The latest edition of the Federal Reserve Bank of New York’s Current Issues in Economics and Finance, Reserve Accumulation: Implications for Global Capital Flows and Financial Markets, is available.
Authors Matthew Higgins and Thomas Klitgaard examine the recent surge in central bank purchases of foreign government securities and other foreign currency assets. Since 1995, holdings of such assets—known as foreign exchange reserves—have more than doubled. The authors identify both the benefits and the costs accruing to countries from reserve purchases and argue that the large share of the purchases going to dollar assets may have important effects on U.S. financial markets.
Central banks in Japan and the emerging Asian nations have been especially active in building up their holdings of foreign currency assets—above all, those denominated in U.S. dollars. As Higgins and Klitgaard explain, these purchases are part of the process in which countries that save more than they need for domestic investment send their surplus saving abroad to purchase foreign assets. Thus, in 2003, countries in Asia were the source of substantial net capital outflows, with roughly $309 billion supplied to the rest of the world. Western Europe, Canada, and oil-exporting countries were also net suppliers of saving. This saving, for the most part, ended up in the United States, which borrowed $531 billion from the world.
According to the authors, holdings of dollar-denominated assets offer a foreign central bank an important advantage: they help insure the country against a rush by investors to convert domestic currency assets into dollars. Having a large stockpile of dollar assets to meet such a shift in market demand can serve as a public demonstration of a commitment to exchange rate stability. In addition, central banks also buy reserves to “lean against the wind” when private capital inflows or outflows threaten to bring unwanted changes in the value of the domestic currency.
Higgins and Klitgaard also note, however, that foreign central banks incur significant risks by accumulating large foreign currency reserves. Reserve purchases generally result in lost interest income for central banks and expose the banks to potentially large capital losses should the domestic currency strengthen against reserve currencies.
In analyzing the impact of the reserve buildup on U.S. financial markets, the authors observe that the large reserve purchases by foreign central banks have made these institutions important players in U.S. financial markets. Indeed, data from the Bank for International Settlements show that at end-2003, central bank holdings of dollar assets, at roughly $2.1 trillion, were equivalent to more than half of marketable Treasury debt outstanding.
According to the authors, the central bank reserve purchases have compensated for a decline in foreign private purchases of U.S. assets. “Continued large U.S. current account deficits,” Higgins and Klitgaard suggest, “raise the risk that foreign investors could eventually require some combination of lower U.S. asset prices, higher U.S. interest rates, and a weaker dollar as compensation for adding to their stock of claims on the United States.”
Matthew Higgins is an international officer in the Development Studies and Foreign Research Function of the Emerging Markets and International Affairs Group; Thomas Klitgaard is a research officer in the International Research Function of the Research and Statistics Group.