C3S Fortnightly Column No. F007 /2015
Dr. Y.V. Reddy, former Governor of the Reserve Bank of India (RBI), had clear views about the role foreign exchange reserves play in managing the monetary policy. Indeed, they were not in line with the accepted mainstream wisdom. He did not mind. In a lecture delivered in 2002 as Deputy Governor, he spelt out the contours of the reserves policy and his own perceptions. Those were the days when the global financial community was murmuring against the reserves accumulated the by emerging economies.
In one of his famous lectures delivered in Bombay, Dr. Lawrence H. Summers, former US Treasury Secretary, criticized the developing countries like India for investing their reserves in U.S. Treasuries and getting very low returns. Instead, he advised them to deploy them in money markets through reputed brokers to get better returns. He referred to the exploits of U.S. money managers performed for university endowments like Stanford through that route. Dr. Reddy was sitting by his side and would have dismissed the suggestion with a grin. (Dr. Summers did not disclose his close connection with some hedge funds and the high fess he was earning.)
In a way, Dr. Summers was right. The returns on the reserves were indeed low. But, a nation’s reserves are not to be managed like Mr. Scrooge. There are larger economic rationaleand purposes. In fact, Dr. Reddy had elaborated all the concerns perspicuously in the lecture referred to above.
The pace of accumulation of reserves by emerging economies began to worry even economists sympathetic towards developing countries. They felt that the reserves should be within reasonable limits and they should also avoid short term liabilities. Prof. Dani Rodrik of Princeton voiced suchviews. However, there was no agreement among the economist community on what the reasonable level should be.
By 2004, the reserves of developing economies had risen to $1.7 trillion. This was a backlash to the humiliating treatment some of the Asian countries received from the IMF/World Bank led by the developed countries during the Asian crisis of 1997 and the stringent conditionalities attached to IMF assistance. Asian countries were short- changed. They felt that the effort was more to save the western banks which had lent recklessly than to help the countries or their poor people. Net result was thatdeveloping countries began to move away from the Washington Twins and turn inwards. They began to build forex reserves to safeguard (insure) their economies against future crises.
Perhaps, our RBI took the lead in enunciating a policy on reserves. In his lectures and writings Dr. Reddy emphasized that the RBI should build reserves at a “comfortable” level to be able to meet emerging risks or shocks. He went on to add that it would not be practicable to quantify the comfort level. He explained that it was a varying amount and much depended on domestic and external circumstances and, ultimately, it was the judgement of the central bank which steered the monetary policy and could not be dictated by any outside agency.
Around those days, the IMF took the lead in warning developing countries over “excessive” reserves build up. As usual, it began to churn out a number of documents, working papers, etc. warning developing countries. Unfortunately, there was no finality and the papers turned into pedantic work for some IMF staff. They went on to rely on the so-called Greenspan-Guiodoti rule which required reserves to be just adequate to cover trade deficits and short-term foreign debt. They criticized developing countries in Asia for building reserves far in excess of the amount required as insurance against future shocks. Some of them emphasized the potential for large reserve accumulation to threaten the stability of the international monetary system. Those were also the years when the IMF was worried about “global imbalances” and its economists were blaming China for creating the imbalances ignoring the role of the U.S. in bringing them about.
The debates on reserves ceased when the Great Economic Recession erupted in 2007-08. Globally, the banking system came to a grinding halt and credit froze. Central banks of G-7, led by the U.S., had to arrange huge amounts of liquidity directly or through swaps. These were targeted at western banks and developing countries had no share in it. For a long time the central bankers, including the US Fed, assumed that their financial system was deep, diversified and complex and their banks had evolved new generation innovative products (derivatives in myriad forms) to reduce the risks and the system would never collapse. They also believed that the system would correct itself. These assumptions proved to be wrong. They realized that there could be mismatches and misalignments and regulatory intervention was necessary. It was the concerted action of the U.S. Fed and other G-7 members to pump liquidity into the banks that saved the crisis in the early stages. To their horror, they also realized that part of the liquidity came from the reserves of developing countries. How did it come about?
With the increase in the accumulation of reserves, some of the developing countries like China and oil exporting countries began to establish Sovereign Wealth Funds (SWFs) for investment abroad. In the early years of SWF formation, the advanced countries viewed them with suspicion. Some loathed them as politically driven creatures which cannot conform to western prudential lending rules. Gradually, there commenced a better understanding of their role and agreement to admit them to the high table. When major banks like CITI were starved of capital, SWFs from China or the Gulf provided it. In a way, the Great Recession paved the way for normalization of relations with SWFs. The other result was a benign view of the reserves accumulated by developing countries.
The report of the Independent Evaluation Office (IEO) on reserves should have disturbed the economists and IMF Management considerably.The Report argued that “the IMF’s emphasis on reserve accumulation as a risk for the international monetary system was not helpful in that it stressed the symptom of the problem rather than the underlying causes, and thus led to a loss of clarity in discussions options to reduce such risks.” It also said that “the new reserve adequacy metric which was introduced in 20011 and that defined upper and lower bounds for precautionary reserves was received with skepticism by country officials, who worried that it could become a rigid benchmark to limit reserve accumulation at a time of heightened uncertainty in the global economy.” It faulted that “the IMF’s assessments of reserve adequacy were often pro forma, emphasizing a few traditional indicators and insufficiently incorporating country-specific circumstances.” The report also explained that when a country assesses the adequacy of its reserves, country authorities in practice consider a number of factors. “Some of these are difficult to quantify – for example, the resilience of the economy to exchange rate volatility, the effect of reserves on market confidence and the robustness of the domestic financial system.” The I.E.O. Report vindicates the policy outlined by Dr. Reddy.
Based on the IEO Report and on internal discussions, the IMF brought out a Policy Paper. It grudgingly admits that “Reserves are an essential external liquidity buffer.” It also admitted that reserves were used by advanced countries as an important buffer. Finally, it ends with the view that “while reserves bring significant benefits, although these decline at the margin, and are countered by their cost.” It defends the basic IMF faith that “intervention, including in the form of bank funding needs in foreignexchange, can be effective provided it is not aimed at defending an exchange rate out of line with fundamentals.”(Emphasis added.)
The Executive Board of the IMF discussed the Policy Paper on December 4, 2013. Surprisingly, the Board decisions were released three months later, on March 14, 2014. The Board decisions are not edifying. They are too general and broadly applaud the workdone by the Staff taking into account the IEO Report. The Board looks forward to further discussions on reserve adequacy issues before guidelines could be issued. It is unlikely that there would be any agreement on such guidelines in the coming years.
The IMF staff and Executive Directors of G-7 continue to live in a cuckoo world of free market relying on neo-classical tenets which had led to so much misery and global disruption after 2007. They are averse to any intervention to stabilize the exchange rates and feel that these rates are God given. There have been abundant reports since last year in major financial papers such as Financial Times, The Economist, The Wall Street Journal, etc. exposing how the LIBOR was fixed for some years by colluding banks and their brokers. LIBOR was the holy cow for all bankers! Many of the major banks have paid fines or settled cases filed against them in the US and the U.K. There is another case going on about the same banks fixing exchange rates in collusion. These manipulations have always adversely affected developing countries. Their economies are destabilized or under constant attack stemming from volatile capital. Even so, the IMF experts will frown upon efforts by emerging economies to maintain their exchange rates. The so-called “fundamentals” are a myth and exist only in textbooks. Fortunately, emerging economies are moving together and providing a counter to the Fund’s mindset. We can see this reflected in the Board minutes, including in the one on reserves. This case unravelling the issues connected with accumulation of reserves is a classic in its own way. As I said earlier, the struggle will continue and there will be no finality.
Reddy, Y.V.: India’s foreign exchange reserves – policy, status and issues, Lecture delivered at the National Council for Applied Economic Research, New Delhi, 10 May 2002. Available at www.bis.org/review/r020510f.pdf
Summers, Lawrence H.: Reflections on Global account imbalances and Emerging Market Reserve Accumulation, Reserve Bank of India, L.K. Jha Memorial Lecture, and March 24, 2006.
Rodrik, Dani: The Social Cost of Foreign Exchange Reserves, NBER Working Paper No.11592, January 2006.
See for instance Jeanne, Olivier and Ranciere, Romain: The optimal Level of International Reserves for Emerging Market Countries, Formulation and Applications, IMF Working Paper, WP/06/229 October 2006.
IEO: International Reserves: IMF Concerns and Country Perspectives, December 119, 2012.
IMF: IMF Policy Paper- Assessing Reserve Adequacy—Further Considerations, November 2013.
IMF: IMF Executive Board Discusses Further Considerations on Assessing Reserve Adequacy, Press Release No.14/96, March 14, 2014 available at http://wwwww.imf.org//external/np/sec/pr/2014/pr14496.htm