15   : Updating the Foreign Exchange Reserve Situation

Jane D Arista in FOMC Alert

"Mirroring the sharp rise in international capital mobility, holdings of foreign exchange reserves by the world’s central banks and governments more than doubled between 1990 and year-end 1999. By 1999 the share of total reserves held by just ten Asian countries nearly equalled the 39% share held by all developing countries in 1990.

"Correspondingly, the share held by industrial countries fell from 61 to 40% over the same period. Among industrial countries, US holdings experienced the greatest decline. From 1990 through 1999, US foreign exchange reserves fell by $20 billion and dropped from 6.6 to 1.8% as a share of official reserves worldwide.

"Dollar-denominated reserves rose from 55 to 78% of outstanding reserves while the share of all other currencies dropped from 45 to 22%. Moreover, the amount of global reserves invested in US financial assets jumped from slightly more than one-third to one-half of total reserves. As a result, foreign exchange reserves have become an increasingly important component of US external debt, accounting for 18% of total foreign holdings of US financial assets.

"Official foreign exchange reserves function as a balance wheel of the global monetary system. They provide countries a mechanism to adjust the surpluses and deficits that constantly occur as individuals, firms and government entities make payments to one another in the course of international trade and investments. Today, the vast majority of these payments are made in four currencies– the dollar, euro, yen, and pound sterling. Countries that do not issue key currencies must acquire them for their citizens and companies to conduct most types of international transactions.

"Foreign exchange reserves are created as these individuals and companies deposit payments denominated in dollars, euros, yen or pounds (typically in the form of cheque drawn on aUS, European, Japanese or British financial institution) in a local bank, which subsequently redeems the funds for local currency with the nation’s monetary authority. The central bank now owns a deposit with the foreign financial institution that issued the cheque–and the central bank usually invests that deposit in a reserve-currency country’s least risky debt securities to earn a reasonable return. Thus reserve holdings constitute a source of credit for the country in which they are invested, not for the country that owns them.

"Because a growing share of all international reserves is denominated in dollars, the US has become the main user of this credit source. By year-end 1999, foreign central banks and other foreign entities had invested $881 billion of reserve balances in US financial assets–an outstanding loan equivalent of 9.5% of US GDP.

"Ironically, universal acceptance of the dollar as a transactions currency and store of value tends to constrain US opportunities to accumulate foreign exchange. [That is why] US citizens and non-financial firms acquire very little foreign currency. In addition, the Federal Reserve discourages US nationals from holding balances denominated in foreign currencies. What little foreign exchange the US government holds, it has accumulated by intervening in FOREX market, occasionally selling dollars for other currencies to lower the value of the greenback.

"As a result US foreign exchange reserves have grown ever more minuscule. At year-end 1999, the total of these reserves ($32.2 billion) equalled only 3.7% of the dollar reserves held by foreign official institutions–down from 18% in 1990. And the value of US foreign exchange reserves ($32.2 billion) equalled less than one-tenth of one percent of total foreign holdings of US financial assets. A developing country sporting a similarly slender ratio would be deemed woefully uncreditworthy."

"So far, America’s expanding current account deficit has not triggered any adjustment in the stream of foreign exports to the US or discouraged foreign investment in US financial assets. Other countries continue to willingly sell goods for dollars due to the affluence of America’s enormous market and the flourishing credit system. In addition interest differentials have generally tended to favour investment in dollar assets since 1994.

"Given the enormous inflows of foreign capital, it would be remarkable if the US had not experienced a run of general prosperity. But the external factors that have contributed so heavily to America’s good times are not sustainable. The US cannot indefinitely support a growing level of foreign debt–including an $881 billion loan in the form of international reserves–while experiencing a corresponding (indeed, interrelated) run-up in domestic private debt.

"If and when domestic borrowers encounter sustained rising interest rates, their needs to service historically high debt levels will begin to pinch consumption and growth will slow. Declining growth could diminish confidence in the dollar–a development the US has endured before but never with so great an exposure to foreign creditors.

"And the effects would reverberate among countries with large dollar reserve holdings, possibly turning these inactive balances– long a symbol of caution and probity–into a vehicle for financial contagion."

–from Economic Reform, September 2000