On three issues relating to central bank foreign reserves

I was recently asked to deliver a presentation to central bankers on three issues relating to foreign exchange reserves:

• How to mitigate exposures and vulnerability to capital flows.
• How to distinguish central bank reserves from other public investment funds.
• What is the effect of sanctions on the international role of a global currency.

My speaking notes on the three issues are as follows.

How to mitigate exposures and vulnerability to capital flows.

The main point I will argue is that macroeconomic management rather than reserve management is the most important factor in mitigating exposures and vulnerability to capital flows. So, reserve managers should be very clear with their colleagues responsible for monetary policy: the responsibility is mostly on their shoulders. This is not to deny that reserve management can help, but its role is a complement, not the main factor.

One additional general comment is that the ideas I will put forward inevitably have some political implications. Basically, they imply being close to liberal economies, especially advanced ones. If this is a problem for one or the other country, it can, of course, decide to maintain a distance from them. This should be done, however, with the awareness that a price will have to be paid in terms of additional exposure and vulnerability.

My presentation on the first issue is divided into four sections of unequal length:

1. I will first give a conceptual scheme to interpret “sudden stops”, which are the clearest case of vulnerability to capital flows.
2. Then I will present the main macroeconomic factors that protect a country from vulnerability.
3. I will, in the third section, very briefly refer to the importance of relationships with International Organizations and with the leading global players.
4. Finally, I will address how reserve management can help protect from vulnerability.

1. Sudden stops are the most damaging form of vulnerability

Diamond and Dybvig have won, together with Bernanke, the 2022 Nobel prize in economics. Their main contribution was to explain how suddenly, without any apparent proportional economic change, debt may turn from sustainable to unsustainable. Their model was built with banks in mind, but can be applied to any institution, for instance a firm or even a sovereign, which has a maturity mismatch, i.e. shorter-term liabilities than assets. Indeed, governments typically have very illiquid assets and liquid liabilities, and are thus exposed to the risk of sudden stops. The trigger of the move from normal to crisis conditions is a change of expectations. What was sustainable when expectations were in a good state becomes unsustainable when expectations move to a bad state, without an evident cause. This model is often interpreted to mean that fundamental conditions do not matter; only expectations do. I think this interpretation is wrong because the susceptibility to a change of expectations depends on the size of the maturity mismatch: an entity that has gone very far in borrowing short-term to invest in long-term assets is more prone to a change of expectations than an entity with a more prudent behaviour. This became apparent during the euro crisis, when countries like Ireland, Greece, Portugal, Spain and Italy, which had large fiscal imbalances and debt and therefore a sizable liquidity mismatch, were hit by a change of expectations, while countries with a more balanced situation, like Germany or France were immune. This example shows that the vulnerability to changes in capital flows can also affect advanced economies, even if it is emerging economies that they most often touch.

Emerging economies are also particularly exposed to the shocks that can derive from changes in macroeconomic, and in particular monetary, policies of globally relevant countries, in particular the United States. We have here an intrinsic problem: US authorities, including the FED, have a national responsibility, as they must care about the welfare of US citizens, but their actions have global repercussions. Of course, they must consider the feedback on the US economy from spillovers from their actions. Still, they cannot do something negatively impacting their economy, even if this would be beneficial from a global point of view.

The bottom line from this first section is simple and can be summarised in three points:

• Sudden stops mostly impact emerging but can also touch advanced economies.
• The spillover of US policies can be the trigger of sudden stops.
• The risk of being hit by sudden stops primarily depends on macroeconomic vulnerabilities, in particular imbalances between the maturity of external assets and liabilities.

2. Main macroeconomic factors that protect a country from vulnerability.

One can be more specific than just referring to a maturity mismatch in identifying macroeconomic factors that make a country vulnerable to capital flows. The list of these factors looks obvious to me, but it could still look controversial.

Of course, the point of departure to look at vulnerabilities is the current account, which is the counterpart of the foreign indebtedness of a country, cumulating over time into the net foreign position. A large current account deficit, cumulating in large foreign net debt, is an interesting symptom. Still, it is neither proof of a vulnerable situation, nor is a balanced/surplus current account proof that there is no risk. In sum, a current account deficit is, per se, neither a necessary nor a sufficient condition of vulnerability. One must look a bit further into the balance of payment and into general macroeconomic conditions to come to a sound assessment. The composition of capital flows matters a lot: a large role for FDI rather than portfolio, and in particular banking, flows is reassuring, since FDI corresponds to investment in the country receiving it and is more stable and longer term than portfolio flows. More generally long-term flows are more reassuring than short-term ones. The macroeconomic use of capital inflows is also relevant: do financial accounts show that capital inflows finance consumption (either public or private) or investment? And of course, fiscal conditions have a bearing on vulnerability: high budget deficits, not justified by high and productive public investment, increase vulnerability.

The current account is also insufficient as an indicator of vulnerabilities because it only looks at the net between capital inflows and outflows, while also the gross amount of liabilities is relevant. Returning to the concept of liquidity mismatch applied to a country, it can very well happen that a country has a balanced external situation, both in terms of flows and stocks, but is still vulnerable to sudden stops or sudden capital outflows that it cannot manage without disruptions, because its liabilities are more liquid than its assets.

Last, and I would say least, capital controls can, temporarily and in some specific circumstances, help reduce vulnerability. I must admit here that I did not always share this view. For a long time, I thought that capital controls were always producing negative effects. This probably derived from the fact that capital controls were applied in my country, Italy, for far too long, to continue with unsustainable fiscal policies. More recently, I was convinced that flexible exchange rates and interest rate management cannot always protect from external shocks and that capital controls, especially checking capital inflows when global monetary conditions are too exuberant, can help in emerging economies.

One last factor that I would like to mention is fair income and wealth distribution. This has no direct effect in protecting from vulnerabilities. Still, I believe an economy where it prevails is more robust to shocks than one where income and wealth distribution are very uneven. The possible need to tighten fiscal and monetary policy will encounter fewer political resistances if the burden is fairly distributed. The same will apply to the possible need to have temporary recourse to capital controls.

3. Good relationships with the IMF, other international organizations and leading global players

Good relationships with the IMF, other international organizations, and leading global players can help in two critical respects: understanding and action.

First, as regards understanding, good relationships can reduce the vulnerability to capital flows. Indeed, a country having a frequent, frank, and deep relationship with international organizations and leading global players will be fully abreast of economic developments and policies which can have an impact on it. For instance, it could better understand the policy moves and intentions of the Federal Reserve, or the ECB when relevant, or get an updated view of the global economy from the IMF. In addition, it could engage with them in a fruitful discussion about the most appropriate policy moves.

Second, as regards action, good relationships could help manage capital flows when needed, particularly in crisis situations. For instance, the IMF can help with funding when private capital flees from a country while the country is in sound macroeconomic conditions. The Fund can also help regain sound conditions, when these have been lost. Analogously, currency swaps with the FED, and with the ECB, can help manage the sudden drying of liquidity.

4. Reserves

Let me finally come to the role of reserve management in protecting from vulnerabilities and in particular allowing a gradual rather than an abrupt adjustment of demand to sudden stops of capital inflows. Here as well, my ideas are pretty mainstream. I would put four factors in decreasing order of importance:

• Liquidity.
• Usability.
• Safety.
• Size.

I have identified above a liquidity mismatch between assets and liabilities as the primary source of vulnerabilities to capital flows. It is thus obvious that liquidity comes on top of my list of essential factors for reserve management. Liquidity is a concept adjacent to but not the same as maturity or duration. Liquidity has to do with the ease and cost with which a financial asset can be transformed into cash. From this point of view, a long-term security exchanged in a deep and liquid market can be more liquid than a short-term bank deposit. In addition, one should also consider the “repoability” either with the market or with the relevant central bank (especially the FED and the ECB), of any security.

Usability has to do with the match between the currency in which the reserves are held and that which is needed in case of capital outflows. Usability will thus depend on the currency used to settle international trade and to denominate foreign liabilities of the relevant country. It will be better to have currency X, which is used to settle external trade and denominate external debt, than having currency Y, which is not used for either one or the other purpose. From this point of view, I have some doubts about the usability of gold reserves.  Indeed, gold is neither used to settle international trade nor to denominate foreign debt. Its use, when needed, will depend on the ability to sell it for a usable currency, in a market which is not very deep and capable of dealing with very large and frequent operations.

Of course, usability has taken a new dimension in a world with sanctions. Russia has found out that the usability of its large reserves was much less than anticipated because of sanctions. I will deal with this issue below.

As regards safety, the ability of reserves to act as a buffer is impaired if their value is volatile, also taking into account that there could be a correlation between shocks hitting a country and shocks hitting the value of volatile assets in reserves.

I put size of reserves last because of two reasons.

First, a country that has a reasonable macroeconomic situation and has a good relationship with international organizations and global national players will not need large reserves.

Second, I see reserves’ ability to remedy an imbalanced macroeconomic condition and poor relationships with international organizations as limited. In my conceptual Diamond and Dybvig paradigm, a deterioration of expectations that finds its ultimate origin in an unbalanced situation must be remedied by an external actor with potentially unlimited resources. In the original bank case, this is the central bank acting as a lender of last resort. In the case of a country, it will be either an international organization or a global central bank willing to assist. Reserves will risk being considered insufficient, even if available in large amounts. And the evidence is that the additional protection afforded by reserves rapidly decreases with their size[1].

Just to be more concrete, I think strong arguments are needed to justify reserves exceeding the Greenspan-Guidotti rule. But here we are entering into the second topic I was asked to cover:  the distinction between central bank reserve portfolios from other investment funds.

Distinction between central bank reserve portfolios from other investment funds

One important issue in managing international reserves is determining their optimal size or, more modestly, which are the criteria to define a reasonable range for their size.

Different methodologies are suggested for this purpose. Probably the most famous is the Greenspan-Guidotti rule which, in a spirit similar to the Liquidity Cover Ratio for banks, established in the Basel agreements, posits that the optimal level of reserves is equal to the size of the short-term (1 year) liabilities. Of course, this is somewhat indeterminate if nothing is said about the optimal level of short-term liabilities. An even more straightforward rule of thumb is that a country, in particular an emerging one, should hold a level of reserves equal to three months of imports.

Of course, more sophisticated approaches have been developed, and I am not going through them nor proposing my method. What I would like to do is to provide some sort of indicator of when reserves are too large.

To do this, I find it helpful to start from the purpose why a central bank holds international reserves, and here I stress the fact that I talk about central bank reserves, to distinguish them from other public holdings of external assets.  Central bank reserves are a kind of buffer to protect the macroeconomy from shocks. This determines the prevalence in their investment strategy of liquidity, usability and safety, as I argued above.

My first indicator follows from this very brief description: if a central bank tends to move towards giving more importance to return than to liquidity, usability and safety, I would start asking questions whether that central bank is holding an excessive level of reserves.

I have read an interesting recent report[2] indicating two different developments in reserve management: one towards ESG investment, which I find helpful, and another according to which central banks are participating, albeit with care and in a differentiated way, in the generalized search for yield, characterizing much of the investment world. I think this latter phenomenon is concerning because of its possible consequences on financial stability, but I am particularly concerned, seeing that it also applies to central banks. The issue is that it is difficult to move toward higher yield without also moving toward less liquid and riskier currencies and assets.

Of course, I am not extending my indicator to sovereign wealth funds: I would, of course, not advise the Norwegian wealth fund to invest its trillion-dollar only in highly liquid, usable and safe funds. But this is exactly the point; a sovereign wealth fund has very different purposes from a central bank. In addition, I believe the competences and, I would add, the culture of a central bank is different, or at least should be different, from that of an investor like a sovereign wealth fund.

So, my point, in the end, boils down to a very simple specialization advise: endow the central bank with the level of reserves, however estimated, that is needed to protect the macro economy from shocks and keep a mandate that prioritise liquidity, usability and safety. If the country overall decides that its public sector needs a larger amount of foreign assets, it better to attribute it to an entity like a Sovereign Wealth Fund and distinguish very clearly the different mandates of the two institutions.

The desire to hold reserves in a public body, like a SWF, will depend in turn, on two aspects:

• The ability of the private sector relative to that of the public sector in managing funds, if the latter is higher than the former, then it makes sense to hold the assets in a public body like a SWF.
• The macroeconomic policy of the country concerned. In particular, the accumulation of foreign assets in a SWF is consistent with the will to invest rather than consume  resources. It is not by chance that SWF are often created, like in the paradigmatic case of Norway, to substitute foreign financial assets for assets in the ground, like oil and gas.

Of course, the subsequent choice could still be to place the SWF in the central bank. It is important, however, that the investment criteria of the SWF are different from those of the central bank in the management of reserves and that the SWF is organizationally distinct from the central bank carrying out monetary policy.

A second criterion judge about the appropriate level of reserves, with more ex-ante characteristics, is to analytically estimate which amount of foreign exchange reserves could be needed for macroeconomic purposes and to destine any amount exceeding that to “other investment funds”. For an advanced economy like the US or the €-area, this will boil down to an estimate of the reserves that may be needed for FX interventions. This will typically generate very small amounts relative to the size of the economy. For instance, the about 35 billion $ of foreign currency reserves of the United States are only a tiny fraction of the 26 trillion US economy. In the euro area ECB foreign currency reserves at 55 billion € are also a tiny fraction of the euro-area’s GDP of 15 trillion. The about 300 billion of foreign currency reserves held by the entire Eurosystem, including reserves that are not directly targeted to interventions, are still a tiny share of the total GDP of the euro-area.

For emerging economies, these estimates will arguably be a much larger share of GDP. I recalled above the Greenspan-Guidotti rule as a point of departure. But there is a large literature on the optimal level of international reserves for emerging market economies.[3] For instance, Jeanne and Ranciere estimate a benchmark of 10 % of GDP as optimal. They reach this result by inserting plausible valued in their theory derived optimal level of reserves.

In their model the optimal level of reserves depends on 6 parameters:

• The probability of a sudden stop.
• The ratio of short-term debt to GDP
• The output loss ratio (how much output decreases in case of a sudden stop).
• The return on reserves.
• The term premium.
• The risk aversion parameter.

The two first parameters establish a direct link to the points I made above about the importance of macroeconomic factors: the probability of sudden stops and the ratio of short-term debt to GDP. Both should be low for a macroeconomically sound economy, implying a lower level of optimal reserves.

My general conclusion on this point is that, while one can start from a rule of thumb like the Greenspan-Guidotti rule, the choice about the reserves to be held in the central bank to support macroeconomic policies requires a thorough analytical work that considers both the theoretical framework and the specific conditions of the relevant country.

What is the effect of sanctions on the international role of a global currency

The United States and other countries or jurisdictions sitting over globally relevant financial markets, like the euro-area, the UK and Japan, are always confronted with a dilemma when adopting financial sanctions against another country. On one hand, sanctions can indeed cause the sought-after damage to the affected country and can, over time, give incentives to change behaviour. On the other hand, sanctions give incentives to become immune from them, severing ties with the global financial system.

We have seen an example of this dilemma with SWIFT, which is the archetypal representation of the global financial system. Fears of sanctions to be excluded from it led China and Russia, with different but in both cases limited success, to build their own messaging system. Another occurrence has been the imposition of sanctions on Iran, after the abandonment by the Trump administration of the agreement to avoid the construction of an atomic bomb by that country. In that case, the Europeans were not directly affected by the sanctions, still they suffered from so-called secondary sanctions and tried, again without much success, to establish a parallel arrangement that would have allowed them to continue trading, for some products, with Iran. In these cases, either the imposition of sanctions or just the fear of sanctions led to initiatives that could lead to a fragmentation of the global financial system.

Given this dilemma, two, interrelated, questions arise:

• Which are the criteria to determine which of the two horns of the dilemma prevails?
• What is the potential fragmentation effect of Russian sanctions?

In my view, the following factors attenuate the potential fragmentation effect:

• The wider is the group of countries that take the sanctions relative to that hit by the sanctions.
• The more the sanctions are reasonable, i.e. are consistent with some objective reasoning that resonates with global interests, rather than just being the result of narrow national interests.
• The more the sanctions react to a behaviour from the affected country generally felt as unacceptable.

Just to be more concrete, sanctions decided by the United Nations would satisfy the three criteria above better than a unilateral initiative by anyone country.

How do these factors play out in the case of the Russian sanctions?

My assessment is that the fragmentation risk is there, but is attenuated by the following considerations:

• The sanctions were consistent with a large majority of countries at the UN condemning the Russian invasion of Ukraine (the relative resolution was approved with 141 votes in favour, 5 against and 35 abstentions, even if two heavy ones from China and India).
• It is a general interest to send a signal that changing borders by military force goes against a peaceful world order.
• There is a large, if not universal, support for a country militarily attacked by another one.

In conclusion, while the imposition of sanctions, in particular the freezing of transactions of the Central Bank of Russia that affected its ability to use its reserves, will have fragmentation effects, in particular as it could further push China to protect itself from sanctions preemptively, I think that these will be attenuated by the factors mentioned above.

Of course, the damage to the integration of the global financial system will also depend on how long the sanctions will prevail. If, as one hopes, a peaceful solution will be found to the war, and Russia will no longer threaten and militarily attack another country, sanctions could be gradually raised, and this would confirm that they were imposed just because of the exceptionally grave event that took place.

I think it is in everybody’s interest to have a peaceful and thriving Russia integrated into the global economy and financial system: the sooner its behaviour changes and it will therefore be possible to withdraw the sanctions, the sooner this result will be achieved.

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[1] The size of foreign exchange reserves. Yavuz Arslan and Carlos Cantú. BIS Paper No 104.  

[2] Trends in reserve management: 2021 survey results by Nick Carver, Central Banking Publications.

[3] IMF Working Paper Research Department  The Optimal Level of International Reserves for Emerging Market Countries:  Formulas and Applications.  Prepared by Olivier Jeanne and Romain Rancière. The size of foreign exchange reserves.  Yavuz Arslan and Carlos Cantú. BIS Paper No. 104