Why do countries hold international reserves?

J. Soedradjad Djiwandono

IO – In the aftermath of the Asian Financial Crisis (AFC) of 1997/98, Martin Feldstein, Harvard Professor and Chairman of President Reagan’s Council of Economic Advisors, wrote an article defining a “rule of thumb” an economy might follow to defend itself against any potential financial crisis, through accumulating sufficient international reserves (Feldstein, 1999). His exposition and argument is not based on any solid theoretical construct, nor on any established practice.

Theoretically, international reserves are required for an economy imposing a fixed exchange rate, when a given country pegs its currency to an international reserve currency, such as the US Dollar (USD), as in the Bretton Woods system. According to this theory, a country needs to hold ample foreign reserves in its central bank to hold the value of its national currency against foreign currencies like the USD (commonly known as the “exchange rate”).

However, in the wake of the AFC, most countries abiding by a fixed exchange system abandoned it, replacing it instead with a flexible exchange or “floating” system. In reality, a country adhering to a floating system does not need to hold international reserves. Its exchange rate will shift in accordance with the supply of and demand for the USD, to clear the markets. If that is the case then why should countries no longer saddled with a fixed exchange system bother to hold international reserves?

Since the world agreed to adhere to a fixed exchange rate regime in 1944, the customary practice, based on IMF guidance, has been to hold international reserves at least equivalent to a country’s need to finance three months’ worth of imports. Thus, the Feldstein proposal is indeed a rule of thumb, one based neither on solid theory nor on established past practices, except for the IMF rule. Surprisingly however in practice it seems to work well, and most countries have in fact been diligently striving to accumulate international reserves. The economies of Asia (including that of Indonesia), taking to heart a lesson from the horrendous experience of the AFC, strengthened by their survival following the onslaught of the Global Financial Crisis (GFC) of 2008/09 and an aftermath of prolonged weakness (the Great Recession), seemed even more convinced that accumulating foreign reserves does work as an effective safeguard against coming financial crises.

More reasons for holding international reserves
At the outset, we should make clear what we mean by “international reserves”. Foreign or international reserves are assets in foreign currencies, held by central banking institutions like Bank Indonesia or the Federal Reserve. They are used to back liabilities on their own, issuing currencies as well as influencing monetary policy. International reserves consist of any foreign currencies held by a monetary authority or a central bank, including foreign banknotes, bank deposits, bonds, treasury bills or other government securities. The term can also encompass gold reserves or IMF funds, what are known as Special Drawing Rights (SDRs). Foreign exchange reserves serve a variety of purposes, but are primarily intended to impart flexibility and resilience to the central government: should one or more currencies crash or succumb to extreme devaluation, the central bank has other currencies to defend against such market shocks.

It should be noted that it is in fact somewhat difficult to ascertain a precise value to the international reserves held by a country, due to the absence of a precise definition of what and what not different financial assets held by central banks to include as “international reserves”, according to their quality and tenor. For example, foreign debt papers (treasury bills) of different maturities may be held from quite brief to very long terms: there is no specific rule to follow to determine which of these should be considered “reserves” and which ones not. Other considerations arise, such as whether one should place a given value in gross or net. Such a decision could easily result in strikingly different estimates of the volume of international reserves held by a central bank. During the AFC, according to a standing BI method of calculation, Indonesia held a total of USD 20 billion of reserves at the time the IMF team came to negotiate Indonesia’s Stand-By Arrangement (SBA), or loan. In the event the IMF team insisted that the foreign reserves held by BI should be reported as USD 25 billion. The discrepancy arose from different techniques of classifying financial assets to calculate international reserves.

On the last point above I stand by the claim in my book, Bank Indonesia and the crisis (Djiwandono, 2003), that Indonesia was in fact more prudent than the IMF in calculating its international reserves; as those concerned are apparently unaware of this I continue writing and arguing about this matter. The IMF loan (or SBA) given to Indonesia in October 1997 amounted to USD 18 billion, consisting of USD 10 billion (the actual IMF loan) and USD 8 billion (loans from the WB and ADB). The actual loan was thus USD 18 billion, while the USD 5 billion added on top to stand at an announced USD 23 billion was in fact Indonesia’s own money in foreign assets held by BI, but this was not counted as “international reserves”.

As popularly (but incorrectly) reported in the mass media, the amount of loans Indonesia received from the IMF to cope with the financial crisis of 1997 (popularly termed the “IMF bailout”) was USD 43 billion. How did this magic number arise? It came from adding another USD 20 billion to an already inaccurate USD 23 billion (as mentioned above). This was the line of credit proffered by Asian and other countries which were willing to help Indonesia resolve its financial crisis. This credit line is usually known as the “second line of defense”, which basically means that it would only become available to Indonesia if needed, in case the actual loan (the first line of defense) had been exhausted. In fact, only USD 1.5 billion of the credit lines from Singapore and Japan was actually disbursed in a market intervention by BI, aimed at propping up the Rupiah for the week following the signing of the SBA.

Thus, the widely-reported “USD 43 billion IMF bailout for Indonesia” extended during the 1997 financial crisis amounted to nothing but fake news. The actual amount was USD 18 billion from the first line of defense, plus USD1.5 billion from the second, which totaled just USD 19.5 billion. Of course the total amount ultimately became larger than this, since additional loans followed on afterwards.

Let us now return to the question of how international reserves serve an economy as a “safety net” against financial crises. According to Professor Feldstein, in the aftermath of the Asian financial crisis it became clear that emerging countries cannot rely on the new international financial architecture as proposed by the IMF to protect themselves from unforeseen events, even with the support of sound macroeconomic policies, since in today’s “borderless world” even well-managed countries can be infected by contagion from elsewhere. This naturally led to the argument for self-protection through increased liquidity. Countries with higher levels of liquid foreign assets will be more able to withstand panics in financial markets and sudden reversals in capital flows. They may not only minimize losses incurred in financial crises: such crises are in fact less likely to occur. This was the stance taken by Professor Feldstein. Liquidity could in turn could be achieved via three strategies: reducing short-term debt, creating a collateralized credit facility and increasing the foreign exchange reserves of the central bank.

According to Jeff Desjardins in his report entitled “Mapped: The Countries With the Most Foreign Currency Reserves” (Visual Capitalist, 24/05/2018*), reserves are in USD (63.5%), followed by Euros (20%), Yen (4.5%), Pounds Sterling (4.5%), Canadian Dollars (2%), Australian Dollars (1.8%), Chinese RMB (1.1%) and others (2.6%). The report states that the 10 biggest holders, by country, are: China with USD3.2T, Japan USD1.2T, Switzerland USD 0.79T, Hong Kong USD 0.44T, India USD 0.4T, South Korea USD0.39T, Brazil USD 0.36T, Russia USD0.36 and Singapore 0.28T. It might be surprising to those studying this list to note that despite its position as the biggest economy in the world, the US only holds USD 0.04T in foreign reserves.


International reserves and the “original sin”
Why does China hold the largest pool of international reserves while that of the US is tiny in comparison?

This does not seem to be consistent; something does not seem right. The easy explanation is that since international reserves are held to support the stability of international payments, China, like other countries of its type, does need to hold and accumulate foreign reserves to support steadily-increasing trade and investments. Since the USD is by far the most popular reserve currency in the global payment system, it is therefore only natural that China should accumulate USD.

On the other hand the US has no real need for foreign reserves, since Americans can freely use the same dollar as that spent domestically anywhere in the world. This also explains why other countries whose currencies are recognised and accepted as reserve currencies are also not obliged to hold a huge volume of international reserves.

The reality is that since the end of WWII global finance and payment systems have dominated with the USD as a global reserve currency, emerging from what was called the “Bretton Woods system”. The United States, as the leader of the Allied forces that won the War, acted as a guarantor for the workings of a system whereby all countries determine the par value of their currencies against the USD at a fixed rate, while the USD itself was pegged to gold, based on a formula pricing one troy ounce (28 grams) of gold at a fixed USD 35.00. The US provided assurance by promising to exchange any amount of USD held by other countries for gold bullion, at that fixed rate. This rate was left undisturbed from its inception in 1944 until the time President Nixon delinked the USD from gold in 1971, subsequently devaluing the USD to USD42 per ounce of gold in 1973. The established Bretton Woods system of exchange was thus discarded, followed by the IMF adopting a floating exchange protocol to replace the adjustable fixed exchange (or Bretton Woods) system, a decision emerging in 1978 from its annual meeting in Jamaica.

One more key point to mention here is what economists Barry Eichegreen, Ricardo Hauseman and Ugo Panizza proposed in 1999, first known as the “original sin hypothesis”. While this term has since been changed several times, it basically refers to an environment in which a majority of countries are not able to borrow abroad in their domestic currency, and applies to countries whose currencies are not recognised as international reserve currencies, unlike the USD, the Euro, Japanese Yen, Pound Sterling, and more recently the Chinese Yuan or Renminbi.

Of course in present-day globalized finance even Indonesia’s Rupiah bonds are commonly held by overseas interests, which would seem to contradict the “original sin” hypothesis. However, inasmuch as 40% of our Rupiah bonds are held by foreigners, some type of safety net is needed to provide such offshore investors evidence that their investment in Rupiah bonds is secure. And here is where the backup by Bank Indonesia international reserves provides assurance.

Concluding notes
There is a common-sense explanation about why most countries instruct their central banks to hold international or foreign reserves, while the US, the EU and certain other countries only report a small amount. Conceptually, this derives from the world monetary and payment systems based on the Bretton Woods agreements, in force since the end of WW II, whereby some currencies were to be designated as an “international currency”, and thus could be used as an anchor for others. In practice, the USD has become the “anchor currency”, which implies that all others peg their value to the USD, while the USD itself is pegged to gold at a fixed rate. While this system was discarded in 1971, and formally reset to a flexible rate in 1978, even after the USD peg was officially lifted, the American currency has remained accepted as a de facto anchor for others, despite a tendency to slowly lose out to other prominent trading nations.

The role of the USD as an anchor currency, in the form of an international reserve, marked around 70% at its peak, but this has gradually been eroded by other popular currencies, such as the Euro, Yen, and more recently the Renminbi. Time will tell as to whether a USD-based system of finance and payments will be supplanted by other, more practical currencies. Historically, a system lasts approximately a hundred years before it was replaced by a new one. Prior to the US dollar-based exchange of the Bretton Woods system global finance was under the gold standard.

In the current era of globalized finance, the prime role of international reserves is to provide a safety net for national assets and liabilities held and floated globally, similar to the way a bank holds reserves to assure its depositors, the central banking institution of a country holds reserves in foreign currencies, or foreign currency-denominated assets, to guarantee offshore holders of its bonds and other securities floated globally that it can repay or redeem such liabilities.