Large foreign currency reserve balances may not be needed to maintain an effective exchange rate policy over the medium and long term, according to a recent study by staff at the Federal Reserve Bank of New York.
In their study—“Do Industrialized Countries Hold the Right Foreign Exchange Reserves?”—New York Fed economists Linda Goldberg, Cindy Hull, and Sarah Stein note that the need for foreign currency reserves has been an important tenet of the post Bretton-Woods international financial order. Recent growth in the reserve balances of industrialized countries, however, raises questions about what level and composition of reserves are “right” for these countries.
According to the authors, countries hold reserves as a tool for intervening in foreign exchange markets to potentially stabilize the value of their currency and as insurance against disruptions to capital market access. The authors note, however, that the evidence is mixed on whether foreign exchange interventions can influence exchange rate levels for more than a short period of time. In addition, authoritative metrics are lacking on the level of reserves needed for such interventions. If interventions achieve their effects on exchange rates by signaling the intentions of policymakers, the authors argue, then the purchase or sale of a small amount of reserves might suffice to send the appropriate message. Moreover, while reserves may provide insurance against a loss of access to the capital markets, countries may have other ways to alleviate funding pressures.
Goldberg, Hull, and Stein also contend that reserve accumulations entail costs. In particular, countries incur an opportunity cost by maintaining funds in currency and asset portfolios that, while highly liquid, produce relatively low returns. In addition, large reserve holdings can leave central banks and, ultimately, taxpayers exposed to future movements in exchange rates. Finally, the authors suggest, countries that have accumulated large reserve balances may experience a period of exchange rate distortion when they begin to “unwind” their holdings.
In the second half of the article, the authors provide some context for their arguments by considering the differing experiences of six industrialized countries—the United States, Canada, the euro area, the United Kingdom, Japan, and Switzerland—in acquiring and holding foreign exchange reserves. The authors note that while the first four of these countries have all seen their reserve holdings expand, the reserve portfolios of Japan and Switzerland have grown at a markedly faster pace. In addition, while all six countries mandate that their reserves be held in highly liquid assets, three of the six—Canada, the euro area, and Switzerland—have diversified their portfolios to include a somewhat broader range of investments. Goldberg, Hull, and Stein provide some suggestive evidence that this investment strategy has yielded higher returns and thus tempered some of the opportunity costs associated with large reserve holdings.
Linda Goldberg is a vice president in the New York Fed’s Research and Statistics Group, Cindy E. Hull is a policy and market analysis senior associate in the Markets Group, and Sarah Stein is a research associate in the Research and Statistics Group. Their study can be read in full in the latest Current Issues in Economics and Finance.