CENTRAL BANKS MAY NOT NEED LARGE FOREIGN CURRENCY RESERVES / THE WALL STREET JOURNAL

April 1, 2013, 3:43 PM

Central Banks May Not Need Large Foreign-Currency Reserves

By Matthew Walter



Since 2008, central banks from China to Japan to Switzerland have squirreled away money and engineered an unprecedented expansion in their foreign-currency reserve holdings, typically with the goal of trying to manage their exchange rates.

But a new paper from the researchers at the Federal Reserve Bank of New York argues that for many of those institutions, the pool of money might be getting so unwieldy that the benefits of this supposed “insurance policy” are outweighed by the costs.


China’s gargantuan $3 trillion store of reserves attracts the most attention, but the paper also singles out central banks in industrialized countries, including Japan and Switzerland, for their aggressive reserve accumulation.


With both the financial crisis of 2008 and the subsequent euro crisis boosting “safe haven” inflows into both the Japanese yen and Swiss franc, the Bank of Japan and the Swiss National Bank have periodically intervened in markets to buy up foreign currencies and temper that appreciation trend, all in a bid to protect their exporters’ competitiveness. But managing the massive portfolios of reserves that they have built up carries risks, the authors of the report, Linda Goldberg, Cindy Hull and Sarah Stein say.


What’s more, increasingly there are other tools available to central banks seeking to manage their exchange rates than merely buying and selling reserves, they argue.


“While the scale of international financial and currency transactions has grown tremendously over time, it does not necessarily follow that the reserve balances of industrialized countries should expand correspondingly,” according to the paper, which was posted Monday on the New York Fed’s website.


Switzerland may be the poster child for rapid reserve growth. The SNB’s foreign-currency assets have jumped 158% since the beginning of January 2010 and totaled $532.8 billion as of February. That is about 80% of the country’s annual gross domestic product.


The paper identifies two major risks for large reserve accumulators. The first is the so-called opportunity cost: most central banks are only allowed to invest in relatively low-yielding assets, providing minimal returns. Switzerland stands out here as an exception, as its central bank can invest in a wider range of assets, including corporate bonds and equities.


The other is the possibility that exchange rates will eventually shift substantially, potentially reducing the value of a central bank’s large holdings. The SNB, for example, has bought large amounts of euros, leaving it exposed to the risk that the common currency may weaken.


The research points out that successful currency interventions historically haven’t always required large amounts of reserves. Central banks are often most effective when they act in a coordinated way with other central banks, or when they use the intervention to signal the direction they intend to take in the more traditional aspects of monetary policy via interest rates and buying and selling home-country assets.


Banks that build up reserves as insurance against a sudden stop in liquidity, such as occurred during the Asian financial crisis in the 1990s, might do well to consider alternatives. For example, the Federal Reserve‘s swap agreements that provided dollar funding to foreign countries at the height of the financial crisis allowed those central banks to avoid using their reserves.


At the very least, the paper argues the topic needs more discussion.


“Considerable uncertainty exists about the level of foreign currency reserves needed by industrialized countries,” the report concludes.