6. The Cost of Holding Foreign Exchange Reserves

Indeed, one could see leaning-against-the-appreciation-wind during expansions as the countercyclical prudential response to procyclical capital flows and real exchange rates, the goal of which is to avoid current account deficits in good years and prevent a dollar squeeze in the downturn. Such a strategy would be related to precautionary motives, although it would differ from the simple hoarding of liquid assets typically associated with the precautionary story.

A typical figure here is a country that maintain a constant current account surplus with a tradable sector net bidder of local currency, who sells its foreign currency net export proceeds to the central bank in order to not restring its domestic absorption. By this token, the consolidate government can accumulate reserves without the necessity of incurring in new borrowing.

On the high cross-country correlation of reserve needs displayed during episode of global distress, see Cordella and Levy Yeyati (2010).

Since intervention is geared to offset the demand for the local currency, the issuance dollar debt would not do the trick in this case.

See also Chap. 15.

See, Fernandez-Arias and Levy-Yeyati (2010).

Readers interested in this model might look at Jeanne and Ranciere (2011), Jeanne and Sandri (2016), and the references therein.

See, for example, Levy Yeyati (2014).

Fernandez Arias and Levy Yeyati (2010) explore the relationship between a reaction to the traditional IMF approach and the emerging in the 2000s of regional safety nets (CMI and LARF) as alternatives. It is also worth noting that emerging members of the G20 are main promotors of global financial safety nets, having achieved reforms aimed at enhancing financial resources and renewing instruments for emergency liquidity provision, but failed at accomplishing reforms concerning the governing structure of International Financial Institutions. For a review, see Cheng (2016).

Sarno and Taylor (2001) provide an early survey for advanced countries, and Levy Yeyati and Sturzenegger (2010) provide a review with a focus on developing economies.

See, among others, BIS (2005, 2013), Levy Yeyati (2010), Adler and Tovar (2011), and Daude et al. (2014).

Perhaps in the realization of this inconsistency between goals (precautionary exchange rate smoothing) and instruments (short-run reserve assets) lies the hope to reduce the excessive demand for the latter that triggered the quest against reserve accumulation in the first place.

The section is based on Levy Yeyati (2011).

As stated before, we do not consider the case of hoarding reserves due to current account surplus.

See Jeanne and Ranciere (2006).

All variables are in logs. All regressions controls are based on monthly data, include country fixed effects and exclude observations for countries in default, for which the spread can no longer be interpreted as a measure of credit risk. Regressions also exclude cases in financial distress (spreads above 1000 basis points) and the crisis years 2008 and 2009, as they are likely to exhibit a qualitatively different relation between reserves and credit risk. We used splines interpolation to turn debt and GDP (originally yearly data) into monthly data.

Additionally, we find that the international rate (proxy for international liquidity) performs as expected before the crisis, but as the interest rates reach the so-called zero lower bound in the aftermath, the elasticity becomes negative, meaning that low level of rates in advanced countries started to increase the cost of borrowing for emerging markets.

We could also add that, since the fact that reserves are held in short-dated instruments is related less to liquidity than to central banks’ agency problem associated with reserve management practices (for example, the manager’s fear of short-term mark-to-market losses), the term premium is in most cases an unnecessary cost.

See Levy Yeyati and Sturzenegger (2010) for a discussion.

While not strictly related to the focus of this chapter, the same is true for the opposite case of a temporary depreciation pressure: the bank sells at a depreciated exchange rate reserves that were purchased or are later replenished at a lower parity.

Can the central bank intervene in a way that maximizes valuation gains? While that purpose is not often written in official documents, Sarno and Taylor (2002) suggest that the information available to, and used by market agents is often less accurate that the authorities provide. Along the same lines, Blinder et al. (2008) argues that “central banks may have, or may be believe to have, superior information on the economic outlook [because they] usually devote many more resources than private sector forecasters to forecasting and even to estimating the underlying unobservable state of the economy.” By this token, the central bank with its powerful research department may use its more accurate data to intervene in a profitable way by hoarding reserves, while its price is perceived to be low, and selling when it is perceived to be high. A similar argument has been proposed and tested to explain why an unanticipated interest rate hike by the central bank typically shifts the yield curve upwards despite the fact, whereas it is expected to reduce inflation over the long run (Romer and Romer 2000).