Chapter 9: The Global Reserve System
9.3 The effects of the existing reserve system on developing countries
We have examined some reasons for holding reserves. However, there are also costs to holding reserves which weigh against the benefits of holding them. Before describing these costs, let me first give an indication of the size of the global pool of reserves. The size of reserves held globally matters because the costs of holding reserves are magnified depending on the size of global reserves.
The size of reserves held by countries has increased greatly in recent times. Between 2001 and 2005, eight East Asian countries more than doubled their total reserves. The countries – Japan, China, S. Korea, Singapore, Malaysia, Thailand, Indonesia and the Philippines – increased their total reserves from around $1 trillion
to $2.3 trillion. China alone had about $900 billion in reserves by 2006 – which amounts to over $700 for every inhabitant of the country. To put this into perspective, the annual per capita income of China is under $1500. For developing countries as a group, reserves have risen from 6-8% of GDP in the 1970s to almost 30% of GDP in 2004 (Stiglitz 2006: 248).
Among the causes of this increase are the following two. One, the very high level of global economic and financial instability – which I will discuss later – and two, the way in which the IMF handled the 1997 East Asian crisis. The IMF attached certain conditions to the loans it made to the countries experiencing crises at that time. Those conditions are widely acknowledged to have worsened the economic
downturns of the affected countries. Many of the East Asian countries learnt lessons from the crisis and are boosting reserves to draw upon in times of need so that they do not have to borrow from the IMF instead (Stiglitz 2006: 248).
9.3.1 The cost of reserves for developing countries
There are large costs to developing countries of holding reserves. For the most part, reserves are held in US Treasury bills or T-bills36. T-bills earn a meagre real interest rate (that is, an inflation adjusted interest rate) of around 1-2% or even lower. It is possible for T-bills to offer such meagre interest rates as continued demand for T- bills is assured because of the status of the US$ as the major reserve currency.
Meanwhile, most developing countries are cash strapped. They have a choice of many high-return projects, if only they could raise some money to invest in them. Were they not using their money to buy US Treasury bills to build reserves, the money could instead fund these high return projects and earn somewhere in the region of 10-15% (Stiglitz 2006: 249). The difference between the two interest rates can be seen as the opportunity cost to developing countries of holding reserves. Let us place this opportunity cost into context.
Supposing an estimated 10% difference between the two real interest rates, the cost to developing countries of holding reserves is more than $300 billion annually (developing country reserves total in excess of $3 trillion). This amount is four times the level of foreign aid from the whole world. It corresponds roughly to estimates of what is needed to achieve Millennium Development Goals, including the halving of global poverty.
Another striking way to put the cost of reserves into context is this. Suppose a firm in a developing country borrows $100 mil for a short term from a US bank at, say, 20% interest. We noted above in discussing reasons for maintaining reserves that it is advisable to maintain the larger of (i) enough reserves for a few months of imports and (ii) enough to match all short term debt denominated in hard currency. So, suppose the developing country follows this advice and increases its reserves by the amount of the short term loan, namely by $100 mil. It does this by purchasing $100 mil worth of Treasury bills at, say, 5% interest. In this case, there is no net flow of funds from the US to the developing country. Moreover, since the US loan charges
36
In my discussion of the global reserve system, I will generally talk of the US$ as the reserve currency rather than as one of the reserve currencies (and the main such currency by a long way). This
a much higher rate of interest that the Treasury bills pay, there is a net transfer of $15 mil from the developing country to the US.
Having discussed the costs of the existing system to the developing countries, let me note that the main beneficiaries of the existing global reserve system are those countries whose currencies are the reserve currencies. Given that globally, reserves are overwhelmingly (but not solely) held in US$, the main beneficiary is the US. The existing system is advantageous for US banks and for the US economy more
generally. US banks enjoy a large and steady demand for loans from the developing world. The US economy benefits from the injection of loans in the form of issuing of T-bills. The Treasury receives money for the bill it receives and agrees to pay an interest rate plus the principal upon maturation of the loan period. The system allows the US to borrow vast sums of money at very low cost – real interest rates of Treasury bills are, as we have noted, around 1-2% or even less.
However, the developing country does not fare well. The desire to maintain sufficient reserves to guard against economic instability leads the country to divert much needed money for development to instead build reserves. At the same time, this is also effectively a transfer from the public sector in the developing county to the private sector in the same country. The private sector is better off, able to borrow the $100 mil. Yet the public sector now has a smaller pool of funds for public expenditure (Stiglitz 2006: 249-50).
Of course, there are benefits for the developing country, since the addition to reserves improves the economy’s resilience to instability. The point to note, however, is that an alternative global reserve system which maintained stability just as well but which did not require as large an accumulation of reserves on the part of the
developing country would be preferable on that count. Under such an alternate system, the developing country would be able to keep more of its money for its own development rather than as a shield against economic instability. We will discuss Stiglitz’s proposed alternative global reserve system below.
9.3.2 Cost of the existing system in terms of global economic instability
The deflationary effect makes itself felt in the reserve currency economy as the continuous pressure to run trade deficits means a drag on aggregate demand (remember aggregate demand is AD=C+I+G+NX and NX or ‘net exports’ is negative in a trade deficit, where imports exceed exports). The reserve country fights this pressure by aggressive fiscal and monetary policy in an attempt to boost aggregate demand by affecting government expenditure and investment. In non-reserve
countries, outside of crisis times, the opportunity cost of accumulating large reserves is that they now spend less domestically, meaning that aggregate demand is lower. On a worldwide level, this has to be offset by the US demand for imports.
For these countries, the deflationary pressure erupts occasionally in the form of events like the East Asian crisis, where economic crisis or slowdown spreads from one country to its trade partners. A country facing economic crisis may have
insufficient reserves and may be forced to borrow overseas. The loans may be necessary to repay flighty creditors and investors or the government may use the
money to spend its way out of a recession. Thus, recessions can contribute to growing sovereign debts.
The self-defeating nature of the reserve currency system is that the reserve country gets increasingly into debt as it has chronic and growing net foreign deficits to satisfy the rest of the world’s demand for reserves. The large and increasing debt of the reserve country comes with a growing risk of inflation – a reduction in the buying power or real value of the dollar. As one of the features which make a currency desirable as reserve is the stability of its value, the inflation, especially if sudden or large, makes the currency less attractive as a reserve.
Traditionally Central Bankers focused on inflation, an attractive reserve being one whose value in terms of goods it can buy is not greatly eroded over time.
However, for those outside US, the dollar exchange rate is also a very important determinant of the value of the currency as a reserve. The US$ has been increasingly volatile in its exchange rate. For example, in a few months in 1995, the US$ lost 20% of its value against the Yen. While there had been little inflation in the US, those in Japan who had their money in US$, found they were suddenly less wealthy. Between Feb 2002 and Dec 2004, the US$ fell against the Euro by about 37%. These are very substantial declines in the value of the dollar which have put an end to the once widely held notion that the dollar was unassailable and very secure as a store of value. As a result, the currency is less attractive as a reserve. In early 2005, China announced that it was no longer committed to reserves in dollars. It had already moved about ¼ of its reserves out of dollars. Central Banks in many other countries are also quietly moving away from dollar holdings (Stiglitz 2006: 255-6).
As US debt rises, so do doubts about the soundness of the dollar. As the value of the dollar falls, investors with assets denominated in US$ will be better off
converting their assets to some other currency. They will convert their money into strong currencies of vibrant economies, including Euros, Yen, and Yuan. Thus there will be a downward pressure on the dollar. At the same time, investors will pull out of US securities as the depreciating dollar will lower returns. US stock prices will fall or stagnate as demand for US stock stalls or falls. This further weakens the US economy and reinforces the decreasing appeal of the dollar.
Turning to Central Banks, as they reduce their holdings of dollars, the supply of dollars on the market increases and this sends its price even lower. This spreads further concern among Central Banks that the value of their reserves is falling (as the value of the dollar is falling) and can trigger a self-reinforcing rush to liquidate dollar holdings. Such a rush can be very dangerous both for the US, as its currency
plummets in value, and for countries holding dollar reserves as the value of their holdings plummet. The move out of dollar holdings may be smooth and drawn out or it may be a sudden crash.
That the reserve currency, the US dollar, might suddenly lose its value as the supply of it increases in the world, is a possibility which has been recognised and feared for several decades. A countervailing consideration which has so far kept the value of the dollar more stable than it otherwise might have been is the interest of holders of US currency and debt. Central banks which maintain much of their wealth in US currency or debt have an interest in the strength and stability of the US dollar.
For, if the dollar suddenly loses some of its value, the central banks would also lose some of their wealth (the wealth denominated in US dollars). So, they continue to buy up the available dollars in sufficient amounts so that the dollar’s value remains high. They can continue to buy dollars even as they buy other currencies for their reserves and even as they increase the ratio of other currencies to dollars in their reserves. There is no guarantee however, of how successfully and how long these Central Banks can continue to prop up the value of the dollar.
As confidence in the dollar as a stable store of value is diminishing, demand for other currencies as reserves has increased. In particular, demand for the Euro has increased. Europe was initially quite happy to see its currency rise against the dollar, wanting respectability for the Euro and eager for it to be the new reserve. However, as the Euro becomes the new reserve, demand for it rises, increasing its value. This makes European exports less attractive and opens Europe to a flood of imports. Accordingly, it will have an even harder time maintaining full employment. Given that European Central Banks are charged with a focus on inflation and not
unemployment or growth, and given that the unemployment there is already
problematically high, this does not bode well (Stiglitz 2006: 256). Enthusiasm within the Euro community for the appreciation of its currency has waned, precisely for these reasons. A possible move to another currency as reserve comes with the same
problems, simply transplanting them to another economy.