from Follow the Money

Reserves are meant to be used in bad times

December 5, 2008

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Tracy Alloway of the Financial Times’ Alphaville blog -- echoing Robert Sinche of the Bank of America -- thinks that spending reserves to defend your own currency and support your own banks is a form of economic nationalism.

Funnily enough, I always thought that building up reserves through thick and thin -- and accumulating more reserves than a country ever needed for its own financial stability -- was a far more egregious example of economic nationalism. A country that only adds to its reserves is presumably pursuing a policy of intentionally holding its currency below its equilibrium value in order to support its export sector. A country like China isn’t just accumulating reserves because it enjoys financing the US, UK and many European governments at low rates ....

The tone of the the FT’s excerpts of the Bank of America report suggest that a country that sells its reserves to support its own economy hurts the global economy. Not true. It may drain liquidity from some parts of the financial market, but the sale of reserve assets finances policies that add liquidity (so to speak) to parts of the goods market.

Reserves are meant to provide a buffer against external shocks. And right now a host of emerging economies are facing a major shock. Remember, a country that is selling its reserves is trying to keep its currency from falling. That means it is trying to keep the price of the world’s goods in its market from rising -- and in so doing, it is keeping demand for the world’s exports up.

And a country that draws on its reserves to make up for shortfall in export revenue is substituting the sale of foreign assets for a fiscal contraction -- a contraction that would subtract from global demand growth.

Suppose for example Russia stopped intervening, let the ruble depreciate, didn’t bailout its banks (so they defaulted on their foreign debt and couldn’t finance domestic firms) and budgeted for $40 a barrel oil next year. Russian imports would collapse. That would have a big impact on Europe’s exports. The UK doesn’t make all that much these days, so this shift would hurt Germany more than the UK. But just because it helps some countries (and sectors) more than others doesn’t meant that the world doesn’t gain when a country draws on its own reserves to avoid a major contraction in demand.

Indeed, if -- and it is a huge if (see below) -- private savings and investment do not change as a result of the government’s decision to run a bigger fiscal deficit, selling foreign assets to make up for a shortfall in say oil export revenue and to finance a budget deficit leads directly to a larger current account deficit and more demand for the world’s goods. It isn’t a beggar-thy-neighbor policy.

Nor does it necessarily mean that the US and others won’t be able to finance large fiscal stimulus.

Remember, the big if -- a rise in the fiscal deficit only leads to a rise in the external deficit if private savings and investment do not change, so the extra call on savings from the deficit has to be met by the world. And right now private savings and investment patterns are changing -- particularly in the US. Goldman forecasts private sector in the US will go from rough balance in q2 2008 to a large (10% of GDP) financial surplus by the end of next year. That means private savers in the US will be in a position to lend to the US government. Some money that say would have been spent on a Toyota instead will be lent to the US Treasury. In this case, the rise in the fiscal deficit will offset a rise in private savings and fall in private investment, allowing the US current account balance to improve even as the fiscal deficit expands.

And in the off chance the emerging world spends so much that demand for US exports prevents a large US slump, the US wouldn’t need such a large stimulus in the first place.

Bottom line: the US and Europe need emerging markets to buy their goods at least as much as they need emerging markets to buy their bonds. Consequently, a fall in central bank demand for US Treasury bond is no bad thing if it is the product of a set of policy choices that increase demand for US exports. Changing the basis of global growth requires, well, change.

One technical note: foreign exchange reserves cannot directly be sold off to finance a fiscal deficit most of the time. Fiscal deficits are usually financed by selling off domestic bonds -- and only indirectly put pressure on the balance of payments as higher spending (or lower taxes) leads to more demand for imports. Foreign exchange reserves can only directly be used to cover an external financing need. But if a country has grown accustomed to financing a high level of domestic spending (and an associated high level of imports) with the government’s revenues from commodity exports, reserves can substitute for a shortfall in the government’s export revenues.

This gets to the difference between central bank reserve purchases through intervention in the foreign exchange market (China) and Treasury reserves accumulated through saving the revenue from a commodity windfall. If the Treasury has lots of foreign assets on deposit at the central bnk, the Treasury can withdraw some of its foreign exchange, sell it to the central bank for domestic currency and draw on its external assets (rather than issue domestic liabilities) to cover a fiscal deficit. Fiscal spending in turn leads to higher demand for imports, and thus a current account outflow that reduces the central banks foreign exchange reserves: for example, government employees looking to buy the world’s goods may sell domestic currency for foreign currency. The overall result is a fall in the country’s overall foreign exchange assets, not just a shift in ownership of the foreign asset from the Treasury to the central bank.

Apologies if this is confusing; of all balance of payments concepts, the way Treasury foreign assets can be used to cover a fiscal deficit is one of the more difficult.

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