The following are edited excerpts
from a speech
given by Alan Greenspan before the World Bank Conference on April 29,
One way to address the issue of the management of
foreign exchange reserves
is to start with an economic system in which no reserves are required.
There are two. The first is the obvious case of a single world
The second is a fully functioning, fully adhered to, floating rate
All requirements for foreign exchange in this idealized system could be
met in real time in the marketplace at whatever exchange rate prevails.
No foreign exchange reserves would be needed.
If markets are functioning effectively, exchange rates
are merely another
price to which both public and private decision makers need respond.
competitive rates of return on capital in all currencies would
Only liquid reserves, denominated in domestic currency, would be
by public and private market participants. And in the case of a central
bank of a fiat currency regime, such reserves can be created without
Clearly the real world is not perceived to work that
way. Even if it
did, it is apparent from our post World War I history that national
are disinclined to grant currency markets unlimited rein. The
of income that arise in unregulated markets have been presumed
by most modern societies, and they have endeavored through fiscal
and regulation to alter the outcomes. In such environments it has been
the rare government that has chosen to leave its international trade
finance to what it deems the whims of the marketplace.
Such attitudes very often are associated with a
mercantilist view of
trade that perceives trade surplus as somehow good, and deficits bad.
in the short run, if not in the long run, trade balances are affected
exchange rates, few are allowed to float freely. In a crisis, of
course, monetary authorities are often overwhelmed and lose any control
of the foreign exchange value of their domestic currency. For good or
most nations have not been indifferent to the foreign exchange value of
their currency. I say most, but not all.
Immediately following the dollar's float in 1973, U.S.
not intervene and left it to others to adjust their currencies to ours.
We did not sense a need to hold what we perceived to be weaker
in reserve because presumably we could always purchase them in the
when and if the need arose. We held significant reserves in only that
we judged a "harder" currency, that is gold.
It has become a general principle that monetary
only those currencies they believe are as strong or stronger than their
own. Thus central banks, except in special circumstances, hold no
of weak currencies other than standard transaction balances that are
viewed as stores of values.
The United States built up modest reserve balances of DM
and yen only
when the foreign exchange value of the dollar was no longer something
which it could be indifferent, as in the late 1970s when our
trade went into chronic deficit, inflation accelerated, and
confidence in the dollar ebbed.
The choice of building reserves in a demonstrably harder
almost by definition not without costs in real resources. The budget
of paying higher interest rates for the domestic borrowings employed to
purchase lower yielding U.S. dollar assets, for example, is a transfer
of real resources to the previous holders of the dollars.
The real cost of capital is higher in a weaker currency
of risk. Countries with weaker currencies apparently hold hard currency
reserves because they perceive that the insurance value of those
is at least equal to their cost in real resources. Reserves, like every
other economic asset, have value but involve cost. Thus the choice to
reserves, and in what quantities, is always a difficult cost-benefit
In general, the willingness to hold foreign exchange
to depend largely on the perceived benefits of intervention in the
exchange markets. That would appear to require a successful model of
rate determination and a clear understanding of the influence of
intervention. Both have proved to be a challenge for the economics
The two main policy tools available to monetary
authorities to counter
undesirable exchange rate movements are sterilized intervention
in foreign exchange markets and monetary policy operations in domestic
Empirical research into the effectiveness of sterilized
in industrial country currencies has found that such operations have at
best only small and temporary effects on exchange rates. One
for the limited measurable effectiveness of sterilized intervention is
that the scale of typical operations has been insufficient to counter
enormous pressures that can be marshaled by market forces.
Hence reserve assets do not, in a meaningful way, expand
the set of
macroeconomic policy tools that is available to policy makers in
countries. In addition there is scant evidence that the rapid
of new financial instruments and products has undermined the liquidity,
efficiency, or reliability of the market for major currencies.
While the stock of foreign exchange reserves held by
has increased over time, those increases have not kept pace with the
increases in foreign exchange trading or gross financial flows. Thus in
a relative sense, the effective stock of foreign exchange reserves held
by industrial countries has actually declined.
In recent years volatility in global capital markets has
pressure on emerging market economies. This has important
for financial management in those economies. There have been
fluctuations in the willingness of global investors to hold claims on
economies over the last two years. Between 1992 and 1997, yields on a
range of emerging market debt instruments fell relative to those on
debt instruments issued by industrial country governments. But this
reversed sharply with the onset of the Asian financial crisis in the
half of 1997, and again following the ruble's devaluation in August of
These changes in foreign investors' willingness to hold
claims on emerging
market economies had a particularly severe impact on currencies
under fixed or pegged exchange rate regimes. Accordingly, those
foreign exchange reserves and reserve policy played an important role
the recent financial crises.
The Asian financial crises have reinforced the basic
lesson that emerging
market economies should pay particular attention to how they manage
foreign exchange reserves. But managing reserves alone is not enough.
particular, reserves should be managed along with liabilities and other
assets to minimize the vulnerability of emerging market economies to a
variety of shocks. In this context some simple principles can be
that are likely to be useful guidelines for policymakers.
Pablo Guidotti, the Deputy Finance Minister of
that countries should manage their external assets and liabilities in
a way that they are always able to live without new foreign borrowing
up to one year. That is, usable foreign exchange reserves should exceed
scheduled amortizations of foreign currency debts without rollovers
the following year.
This rule could be readily augmented to meet the
additional test that
the average maturity of a country's external liabilities should exceed
a certain threshold, such as three years. The constraint on the average
maturity ensures a degree of private sector "burden sharing" in times
crisis, since in the event of a crisis, the market value of longer
would doubtless fall sharply. If the preponderance of a country's
are short term, the entire burden of a crisis would fall on the
market economy in the form of a run on reserves.
Some emerging countries may argue that they have
long-term maturities. If that is indeed the case, their economies are
exposed to too high a risk generally. For too long emerging market
have managed their external liabilities to minimize the current
cost. This short-sighted approach ignores the insurance imbedded in
debt, insurance that is often well worth the price.
The essential function of an external balance-sheet rule
should be to
make sure that actions of the government do not contribute to
in the foreign exchange market. Consequently it makes sense to apply
rule to all of the government's foreign assets and all sovereign
denominated in, or indexed to, foreign currencies.
It is important to note that adherence to such a rule is
that all financial crises can be avoided. If the confidence of domestic
residents is undermined, they can generate demands for foreign exchange
that would not be captured in this analysis. But controlling the
of external assets and liabilities could make a significant
A "liquidity at risk" standard could handle a wide range
financial instruments -- contingent credit lines with collateral,
on commodity prices, put options on bonds, etc. Such a standard
encourage countries to manage their exposure to financial risk more
Clearly it would not be feasible at present for most
countries to implement a policy regime based on liquidity at risk. It
not even be feasible for most emerging market economies to adhere to a
more simple external balance-sheet rule, since many countries will
some time to build up foreign exchange reserves, and to adjust the
of their external liabilities. It is almost certainly desirable,
for countries to begin to think about managing their assets and
or just monitoring their vulnerabilities, in a more sophisticated way.
An external balance-sheet rule is probably a good place to start.