Neelkanth Mishra | April 19, 2022, 8:31PM IST
This appeared in the Times of India on April 20, 2022 (link)
Sanctions following the Russia-Ukraine conflict have triggered much discussion on how other countries would manage their foreign currency (FX) reserves going forward. These reserves are a country’s insurance against economic shocks, like households or companies keeping some assets in ‘liquid’ form, which means easily convertible to cash, or in cash.
A country’s FX reserves need to be similarly liquid and stable in value at times of crisis: Imagine holding an asset as insurance which becomes inaccessible during a crisis, or whose value drops sharply! The ‘safety’ of reserve assets is thus paramount, which depends on the type of assets held and the currency in which they are denominated.
Reserves have been part of economic discourse for more than a century For example, in the interregnum between the two world wards, in 1935, while deliberating on economic sanctions on Italy for attacking Ethiopia, countries discussed whetehr Italy’s reserves would last long enough for it to finish the campaign.
In the 1960s, economist Robert Triffin identifed the paradox named after him that a country whose currency became a global reserve currency would have to run a continuous trade deficit and thus keep borrowing to provide sufficient supply of assets for the whole world. It followed that as the global economy expanded, and demand for reserve assets grew, the US would be unable to find and own enough gold to maintain the dollar’s peg to gold. This presaged the break in the dollar’s peg to gold in 1971.
The Asian Financial Crisis of the late 1990s reinforced the need to have sufficient reserves. ‘Sufficient’ for some meant it must cover all short-term external debt; others thought reserves worth three months of imports sufficed. What followed was a steady rise in global FX reserves, from 2 trillion USD in 1999 to nearly 12 trillion USD by 2014.
However, then they stagnated, before rising during Covid years. Reserves as a share of global GDP rose from 5.5% in 2000 to 15.4% in 2014 but are now below 14%. In fact, if not for Switzerland and India, both of which bought dollar assets to prevent their respective currencies from appreciation, and not so much to buy more insurance against volatility, the absolute quantum of global reserves would have fallen over the past eight years. This is primarily because of sharp decliens in FX reserves in China and Saudi Arabia. But growth also slowed in most countries.
A country running current account surpluses, equivalent to a household that produces more than it consumes, will accumulate foreign assets over time. Foreign asset holdings of China and Saudi Arabia have grown steadily: They have just stopped sequestering most of them as FX reserves, that is, liquid foreign assets held by a state actor, for it to be useful in times of crisis.
As any wealth manager knows, liquidity comes at a cost – financial or geopolitical returns on these assets are by definition lower than on less liquid and less safe assets. FX reserves as a share of China’s total foreign assets have fallen from 70% in 2010 to less than 40% now; for Saudi Arabia these have fallen from over 60% to less than 40% over the same period.
In fact, other than Switzerland and India, the ratio has fallen in nearly every country. For the 10 countries that add up to 70% of global FX reserves, the share of reserves in total foreign assets has fallen from 27% to 20% over the past decade.
Countries like Norway, Saudi Arabia and Singapore have grown their Sovereign Wealth Funds (SWF), which make longer-term investments for better returns. SWFs globally now manage 10 trillion USD of assets. Other countries like Japan and China have allowed their firms to buy foreign assets: such assets are hard to use in times of crisis, but are better overall for the economy.
The share of USD in global FX reserves has indeed fallen from 71% in 1999 to 59% in 2021, with nearly half the decline occurring since 2014. Share has shifted to the euro, the yen, the Chinese yuan (CNY), the British pound, and the Canadian and Australian dollars: the last three have not gained share since 2014.
Nearly a fourth of the CNY reserves are in Russia. For the central bank reserve managers to shift allocation from USD to CNY would require CNY-based assets to be freely tradeable (that is, a more open capital account: a process that is underway), and CNY share of global financial transactions (both trade-related and financing related) to rise. China’s current account surplus potentially limits the safe assets it can provide to global savers, but this is not a binding constraint.
While these shifts are generally slow, there are risk they may accelerate.
The recent 8% decline in the value of 10-year US government bonds (when yields rise, the value of the bond falls) questions the first requirement of a reserve asset: Stability during market volatility. This is better than currency-adjusted returns on other developed country alternatives, but high and sticky US inflation could continue to push down the share of global reserves in USD assets.
Further, contrary to fears of a “New Triffin dilemma” that as the US share of global GDP declined, it would be unable to supply the safe assets the world needs, supply of US government bonds has grown significantly more than the demand for them from global central banks.
Even as debates continue on global reserves’ currency composition, a deeper challenge may be stagnation in their size.