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Reserves as safety nets

by Gary Smith and John Nugée

Reserves and safety nets

After almost 15 years of unremitting growth to mid-2014, foreign exchange reserves totals have declined, in some countries rather rapidly. China’s foreign exchange reserves, after peaking at around $4tn in mid-2014, have fallen to $3.2tn, a 20% decline. Global reserves, as measured by the International Monetary Fund, have fallen from around $12tn to just under $11tn over the same period.

Some commentators have extrapolated a forecast of a continual decline in official foreign exchange holdings of the emerging market economies that dominate global reserves holdings. But these forecasts are unlikely to be correct in our view. There has not been much change in the underlying economics of emerging markets, and in the strategies adopted to meet their challenges.

Trends are still firmly in place that provide longer-term structural support for growing foreign exchange reserves. The global reserves surge in the 15 years to 2014 is unlikely to go into full reverse.

Reserves have become too important to be run down rapidly, as this would risk compromising a range of objectives. Holding reserves can be costly, but the benefits should not be underestimated.

China illustrates some important lessons. In little more than a year the country went from having a ‘very big problem’ with the burgeoning size of its reserves (to quote Li Keqiang, China’s premier, in May 2014), to speculation (for example in September 2015) that its reserves levels were inadequate. The absolute level of reserves is now less important as an indicator of the health of a central bank and underlying economy than their rate of change. Rapid use of reserves is likely to be perceived as a sign of weakness. This is a key problem for central bankers as they seek to defend their accumulation strategy.

For many countries, the definition of excess reserves is constantly changing and may prove elusive. The natural bias of central bankers and finance ministers for ‘more not less’ has probably not ended. Politicians cling to the sentiment that reserves are a national safety net, so a sustained decline would be unpalatable for many nations.

Two trends appear inescapable. Developing economies will, over time, continue to take a growing share of global GDP. And emerging nations will continue to have more foreign exchange reserves per unit of GDP than developed countries. As the global financial system expands much more quickly than world output, central banks may feel the need to bolster their reserves faster than global economic growth. ▪

Gary Smith is Head of Sovereign Wealth Funds and Official Institutions at Barings Asset Management. John Nugée is a Director of OMFIF. This is an edited extract from the authors' OMFIF paper, 'Foreign exchange reserves in a volatile world', published on 14 June.