Greenspan suggests new guidelines on reserves

by Chakravarthi Raghavan

Geneva, 7 July -- The view that current methodologies of assessing adequacy of reserves of developing countries, in terms of six months import cover, may not be adequate in a financial world of capital volatility and speculation has received support from a powerful quarter - the chairman of the US Federal Reserve, Mr. Alan Greenspan.

In a speech (published in the BIS review) at the World Bank Conference on Management of Reserves, held in April in Washington, Greenspan has said that emerging markets are particularly vulnerable to speculative attacks on their currencies and financial assets, and traditional focus on managing reserves alone might not be enough.

Greenspan has commended the view that a country's usable foreign exchange reserves should exceed scheduled amortisation of debts, assuming no rollovers, during the following year, and that the average maturity of a country's external liabilities should exceed three years.

Traditionally, the International Monetary Fund, which provides the data on country reserves and its balance-of-payments situation to the GATT and now WTO bodies (including the balance- of-payments committee) has judged the adequacy on the basis of enough reserves to cover six months import bills of goods and services.

And in terms of Art. XV of the GATT, the IMF's findings of statistical and other facts relating to a country's foreign exchange, monetary reserves and balance of payments are to be accepted by Contracting Parties to the GATT (and now the WTO members).

Whether this also requires the IMF assessments of adequacy of reserves to be dispositive of the issue (i.e. binding on WTO members and bodies and dispute panels) has been theoretically left open by the recent WTO panel on Indian BOP restrictions (which are now the subject of appeal on points of law before the Appellate body), which has however accepted some of the IMF assessments.

Recently, after the financial crisis that hit Asia, and then spread to other parts of the world, the IMF has suggested Special Data Dissemination Standards, suggesting some detailed information that countries should gather and provide periodically for balance-of-payments. The SDDS, under BOP, refers to the desirability of a breakdown of relevant financial transactions between direct and portfolio investment, and international reserves being looked into in terms of reserves-related liabilities (such as forward exchange commitments of monetary authority).

In responses to questions put to it by the India BOP panel, the IMF responses (summarised by the panel) suggests that it purports to have taken these elements into account, though its "judgement" and "assessments" may be open to question.

For example, would a six-month import cover adequacy assessment, even one based on trends, in an import restricted regime, be the same if import restrictions are suddenly removed and pent-up demands for luxury goods resulted in a rush of imports, and what would be effect on a country's reserves and judgements of the market on the outlook?

The IMF's response was that with suitable macro-economic policies (is it divorceable from development policies and strategies that a country cannot be asked to change in considering BOP issues?) these problems could be overcome.

But this question apart, Greenspan's views raise some other fundamental questions that neo-liberal economists and trade theorists ignore.

The Fed Chairman has said that no reserves would be needed by a country in an international system of a single world currency (which is not there) or a fully functional floating world.

In a fully functionable floating world, if markets were functioning effectively and exchange rates merely another price to which decision-makers (public and private) need respond, risk adjusted competitive rates of return on capital in all currencies would converge and an optimised distribution of goods and services enhancing all nations' standards of living would evolve. Public and private market participants would require only liquid reserves denominated in domestic currency, and a central bank could create such reserves without limit.

But the real world is not perceived to work that way, and even if it did, national governments are disinclined to grant currency markets unlimited rein, he notes. The distributions of income that arise in unregulated markets have been presumed unacceptable by most modern societies, and they have endeavoured, through fiscal policies and regulations, to alter the outcomes. In such an environment, it has been a rare government that has chosen to leave its international trade and finance to what it deems the whims of the market place.

Such an attitude, he notes, is very often associated with a mercantalist view of trade that perceives trade surplus as somehow good, deficits bad. Since in the short run, if not long, trade balances are affected by exchange rates, rates that are allowed to float freely are few and far between. In a crisis, monetary authorities - most, but not all - are often overwhelmed, and lose any control of the foreign exchange value of their domestic currency.

Arguably, after the float of the US dollar in 1973, the US authorities did not intervene and left others to adjust their currencies to the US dollar. No need was felt to hold weaker currencies in US reserves, since the US could always purchase them in the market if the need arose. Significant reserves were held only in gold.

It is now a general principle that monetary authorities hold in reserve only currencies believed to be strong or stronger than their own and, except in special circumstances, don't hold weak currencies. The US now has built up modest reserves in Deutchemark and yen only when it was perceived that they could not be indifferent to the exchange value of the dollar.

But holding a demonstrably harder currency is not without costs in real resources. Paying higher interest rates for domestic borrowing employed to purchase lower yielding US dollar assets, means a transfer of real resources to the previous holders of the dollar. Holding reserves like any other assets involves costs, and there is a difficult cost-benefit trade-off.

[Though Greenspan did not mention it, when foreign countries make the US dollar their currency or when their citizens hold dollars, the US treasury gains in seigniorage and to the extent of foreign dollar holdings is getting an interest free loan.]

Monetary authorities try to counter undesirable exchange rate movements by sterilised interventions in foreign exchange markets and monetary policy operations in domestic markets. Empirical research suggests that sterilised intervention in industrial country currencies have at best only small and temporary effects on exchange rates. One is left with the conclusion that foreign exchange market-sterilised intervention by itself has only a limited impact on exchange rates.

Reserve assets don't expand in a meaningful way the macroeconomic policy tools available to policy makers in industrial countries. And there is scant evidence that new financial instruments and products have undermined the liquidity, efficiency or reliability of the market for major currencies.

The introduction of the Euro, he envisages, would significantly alter reserve holdings and as Euro-denominated assets develop, the Euro should become increasingly attractive as a world reserve currency, and its increased attractiveness should reduce the demand for dollars. But this effect would be limited and evolutionary.

And while the stock of foreign exchange assets held by industrial countries has increased over time, they have not kept pace with the dramatic increases in foreign exchange trading or gross financial flows. And in a relative sense, the 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, and this has important implications for financial management of these economies.

Referring to the Asian crisis, Greenspan says that this financial crisis has 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. They should be managed along with liabilities, and other assets, to minimise vulnerability of emerging market economies to a variety of shocks.

Greenspan has commended in this connection the views put forward recently by the Argentine Deputy finance minister and which some of Greenspan's colleagues in the US Federal Reserve feel worth considering, namely, that countries should have net reserves that would enable them to live without new foreign borrowing for upto one year. Greenspan explains this as meaning "usable foreign exchange reserves should exceed scheduled amortisations of foreign currency debts, assuming no 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. Short-term creditors on the other hand are able to exit without loss when their instruments mature.

If the preponderance of a country's liabilities were short-term, the entire burden of a crisis would fall on the emerging market economy in the form of a run on reserves.

Greenspan also suggests that countries follow an external balance-sheet rule to ensure that actions of government do not contribute to volatility in the foreign exchange market.

But it would probably be desirable to move beyond simple balance- sheet rules and work towards a standard that is stochastic - take into account the foreseeable risks that countries face. One approach would be to calculate a country's liquidity position under a range of possible outcomes for relevant financial variables - exchange rates, commodity prices, credit spreads etc. For e.g., an acceptable debt structure could have an average maturity - averaged over estimated distributions for relevant financial variables - in excess of a certain limit.

In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid borrowing for one year with a certain ex ante probability, such as 95% of the time.

Such a "liquidity-at-risk" standard could handle a wide range of innovative financial instruments, and would encourage countries to manage their exposure to financial risk more effectively.

But it would not be feasible at present for most emerging market countries to implement a policy regime based on liquidity at risk, and not even feasible to adhere to a simpler external balance-sheet rule, since many of them would need time to build up external reserves. (SUNS4472)

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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