SecondSettlement Currency Central bankers and policymakers used to think markets were unwise. Burning foreign exchange reserves to take on the forces that push and pull the value of a currency is foolish, so the idea goes, and it’s almost certainly futile. The orthodoxy holds that a country seeking to defend its currency should raise interest rates rather than sell reserves.
This has been put to the test in the real world last year, as U.S. interest rates hiked and the U.S. dollar strengthened. Officials in many emerging economies have deployed their assets to defend local currencies.according to International Monetary Fundglobal foreign exchange reserves fell by $1.1 trillion between the end of 2020 and the third quarter of 2022, with holdings of dollar-denominated assets accounting for half of the decline.
Over the past few months, however, that process has begun to reverse, as the dollar has weakened and the pressure on countries to intervene to defend their currencies has eased. Since October, through a combination of revaluations and new purchases, the aggregate holdings of Asia’s big reserve holders — China, Japan, South Korea and Taiwan — have risen by $243 billion to a total of $5.6 trillion. India’s foreign exchange reserves have also risen by $42 billion since October, recovering more than a third of the decline in the previous 12 months.
A recent paper by Rashad Ahmed of the U.S. Office of the Comptroller of the Currency and his co-authors suggests that, in fact, large reserve accumulators may be justified in rebuilding. All else being equal, countries entering 2021 with larger reserves and greater credibility in their ability to intervene will see their currencies depreciate less.The authors calculated an additional reserve equal to 10 percent of the country gross domestic product Associated with a 1.5% to 2% reduction in the depreciation of the local currency against the US dollar.
Meanwhile, some countries that started the period with small reserves have depreciated significantly. The Egyptian pound/dollar exchange rate was 16 at the start of 2020 and is now 31. The official exchange rate for the Pakistani rupee has also weakened, from 154 to the dollar at the start of the covid-19 pandemic to 278 recently. In both places, the black market offers even lower rates.
There may be another benefit to healthy foreign exchange reserves, Mr. Ahmed and his co-authors note. There is no longer a need to use interest rates to defend the currency, allowing “domestic monetary policy to better target domestic objectives”.
The danger, however, is that monetary intervention is seen as a way to avoid a more painful rise in interest rates.Although International Monetary Fund While not as strongly opposed to foreign exchange intervention as it once was, it still has some limitations. As recently as October, when the dollar was peaking, the agency’s vice-president Gita Gopinath and chief economist Pierre-Olivier Gurinchas Gourinchas warned developing economies not to use monetary intervention as a substitute for tightening monetary and fiscal policy.
The experiences of large currency reserve holders during the dollar’s recent surge may give governments other ideas. Being able to resist the pressure to follow the Fed’s rate moves is the goal of many developing economies — and the more reserves they hold, the more resistant they seem to be. ■
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