Why Foreign Cash Accumulates
An Explanation for a Central Banking Mystery
Like America’s Federal Reserve, central banks around the world play a significant role in their countries’ economies—printing money, lending to banks and casting a large shadow on political and economic policy
So for some time now, economists have been puzzled by a 20-year trend, which escalated in the late 1990s, of developing nations’ central banks accumulating larger international reserves (a catch-all term for foreign currency and other financial instruments with global liquidity) relative to GDP. Goncalo Pina, new assistant professor of economics, argues that if the question is approached from a monetary perspective, in view of the multiple financial crises of the past two decades, it makes sense that these countries were accumulating large reserves.
“It’s been extremely puzzling to economists,” he says. “These are countries that don’t have highways, decent educational systems and the like. You would expect their central banks to be pumping as much as they can into economic growth, yet they’re sitting on large reserves that generate little or no income.”
He realized central banks in developing economies were “sitting on large reserves that generate little or no income.”
His conclusions, and the model explaining them, are laid out in a paper, “The Recent Growth of International Reserves in Developing Economies: A Monetary Perspective.” The paper is currently in the review process with a leading journal.
Traditional economic theory typically doesn’t distinguish between central bank savings and private savings in a given country. Pina says that theory applies well to China, for example, where both savings rates have been high. But he argues that because of that assumption, researchers had a hard time accounting for the magnitude of international reserves and precisely why the central bank is the agent for accumulating them in other countries, where personal savings rates were not so high.
Applying monetary principles to the question, Pina came up with a model demonstrating that the likely explanation of the high reserve rates is that the number of banking crises in recent years and the severity of those crises has pushed central banks to a policy of maintaining higher financial reserves. This gives the banks the flexibility to deal with anticipated future crises in ways least disruptive to their national economies.
As a graduate student in 2008, Pina spent considerable time reading reports issued by central banks around the world and realized that the banks were obsessed with financial stability. The point was particularly driven home by the situation in Russia. That year, as the worldwide recession was beginning, Russia was spending substantial amounts of foreign reserves through its central bank in interventions with financial institutions.
It is not surprising, he says, that the accumulation of reserves in developing countries—which had already been rising steadily for a decade—took an even sharper upward turn following the Asian crisis, which had devastating economic impacts in many countries.
Developing nations are particularly vulnerable to a banking crisis. It has a clearer, more visible effect in their smaller economies, and these countries often lack the cushioning of a substantial borrowing capability, such as that enjoyed by the richer developed nations. From that perspective, maintaining larger reserves as a safeguard against a bank crisis makes financial and political sense.
Ultimately, the central bank has to cover the costs of a banking crisis through inflation, Pina says. The simplest way to do that would be to print more money, but that can have a devastating effect on the international exchange rate of the nation’s currency and on the day to day decisions made by political leaders, businesses and ordinary citizens. It’s better to spread out the cost of inflation over time, and having access to large reserves provides a central bank with a range of tools for doing so.
“Central bankers typically have longer terms of office and greater independence,” he says, “They can’t be sent away in an election, so they tend to take a longer-term policy view and are aware of the high cost of inflating the economy too quickly. In a developing country, when you start printing a lot more money, things can go berserk.”