An echo of Goodhart’s law

Dynamic management and foreign exchange reserves

It can be argued that China’s deployment of foreign exchange reserves between mid-2014 and the end of 2016 was the most unsuccessful use of such reserves in history. Around $1tn was spent and, despite this, the renminbi declined in value against the dollar by almost 15%. The outcome confounded conventional theory. The relationship between reserves deployment and currency value did not work as expected.

In defence of Beijing, it is impossible to say where the currency might have moved if the reserves had not been deployed. Capital controls played an important part, to halt and then reverse currency weakness in 2017. However, these factors should not deflect from recognising that intervention to support the currency not only appeared to be unsuccessful, but counterproductive. When the intervention ended, the renminbi rose in value. This adds to the mystery.

The Chinese experience was not unique. There is plenty of evidence to suggest this outcome is probable. A vicious circle can develop, where the use of reserves creates a sense of unease that undermines the currency, as happened in Russia in 2014, South Korea in 2008, and across Asia in 1997.

In these cases the size and rate of depletion became the focus of market attention. Instead of simply being a tool to help achieve currency stability, the reserves became a policy objective in themselves. This is a variation on Goodhart’s law, which can be summarised as stating that when a measure becomes a target, it ceases to be a good measure.

A nation without foreign exchange reserves will be viewed as vulnerable on multiple levels. But a nation with reserves may also look vulnerable the moment they are utilised. As the head of reserves at a central bank with more than $100bn in reserves noted at a recent OMFIF seminar, it’s not how much you have, but whether you have had any need to spend. The concept of reserves adequacy can be rendered redundant by the act of usage.

These circumstances have led to some questions about whether the use and, in turn, accumulation of reserves is pointless. The answer to these questions hinges on the purpose of foreign exchange reserves. In 2018 they are much more than a tool for currency intervention.

Although managing the value of domestic currencies might have been the original reason to hold and accumulate reserves, this use has a poor record of success. In terms of the list of reasons to hold reserves, this should be a candidate for relegation.

To have value as a threat to the foreign exchange markets, reserves (and the assets of related sovereign funds) may need to be more than 100% of GDP, as in Hong Kong and Singapore, rather than the 40% of GDP in China in 2014.

There are two conclusions, with overlapping implications. First, any argument that suggests a need for greater foreign exchange reserves should also demand a more dynamic approach to their management. Second, a relegation of the currency intervention motivation for holding reserves in turn argues for a promotion of the case for the conservation of reserves.

This implies a diminished need for liquidity, and hence greater justification for pursuing yield- enhancing strategies.

Gary Smith is Member of the Strategic Relationship Management Team at Barings and Member of the OMFIF Advisory Council. This article first appeared in the April edition of The Bulletin.

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