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Foreign Exchange Reserves – What do they represent ?

Foreign Exchange Reserves – What do they represent? - Naresh Ajwani

April 2009

These thoughts have been developed during the times when the Global Financial crisis was at its peak in the beginning of 2009. Several thoughts have been presented by several experts on how to solve the current economic problems. The subject discussed in this article is Economy. However the focus is on Foreign Currency Reserves. The thoughts started with the questions:

- If China withdraws its reserves from USA, what will happen?

- Can China not invest its huge Foreign Exchange reserves in its own economy?

The above questions can apply to any country. China and USA are good representatives being the largest creditor and debtor in the world.

The thoughts do not attempt at all to provide any solution. They merely try to understand the concepts of “Foreign Currency Reserves” and what can be done with it?

1. Questions :

What do reserves of a country mean?

Does it mean “cash balance” in other country’s currency?

Does it mean that more the reserves, more rich is the country?

2. Nature of Foreign Currency :

Say China has exported goods and services worth US$ 1,000 to USA. Assume that these are net exports (export minus import).

What is it that USA has paid? It has paid US$ currency or its electronic equivalent.

What is the nature of its currency? It is nothing but a liability of USA. For China, it is nothing but a “claim” over USA.

Can it utilise its claim for its domestic economy? Or for investing in US treasury bills? Or 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.)

3. Generation of claim :

3.1 Factually this is what happens. Let us assume that the Chinese residents have exported goods and services to US residents for US$ 1,000.

Chinese residents get US$ 1,000. i.e. The Chinese residents get a claim over US government.

The Chinese residents sell the currency or the claim to Chinese government.

Chinese government pays Renminbis to the Chinese residents. i.e. China buys the US$ claim from Chinese residents.

3.2 The corresponding effect is that the Chinese residents substitute their claim over 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 “promises to pay”. How will the Chinese residents get their claims from the Chinese Governments is a different matter. This is not the subject of this article, though principles are similar.

3.3 The Chinese residents utilise the Renminbis for their expenses of raw materials, labour, etc. The surplus will be used for investments, consumption, etc.

In effect the Chinese exporters who receive Renminbis for US$ 1,000 from Chinese Government, pay for raw materials and expenses to other Chinese residents. These other Chinese residents pay for their expenses to some other Chinese residents … and so on. Thus all the Renminbis received against US$ 1,000 get distributed to Chinese residents. The Chinese residents either keep the Renminbis in the banks or invest the same. Thus the export proceeds of US$ 1,000 already gets utilised in investments, etc. (Chinese residents will put the money in the bank / mutual fund, which will invest in infrastructure, etc. Investment will happen through several means.)

[Whether Chinese residents or Chinese Government holds US$ claims, it is the same as far as the country is concerned. For individuals, it is difficult (and impractical) to get claims from other governments. Hence the FX claims are normally held by Governments.]

3.4 Now what is left with Chinese government is only a claim over USA which we refer to as FX reserves.

Can China invest this reserve in its infrastructure? It cannot. It has already been invested / used when Chinese residents sold their US$ to Chinese government and utilised the Renminbis for investment.

Basically, what China has to do is get the equivalent of the claim from USA.

One can express the meaning of “claim” in different manners. For example – 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.

4. Investment in treasury bills :

It is said that China is investing in US treasury bills. Why is it doing?

But what else it can do? When it invests in treasury bills, it is really substituting non-interest bearing cash, for interest bearing treasury bills. At least it will get interest till USA settles its claim.

Hence when we say China is investing in US treasury bills, it is not really investing. It is only substituting one claim with another. And it does not have a choice.

Can China withdraw its investment in the US treasuries? This is corollary to investment. When it cannot really “invest”, it cannot withdraw. However for the sake of argument, when we say it wants to withdraw its investment in US treasuries, what can it do?

It can sell the treasuries and get back US$ currency. US$ is only a claim as seen above. It converts treasuries into cash, which is back to square one.

Therefore foreign currency reserves or treasury bills are “claims”.

5. Withdrawal of reserves :

Can it withdraw the US$ reserves? It prima facie 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 USA has equivalent gold or some other commodity equal to US$ 1,000, it can give that commodity against US$ 1,000. As currencies are backed by promises or goodwill, investing or withdrawing in treasuries really does not mean much.

It can sell the claim to another person, provided there is a buyer. This is discussed in next para.

6. How does China settle its “claim” over USA?

6.1 There are following ways :

i. USA should export to China worth US$ 1,000 (net). Then the claim is settled. (China may either buy goods and consume it; or may buy gold and hold it. Of course US should have the goods to sell which China requires. If USA does not have what China requires, the account cannot be settled.)

ii. USA sells China its capital. i.e. China buys land and property and business in USA. China owns a little bit of USA.

iii. China sells the claim to someone else. i.e. it sells US$ and buys Euros / Yen in the market. But that means it is buying another country’s claim. And that other country is buying a US claim. This does not extinguish US liability.

Or it buys capital in other countries and pays 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)).

iv. China writes off the claim.

The first two ways are the only ways to settle the account. The third way does not really settle the account. The liability of debtor remains. The fourth way is not a desirable way of settling the account.

In reality all of the above happens. It keeps happening 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 some time or the other.

6.2 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.

In case of countries, it happens rarely and that too over a long period of time. Time scales are different for individuals and countries. As time scales are vastly different, one may not be able to see things immediately and obviously.

6.3 If China wants to withdraw its reserves, it can only sell to others – provided there are others who are prepared to buy. If there is no one prepared to buy, or the supply is more than the demand, the value of US$ will go down.

The situation is similar to FIIs holding large stocks in the shares. If they sell, the value of shares goes down. It is they only who suffer.

7. India’s Foreign Exchange Reserves :

India has a current account deficit. i.e. Its import of goods and services is more than the export of goods and services.

Still India has a reserve of US$ 250 bn. So what does it represent? It represents sale of capital and borrowings. (FX reserves is only a bank balance (claim). Only export surplus is a true reserve.)

Foreigners have invested in land, industry, etc. They are owners to that extent of India.

When they have given loans (ECBs), they have a claim over Indian residents.

8. Sovereign Wealth Fund (SWF) :

What is a sovereign wealth fund? The FX reserves of a country are invested abroad.

So the Chinese government’s claim will be converted into an SPV which will be called a SWF. It will invest in other country’s capital. i.e. It either buys capital in USA or sells US$ to someone else and buys capital in other countries. (steps (ii) and (iii) in para 6.1 above).

SWF is supposed to give better yields than treasury bills. Therefore one asset is converted into another asset. Cash -> treasury bills -> SWF.

When FDI and ECB has come in, in a way India is a debtor to the world. If the foreigner sells the capital back to an Indian resident, India will pay back the money.

If India sets up a SWF and invests in other countries, it is borrowing and then investing elsewhere. (ECB converted into FX reserve, and invested by SWF.) By borrowing, one gets FX, but that is not a true reserve.

One may say that ECB is a loan and therefore what is point of borrowing and investing. Can one say the same thing about FDI?

In case of FDI, one can say that India has sold capital. It is its own money. It has claim over other countries. It can buy assets in other countries. It amounts to selling one’s capital and buying someone else’s capital. However it must be remembered that when a foreigner invests in India he can also sell the assets. India will have to return the capital. Therefore in a way, FDI is also a liability for India as a whole. Thus the entire sale of capital is like a liability to a foreigner. In practice, countries do sell capital and it is not treated as a liability. But in the International Investment Position reports, these are shown as liabilities.

One cannot establish a SWF out of borrowed capital. SWFs are usually set up by countries that have current account surplus. Therefore it was a right decision by RBI not to establish a SWF in spite of Montek Singh Ahluwalia’s and Chidambaram’s suggestion.

9. Settling claims :

Coming back to the question of settling claims, how does one settle the claims?

The only way is that the net importing country becomes a net exporter. Or it may sell 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 do a few things :

- Export services. (It includes having technology which can be licensed.)

- Sell tourism services.

- Provide undesirable services like tax evasion facilities by tax havens, gambling, etc.

The most desirable is export of services. One should be able to utilise one’s talent and provide services. This is what most people do. Everyone cannot sell goods. That used to happen in barter economy. There also everyone did not sell goods. Those who could not sell goods sold services. Services can be as employee or as a consultant.

This applies to a country also. In a way, India imports goods for which it does not have exportable surplus. Therefore it sells services – software, etc. Our services should be good enough to generate export surplus. This means we must work hard and be better than others.

If it cannot have a current account surplus, it can sell capital. Selling capital has its own issues.

10. What happens if the country cannot settle the claims?

10.1 If this happens for a long time and claims become large, then the creditor will say one day that you sell your capital or sell me your goods. And the creditor will demand a hefty discount. (If a person is indebted, generally his goods and capital commands a lower price.)

Therefore to generate export surplus, a person has to sell cheap. i.e. it devalues currency. A cheap currency should normally help a country to sell goods and thus settle claim.

India has a current account deficit. Therefore why should its currency be revalued at PPP? (This is contrary to PPP theory which states the value of currency based on the purchasing power.)

10.2 If it cannot generate export surplus, it has to sell capital. Does selling capital create a liability?

May be in case of FDI, one can say that we have sold capital and therefore the reserve is a true reserve. However as we have seen, FDI is also a loan in one way, but better than ECB. In case of FDI, there are other issues like foreigners owning and influencing the country’s policy, big companies may be larger than small countries and that may be a bigger problem, etc.

If the capital of a country is attractive, one can sell the same and treat same as reserve. Therefore many countries have liberal FDI policy. What makes a country’s capital attractive? E.g. Capital in USA may be more valuable than say in India or China. (There are a number of factors – like security, clear ownership laws, perception, etc. If one sells to a Chinese, one would like to settle the claim by buying something from China rather than owning capital in China.)

10.3 Despite China having a current account surplus, why is it that US$ is overvalued and Chinese Renminbis is undervalued? There could be several reasons. One is perception. The other is time lag. As mentioned above, time scales of persons 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 FX surplus by sale of capital, that also contributes to appreciation of currency. USA has been able to do that.

10.4 However in spite of selling capital, if the claim cannot be settled, what happens?

The situation is similar to a bankrupt person. Both the creditor and debtor loose.

The creditor looses claims. And the debtor looses his credit and is declared insolvent.

11. Confidence :

11.1 It all leads to the fact that ultimately, what is the confidence of people in claims of others?

Confidence is made up of several thousand things including perceptions. Some perceptions acquire more prominence than others for various reasons. And these keep changing. USA enjoys the most confidence as it has several institutions and processes which other countries do not have. These include but are not limited to – freedom (of several things), ownership of asset, dispute resolution, security, power of fighting difficulties, etc. Also life is better in USA as it keeps issuing notes.

Why did people come to Mumbai from all over India (and still come). It has a culture of its own. One can do what one likes. Same cannot be said of other cities.

Similarly, one can do what one likes in USA and many European countries. But one does not have freedom in China.

11.2 However this confidence of 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 USA can settle its claim is that it cuts its expenditure, & generates export surplus.

12. Summary :

FX reserves represent only claims. It does not represent wealth, unless one is confident of encashing it before its value is eroded.

Time will tell, whether Chinese reserves are really valuable or not.

The best situation is that the claims of countries remain within reasonable limits. That way the confidence remains. Do not allow large current account surpluses or deficits to be built up.

Naresh Ajwani