Foreign Exchange Reserves
The thoughts expressed in this article emerged when the
global financial crisis was at its peak in the beginning of 2009. The focus is
on Foreign Currency Reserves. It all began with questions such as :
- What will happen if China withdraws its reserves from the USA ?
- Can China not invest its huge foreign exchange reserves in its own
economy ?
The above questions are applicable globally. But China and
the USA, being the largest creditor and debtor in the world ideally represent
the global scenario. The article explores the concept of foreign currency
reserves and the related concerns.
Fundamentals :
What do foreign currency reserves of a country mean ?
- Does it mean ‘cash balance’ in other country’s currency ?
- Does it imply that the more the reserves, the richer is the country ?
Nature of foreign currency :
To cite an example, say China has exported goods and services
worth US $ 1,000 to the USA. Assume that these are net exports (export minus
import). This transaction has resulted in a liability for the USA and for China
it is a claim over the USA. Can China utilise this claim for its domestic
economy ? Or for investing in US treasury bills ? Or for any other purpose ?
To understand this, let us understand the nature of export,
import, payment, claim, etc. (Please note that dictionary definitions are not
relevant.)
Generation of claim :
Let us assume that Chinese residents have exported goods and
services to US residents for US $ 1,000. Chinese residents get US $ 1,000. That
is, Chinese residents get a claim over the US government. These Chinese
residents sell the currency or the claim to the Chinese government. The Chinese
government, in turn, pays Renminbis (RMB) to the Chinese residents. I.e.,
China buys the US $ claim from Chinese residents.
The corresponding effect is that the Chinese residents
substitute their claim over the USA, with claim over China. When any person
holds a currency of any government, it is a loan to the government, or a claim
over the government. All currencies are a ‘promises to pay’.
The Chinese residents utilise the RMBs for their expenses of
raw materials, labour, etc. The surplus will be used for investments,
consumption, etc. Effectively, the Chinese exporters pay for raw materials and
expenses to other Chinese residents. This is followed by further payments to
more Chinese residents and so on. Thus, all the RMBs received against US $ 1,000
get distributed amongst the Chinese residents. These residents will put the
money in the bank or mutual fund, which will invest in infrastructure, etc. It
may be noted that the claims being country-specific, it is immaterial whether
Chinese residents or Chinese government holds US $ claims. It is difficult (and
impractical) for individuals to get foreign exchange claims from other
governments. Hence such claims are normally held by governments.
Now, foreign exchange reserve is the Chinese government’s
claim over the USA. Can China invest these reserves in its infrastructure ? It
cannot. It has already been invested/utilised when Chinese residents sold their
US $ to Chinese government and utilised the RMBs for expenditure or investment.
Basically, what China has to do is recover the equivalent of
the claim from the USA. Claim can be expressed in different ways — it is an
intangible made up of confidence that the other country will settle the claim in
future; it is the goodwill; it is a paper entry.
Investment in treasury bills :
It is said that China is investing in US treasury bills. Why
is it doing so ? What else can it do ? When it invests in treasury bills, it is
really substituting non-interest bearing cash for interest bearing treasury
bills. It is assured of interest income till the USA settles its claim. Hence,
when we say China is investing in US treasury bills, it is not really investing
but is only substituting one claim with another; and it does not have a choice.
Can China withdraw its investment in the US treasury bills ?
This is consequential to investment. When it cannot really ‘invest’, it cannot
really withdraw. However, when it wants to withdraw its investment in the US
treasury bills, what can it do ? It can sell the treasury bills and regain US $,
and the cash claim still remains. Therefore, foreign currency reserves or
treasury bills are ‘claims’.
Withdrawal of reserves :
Can China withdraw the US $ reserves ? Prima facie it
cannot. As we have seen, US $ is only a claim. Withdrawal of reserves can happen
only if the currency is backed by something valuable like gold. Therefore, if
the USA has commodity equal to US $ 1,000, it can give that commodity against US
$ 1,000. As currencies are backed by promises or goodwill, investing in or
withdrawing from treasury bills really does not mean much. It can sell the claim
by way of these securities to another person, provided there is a buyer. This is
discussed in later paragraphs.
Sovereign Wealth Fund :
What is a Sovereign Wealth Fund (SWF) ? The foreign exchange
reserves of a country are invested abroad through special purpose vehicles known
as SWF. So if the Chinese government’s claim is converted into an SPV, it will
be called an SWF. SWFs invest in other country’s capital. In the example of
China, the SWF will either buy capital in the USA or sell US $ to buy capital in
other countries. SWFs are supposed to give better yields than treasury bills. In
an SWF one asset is converted into another asset — cash into treasury bills
which in turn is converted into investment through SWF.
If India were to set up a SWF and invest in other countries,
it will be borrowing and then investing elsewhere. By borrowing, one gets
foreign exchange, but that is not a true reserve. One cannot establish an SWF
out of borrowed capital. SWFs are usually set up by countries that have current
account surplus. Therefore it was a right decision by India not to establish an
SWF.
How does China settle its ‘claim’ over USA?
There are following ways:
i) The USA exports to China goods/commodities worth US $ 1,000 (net). China may either buy goods and consume it; or may buy gold and hold it. However, if the USA does not have the goods or commodities that China requires, the account cannot be settled.
ii) The USA sells China its capital — say China buys property and business in the USA. This way, China owns a little bit of the USA.
iii) China sells its claim over the USA to someone else i.e., it sells US $ and buys other currency in the market. However, this means that it is buying another country’s claim in exchange of its claim over the USA. The other country is buying a claim over the USA. This does not absolve USA of its liability.
iv) It buys capital in other countries and pays for it in US $ i.e., China uses its export surplus to buy capital in other countries and sell its US claim [combination of steps (ii) and (iii)].
v) China writes off the claim.
The first two are the only ways to per se settle the account. The third and the fourth options do not really settle the account. The liability of debtor remains. The last option is not a desirable way of settling the account.
In actual practice all or some of the above happens continuously. The balances/claims keep changing. There is never a perfect settlement of claims. All countries simultaneously can never have an export surplus. Someone has to be a net importer at some time or the other.
When a person buys more than what he can sell and cannot pay, he has to sell his capital. If he doesn’t have capital, the amount is written off by the creditor. This rarely happens in case of countries over a long period of time. As time horizon is vastly different for individuals and countries, one may not be able to see things immediately and obviously.
If China wants to withdraw its reserves, it can only sell its claim to others — provided there are others who are prepared to buy. If there is no one prepared to buy, the supply being more than the demand, the value of US $ will depreciate. The situation is similar to any shareholder owning a major stake of a company’s stocks. If such shareholder sells, the value of shares goes down. In such a case value of his unsold share also comes down and he suffers.
Considering the above, the only way to settle the claim in the long term is — the net importing country becomes a net exporter or it sells capital. Those countries which have raw material or goods to sell may be able to do it. Arab countries have oil and hence are able to sell oil and have surpluses.
What happens to those countries that do not have raw materials or manufacturing sector necessary for generating export surplus? They can:
- Export services (It includes licensing of tech-nology, rendering services as employee or consultant, etc.)
- Provide undesirable services like tax evasion facilities through tax havens, gambling, etc.
India imports goods for which it does not have exportable surplus. Therefore, it sells services — software services, etc. The services should be valuable enough to generate export surplus. In absence of a current account surplus, a country can sell capital. However, selling capital has its own issues.
What happens if a country cannot settle the claims?
If settlement runs over a long period of time and claims become large, then the creditor will demand either sale of capital or sale of goods with a hefty discount. (If a country is indebted, generally its goods and capital command a lower price.) Therefore, to generate export surplus, such country has to sell cheap — it has to devalue its currency.
A cheap currency should normally help a country to sell its goods and thus settle the claim. If it cannot generate export surplus, it has to sell capital. Does selling capital (accepting foreign investment) create a liability? In case of FDI, one can say that the country has sold capital and therefore the reserve is a true reserve. However, even FDI is a loan in one way, but it is better than ECB. In case of FDI, there are other issues like foreigners owning and influencing the country’s policy. This is particularly true when large corporate invests in a comparatively smaller country.
If the capital of a country is attractive, one can sell the same and treat the proceeds as reserve. Therefore many countries have liberal FDI policy. What makes a country’s capital attractive?? For example, capital in the USA may be more valuable than, say, in India or China. A number of factors contribute to this — security, clear ownership laws, perception, etc.
Despite China having a current account surplus, why is it that US $ is overvalued and Chinese RMB is undervalued?? There could be several reasons. One of them is perception and the other is time lag. As mentioned above, time horizons of individuals and countries are different. In case of countries it takes many decades before a perception is corrected or reversed. Just a current account surplus is not sufficient. If a country can generate a foreign exchange surplus by sale of capital, it contributes to appreciation of currency. The USA has been able to do that.
However, in spite of selling capital, if the claim cannot be settled, what happens? In such a case, the situation is similar to a bankrupt person. Both the creditor and debtor lose. The creditor loses the claim and the debtor loses his credit and is declared insolvent.
Confidence:
It all leads to the conclusion that ultimately what is the confidence of people in claims of others? Confidence is built up of due several things including perceptions. Perceptions keep changing. The USA enjoys the most confidence as it has several institutions and processes which other countries do not have. These include freedom, ownership of asset, dispute resolution mechanism, security, power of fighting difficulties, etc. Also living conditions are better in the USA.
However, this confidence of the USA is under threat. Unless it regains the confidence, it will not be able to maintain the value of its currency. All those countries who hold US $ as their reserves, will suffer losses. The only way in which the USA can settle its claim is that by cutting its expenditure and generating export surplus.
India’s foreign exchange reserves:
India has a current account deficit — its import of goods and services is more than its export revenues. Still India has a reserve of US $ 250 bn. What does this reserve represent? It represents sale of capital and borrowings. It must be remembered that foreign exchange reserves is only a bank balance (a claim). Only export surplus or current account surplus is a true reserve. Foreigners have invested in land, industry, etc. To that extent they are owners of India. When foreigners give loans (ECBs), they have a claim over the Indian government/ residents. The foreign currency that comes in through sale of capital (FDI) or by accepting foreign loans (ECBs) goes in to foreign currency reserve. But simultaneously, there is a liability for the country to refund the loan when due and pay the foreigner when there is divestment of FDI. In a way, therefore, FDI is also a liability for India as a whole. In practice, when countries sell capital it is not treated as a liability. But in the International Investment Position Reports, these are shown as liabilities.
Conclusion:
Foreign exchange reserves represent only claims. It does not represent wealth, unless one is confident of encashing it before its value is eroded. Only time will tell whether Chinese reserves are really valuable or not. The best situation is when the claims of countries remain within reasonable limits as it preserves the confidence. Both, large current account surpluses or deficits are not desirable for any country.
