reserves for Industrialized Countries?
Deﬁning the right level of reserves for an industrialized country is difﬁcult.As we have seen, reserve holdings are expected to provide signiﬁcant beneﬁts, enabling countries to intervene in foreign exchange markets and to regulate the value of their currency. But reserve accumulations also entail certain costs.Among these is the opportunity cost of maintaining funds in currency and asset portfolios that produce returns lower than those of many alternative investments. [We do not address the distribution of costs and beneﬁts in limiting the movements of one currency in relation to other currencies.] Most industrialized countries mandate that reserves be invested in highly liquid assets such as foreign government securities; while these assets provide insurance against a loss of access to the capital markets, they generally yield relatively low rates of return. Of course, the larger the portfolios, the greater the overall opportunity cost of these low returns compared with returns on alternative uses of the funds. Moreover, the larger the reserve balances, the greater the exposure of central bank portfolios and, ultimately, taxpayers to moves in exchange rates when these realignments ultimately occur.
Reserve holdings are expected to provide signiﬁcant beneﬁts, enabling countries to intervene in foreign exchange markets and to regulate the value of their currency. But reserve accumulations also entail certain costs.
Authoritative metrics on the ideal level of foreign currency reserves needed by industrialized countries are not readily available. So it is useful to ask—particularly in light of the opportunity costs we have identiﬁed —h ow much beneﬁt a country really derives from maintaining large reserve balances for possible future intervention activities.Are foreign exchange interventions in fact effective for maintaining a desired level or trajectory of exchange rates? Moreover, how many reserves would be needed for these interventions?
Academic researchers studying episodes of foreign exchange intervention activity have reached mixed conclusions on the effectiveness of the interventions in inﬂuencing levels of exchange rates for more than a short period of time. [For an overview of the different arguments about currency intervention and a survey of evidence through the 1990s, see Sarno and Taylor (2001).A more recent survey by Menkhoff (2010) uses high-frequency data to examine the effects of intervention on prices and volatility. Even those who are skeptical of the efﬁcacy of intervention activity acknowledge the potential usefulness of retaining the option for foreign exchange intervention as one part of a broader toolkit (Truman 2003).] One reason to be skeptical of this inﬂuence is that the volumes of foreign exchange market transactions are very large in comparison with the sizes of most foreign exchange interventions conducted by central banks. Indeed, the average daily spot market over-the-counter foreign exchange turnover is nearly $1.5 trillion per day (Bank for International Settlements 2010). Clearly, total reserve balances on the order of tens or even hundreds of billions of dollars are small relative to daily turnover volumes.