February 8th, 2012 by Hafiz Noor Shams
Does anybody know why whenever there is a discussion on foreign exchange reserves, it is typically measured in terms of imports and external debt financing?
I took these metrics for granted in the past. They seem intuitive at first. It provides a humanizing reference to what can be meaningless large numbers. But they lose their relevance after one reminds oneself of the purpose of foreign exchange reserves.
When one measured in these terms, there is an implicit understanding that the foreign exchange reserves are used for imports and external debt financing, an understanding which is false. The foreign exchange reserves are held by the central bank and the central bank is neither responsible in any payment with respect to export and import activities nor responsible in the repayment of external debts per se.
If the foreign exchange reserve is stated within the context of the ability to sustain for example 10 months of imports, does it really do so? If the importers, which is not the central bank by the way, suddenly face a liquidity crunch and unable to pay for its current and future imports, will the large foreign exchange reserves help? No, unless the central bank suddenly becomes the economy-wide importer, which diverges so far away from the traditional central banking functions.
If the foreign exchange reserves are stated within the context of the ability to finance for example 10 months of external debt, does it really do so? If private debtors suddenly go bankrupt, will the central bank take over those debts on behalf of those private debtors? No. The central bank is not a financier of private individuals or businesses.
And if the government suddenly finds itself unable to finance its debts through traditional means, either through borrowing or taxation, will the central bank step in to pay the government’s debt (or specifically, Treasury’s debt in order to clarify the fact the when one speaks of government debt, it really refers to the government sans the central bank, and the Treasury essentially manages government-sans central bank-finance)? Not really. The government or more specifically, the Treasury does not and should not have access to the foreign exchange reserves controlled by the central bank.
The central bank can of course buy treasury to help finance government deficit. But it remains that the government borrows from the central bank. The government does not take the money and pretends that the foreign exchange reserves are some kind of treasury money saved in an account at the central bank. In fact, the central bank and the government collectively do not need the foreign exchange reserves to finance government deficit in time of crisis. The central bank can do so cheaply through debt monetizing process, i.e. through the printing presses or more accurately, money created electronically.
In short, foreign exchange reserves are not government savings.
Some governments take the foreign reserves and use it to fund a sovereign wealth fund. I suppose that is a somewhat more efficient use of the money, but that is essentially an institutional abuse.
The function of the foreign exchange reserves remain for the operation of — tada! — foreign exchange, especially for a country that runs on controlled foreign exchange regime. The reserves are huge exactly to defend the currency if need be. What has happened in Malaysia is that there is a hangover from the 1990s financial crisis. Malaysia continues to have one of the biggest foreign exchange reserves in the whole world, and that is not exactly efficient.
This is especially bad when laypersons catch up with the jargon. There have been several instances in the past when a drop in foreign exchange reserves are taken by some in the public as ominous outflow of funds from Malaysia. It makes discussion on the matter completely off track and irrelevant from the very beginning, just because everybody uses the jargon and nobody understands the function of the reserve properly.
So, somebody, please, share with me why foreign reserves are typically stated in context of imports or external debt.
I think if the metrics is used to convey what I think most individuals want to convey, there is another better concept that should be used. It is the balance of payment. The measurement in terms of imports still does not fit the bill exactly, but at least, it comes closer to being accurate than measuring the foreign exchange reserves in terms of imports will ever be. But the balance of trade is not money owned by any one person. It is money owned by the whole economy.