The Hindu Business Line : `Flexibility in forex reserves vital'

A Standard & Poor's report on reserves held by central banks draws attention to the fact that eight central banks or their governments hold two-third of the world's external reserves. These are Japan, China, Hong Kong, Taiwan, India, Korea, Singapore and Russia.

Japan and China hold nearly half these reserves (or about one-third of total reserves) between them. Of the eight countries, only Singapore is rated `AAA,' while India is rated non-investment grade.

The report said, "The capacity of a sovereign to carry debt is not simply a function of amassing a store of treasure. External reserves are part of the equation, but they are not a sufficient condition for high sovereign creditworthiness. Albeit a positive rating factor, their benefit derives from the flexibility they afford policymakers, a flexibility that does not expand linearly with reserves and that at some point can even begin to decline even as reserves increase."

Building up reserves is an outcome of the foreign exchange regime and an insurance policy against sudden stops in capital flows, the report said.

Diminishing returns

It added, "There are diminishing returns to stockpiling official reserves, as well as ancillary costs. Official reserves are usually held by the central bank and are assets that need to be funded — either through monetary emission (which can be inflationary), open market operations (which often have a negative cost of carry), or government deposits at the central bank or central bank capitalisation (both of which take resources from taxpayers).

By reducing pressure on the currency to appreciate, the sovereign also relieves pressure on exporting firms to seek productivity gains other than those achieved through a depreciated currency."

Sustainable?

The report wondered whether the current trend of reserve accumulation was sustainable.

It said, "At some point, external creditors will reach their limit of desired US dollar holdings, the dollar's value will fall, and the US current account will narrow." It warned that unless other major economic blocks pick up the slack, the global adjustment would be painful.

It added, "Countries that rely heavily upon net exports will be particularly hurt, although most nations will find themselves at a lower growth equilibrium."