Greenspan on Currency Reserves

[William F Hummel <wfhummel@xxxxxxxxxxx>]

As a counterpoint to the Stiglitz article on Global Financial Reform,
here is a shortened version of a speech given by Greenspan before the
World Bank Conference on April 29, 1999.  Greenspan was addressing a
somewhat different problem, namely the avoidance of financial crises
such as the southeast Asia crisis of 1997.  The editing is mine, but I
believe the essential points are faithfully captured.

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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
policy makers.

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.

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.