Too Many Dollars In Reserve? 

News: Recently, the sanctions imposed by the west following the Russia-Ukraine conflict have triggered discussions on how other countries would manage their foreign currency (FX) reserves, which are used as an insurance against economic shocks.  

How countries accumulate Forex? 

A country running current account surpluses accumulate foreign assets over time. For example, China and Saudi Arabia have grown their foreign asset holdings 

History of forex reserves

Reserves have been part of economic discourse for more than a century. They were helpful during the interregnum between the two world wars, and in 1935 when economic sanctions were imposed on Italy for attacking Ethiopia. 

The Asian Financial Crisis 1998 reinforced the need to have sufficient reserves.  

The global FX reserves rose from 2 trillion USD in 1999 to nearly 12 trillion USD by 2014. It was based on the premise that the forex is important to cover all short-term external debt. 

However, the share of the USD in global FX reserves has fallen from 71% in 1999 to 59% in 2021. This has shifted to the Euro, the Yen, the Chinese yuan (CNY), the British pound, and the Canadian and Australian dollars.

CNY share of global financial transactions (both trade-related and financing-related) is bound to rise. 

What are the issues with Foreign Currency Reserves? 

Liquidity comes at a cost, which can be financial or geopolitical cost. On the contrary, the geopolitical returns on the liquid assets are lower than on less liquid and less safe assets.  

Therefore, reserves as a share of total foreign assets have fallen for China, Saudi Arabia and any other country (except Switzerland and India).  

The US inflation could continue to push down the share of global reserves held in USD assets. 

Triffin Paradox: A country whose currency becomes a global reserve currency would have to run a continuous trade deficit. It has to keep borrowing to provide a sufficient supply of assets to the whole world.  

Further, “New Triffin dilemma” says that the US would not be able to supply the safe assets the world needs, as the US share of global GDP declines 

What are other options for investment? 

(1) Sovereign Wealth Funds (SWF):  SWFs globally now manage 10 trillion USD of assets. For example, Norway, Saudi Arabia and Singapore have grown their SWF at large scale 

(2) Other countries like Japan and China have allowed their firms to buy foreign assets. These assets are hard to use in times of crisis. But they are better for the overall economy. 

(3) The countries can accrue returns from bond markets. For example, recent 8% decline in the value (or increase in yields) of 10-year US government bonds provides another investment alternative to currency adjusted returns. In fact, The US government bonds supply has grown significantly more than the demand for them from global central banks. 

Source: The post is based on an article “Too Many Dollars In Reserve” Published in the Times of India on 20th April 2022.