8. Safe Assets and Reserve Management

Managers of official dollar reserves are bound to pay attention to the debate over safe assets: their investment portfolios operationally define such assets. This chapter argues that reserve managers need not worry about a shortage of safe assets. The debate turns first on whether demand for dollar safe assets is likely to grow as rapidly as emerging market economies. Second, it turns on whether the supply of dollar safe assets can only grow with US fiscal deficits. Neither holds. On the demand side, emerging market economies’ growth does not require dollar reserves to grow at the rate observed in the early 2000s. In retrospect, rapid dollar reserve growth reflected emerging market economies’ response to dollar depreciation. When the dollar cycle turned to appreciation, foreign exchange reserves stopped growing. On the supply side, law and policy extend state backing to various IOUs and thereby make safe assets. US government support for the housing agencies Fannie Mae and Freddie Mac makes their debt into safe assets, albeit with wobbles. US government support for banks, including Federal Reserve liquidity, Federal Deposit Insurance Corporation insurance, and, in 2008, Treasury equity can make US bank liabilities safe. In the rest of the world, government support of non-US banks allows ones from well-rated countries to compete with US banks in selling safe dollar deposits. Moreover, international and interregional organizations, non-US sovereigns and agencies all compete with the US Treasury in selling safe dollar bonds. In allocating their dollar foreign exchange reserves, central bank reserve managers make room for all such competitors. In particular, they invest more than a third of their dollar reserves outside of US Treasury securities.