Why Reserves Are Not Resources

India, Friday, May 8, 2020. It is Day 05 of the third tranche of India’s COVID-19 lockdown. We celebrated the death of the gold standard (1945-1971 – its second reign) yesterday. The death of the gold standard liberated nations, their central banks and, therefore, their economies.

The stupendous rise of the ex-colonies of one or more European colonisers is an example. These ex-colonies of imperial dynasties and colonisers would have continued to be low-income economies. They are now stars because of the death of the gold standard. Vietnam, for example, has raised its standards of living and per capita gross domestic product because of its monetary freedom.

Many degrees of freedom

Sovereign nations and their central banks are wholly at liberty to expand and contract their money supply. They are free to set and reset interest rates. Sovereign nations and their central banks are free to fight inflation the way they want. They are free to do what is necessary to move employment and output to their full potential. These are internal or endogenous to their economies.

Currency convertibility, capital mobility and foreign exchange rates are in part external or exogenous to their economies. Sovereign nations and their central banks are at liberty to set the terms of capital mobility across borders. They are at liberty to set the terms of currency convertibility. Sovereign nations and their central banks are at liberty to pursue their own exchange rate policies.

Foreign exchange reserves

We will examine the compatibility of one or more of the above freedoms with one another in progressive steps in the future. Today’s focus is on foreign exchange reserves.

The foreign exchange reserves held by central banks have been erroneously viewed by some as resources. There was a time in 2004 when several chambers of commerce and industry had suggested that the Reserve Bank of India (RBI) could use its foreign exchange reserves to fund investments in infrastructure.

Several Asian, African and South American economies ‘own’ foreign exchange reserves. India, China, Taiwan, Singapore and South Korea are among these economies in the reserves big league.

Foreign exchange rates

The price of a nation’s currency in other currencies is a tricky, double-edged sword. If the Indian rupee (INR) is strong, India’s policymakers and businesses may feel that their chances in the export markets would be dim. I have for long paid attention to the reams of analysts’ and journalists’ reports that recommend a weak rupee so that our exports will flourish.

If the INR is weak, India’s policymakers and households may feel that the prices of imported crude oil would be high upon conversion to INR. So, currency prices or foreign exchange rates are neither good nor bad.

Either exporters or importers – one of them – would be in trouble at any foreign exchange rate. Those who have inward receipts would be upset if the INR is strong. Those who have outward payment obligations would be upset if the INR is weak.

The flows of foreign exchange

A country could have inward flows of foreign currencies because of its exports. Inflows could be the result of remittances by citizens living and earning abroad. These are current account inflows.

Inflows could be the result of foreign direct investments (FDI). Inflows could be the result of foreign portfolio investments (FPI). Inflows could be the result of foreign currency borrowings by companies. These are capital account inflows.

A country could have outward flows of foreign currencies because of its imports. Outflows could be the result of royalty payments. These are current account outflows. Other outflows could include interest on borrowings and dividends on equity.

Outflows could be the result of liquidation of FDI or redemption of FPI. Outflows could be the result of repayment of foreign currency borrowings by companies. These are capital account outflows.

Many flows, one market

The tracing of flows enables us to imagine and understand the economic and financial connectedness of the world in which we live. The classification into current account and capital account is aimed at recognising the reason why these flows occur.

India is an INR economy. We buy our inputs here in INR. We pay our fees, wages and salaries in INR. We earn our revenues and fees in INR. We use the INR to buy machinery. We pay taxes in INR. 

When there is an outward flow, we need to sell the INR and then buy the United States of America dollar (USD), the Great Britain pound (GBP), the Japanese yen (JPY) or the European Union euro (EUR).

Inflows and outflows have causes and classes such as current account and capital account. But there is one foreign exchange market.

In this unified foreign exchange market, (1) the INR is sold to buy foreign currencies and (2) the INR is bought by selling foreign currencies. The sale of INR creates the supply of INR. The purchase of INR creates the demand for INR.

Plutoland and its hypo

There is Plutoland in the blue Mediterranean Sea. Its currency is the hypo (HYP). One EUR – the base currency – is worth at present 5.0000 HYP – the terms currency.

Plutoland has a dominant maker of refrigerators. The premium model is sold at EUR 400. The cost of making and selling the premium model is HYP 1,900 inclusive of freight, insurance and warehousing. The refrigerator company will incur losses if the HYP strengthened beyond 4.7500. This would happen when the EURHYP is lower than 4.7500.

A strong HYP is an enemy. A weak HYP is an ally and a friend. That is the perspective of the refrigerator company. The refrigerator company will earn a profit if the EUR cost more than 4.7500 HYP.

Plutoland’s importers feel the other way. A strong HYP is an ally and a friend. A weak HYP is an enemy. Plutoland’s importers are happy when the EURHYP is lower than 4.7500.

The central bank of Plutoland has two options. First, let the foreign exchange markets determine the value of EURHYP. Or, the second option, do whatever it takes to reach an equilibrium value of 5.000 for the EURHYP.

Market day

A total sum of EUR 20 million is about to enter Plutoland. This inflow comprises both current account and capital account inflows. A part of the inflows is on account of the refrigerator company’s exports.

At that moment in the market day, a total sum of EUR 18 million is needed for funding imports, for making outward debt payments and for making capital investments in Paris. The refrigerator company wants to buy EUR in order to build a new warehouse in Paris.

The market dynamics

The inflow of EUR 20 million triggers a demand for HYP 100 million at a EURHYP of 5.0000.

The required outflow of EUR 18 million supplies HYP 90 million at a EURHYP of 5.0000.

The demand for HYP exceeds the supply of HYP. The supply is HYP 10 million short of demand. We know from our lessons in economics that supply deficits and excess demand push up prices. We also know from our lessons in economics that excess supply and demand deficits pull down prices.  

If Plutoland’s central bank allows the market to take its course, the HYP will strengthen. The EURHYP will fall below 5.0000. The refrigerator company will make a loss.

Print HYP

So, the central bank steps in. It prints HYP 10 million. The death of the gold standard allows Plutoland to print its own money.

I urge you to recall the cool audacity with which Shatrughan Sinha asserts that he is the third king in the movie Kaala Pathar.

तीसरे बादशाह हम हैं

https://www.youtube.com/watch?v=oxL0JhiLWN0

The central bank fills the supply deficit. It buys EUR 2 million. This is accounted for as a reserve. The printed HYP 10 million is a liability. Printed money is the central bank’s “I owe you”. The purchased EUR 2 million is an asset. It is a reserve.

In due course, Plutoland’s central bank may sell the EUR 2 million cash to buy Treasury securities issued by the members of the European Union. These securities too are reserves. In due course, Plutoland’s central bank may sell part of the EUR 2 million Treasury securities to buy gold. This gold too would be reserves.

The many Ps

Reserves are outcomes of printing the domestic currency. They are not the outcomes of productivity, proficiency and profitability. If you have had other views, this is the time to think about this proposition.

Foreign currency and gold reserves are bought by printing HYP. HYP was printed in order to stop HYP from becoming strong. Plutoland’s central bank weakened the HYP to build its reserves.

Reserves are not a sign of a new strength. It is a zero-sum game. The citizens of Plutoland lost a bit of purchasing power so that the central bank could buy into gold, foreign Treasury securities and foreign currencies.

Not a resource

Plutoland now has reserves of EUR 2 million. It is certainly an asset. Citizens wish to have a new school and a skills-training institution to be funded.

They urge the central bank to regard the reserves as a resource. The central bank sells the EUR 2 million. It gets HYP 10 million on the assets side. There is a corresponding HYP 10 million on the liabilities side.

Money is an “I owe you”. The central bank’s assets-side cancels out the liabilities-side by HYP 10 million. There is no money to fund the new school and the skills-training institution. The cash, gold or the European Treasury securities could not fund a cent of education infrastructure. Plutoland accepts this stoically.