As we leave 2020 with relief, and move forward into 2021, the world faces two unprecedented crises simultaneously. Firstly the need to rebuild public sector finances, after they have suffered the biggest ever hit in peacetime in the wake of the Covid pandemic. And secondly the need to tackle climate change, accelerate the switch to renewable energy sources, and transition the world economy onto a more sustainable path.
The scale of these twin challenges is both so enormous and so urgent that it requires nothing less than the mobilisation of the full fiscal and savings resources of every nation. We argue that this must include national foreign exchange (FX) reserves, and that as a result, there should be a complete rethink about the role of reserves, including that ultimate “asset of last resort” gold, and how central banks manage them.
In saying this, we are not suggesting that central banks should abandon the management of the exchange rate as a policy objective. But as part of the rethink of how FX reserves are held, managed and used, we propose a more efficient and less costly way in which currency pressures can be managed using a multi-polar network of cross currency swap lines.
The Urgency of Now
Future generations will be grateful for action aimed at engineering a recovery from the pandemic. We need to rebuild the world economy with all the tools available in order to escape depression, and avoid the long term economic scarring that would reduce the potential for improving lives in the future. But our children will be angry if in doing this, policy makers ignore the need to also take action to honour the Paris Climate Agenda commitments. Addressing climate change is urgent – it is not just the case that life will not get better if we do not tackle the problem, but that it will without doubt get worse.
The Paris agreement includes commitments to both cut climate-altering emissions, and continually revisit and strengthen those commitments. It is an ongoing promise. But whilst the long-term arguments for a move to renewable energy are indisputable, there will be near-term financial costs associated with the transition. The capital investment required in the rollout of solar and wind energy projects and in re-equipping households to enable the switch to green energy will require large scale funds, and will require them now.
This is the argument for mobilising all sources of national wealth to finance a green transition. Martin Luther King in his seminal 1963 speech addressed what he termed “the Urgency of Now”, and it is a phrase being used with increased frequency and vigour in the climate change debate. Now is the time to act, as every year without action makes the task of restoring global climate equilibrium more difficult.
Sovereign Wealth Funds are a clear source of funding for this task, and according to the financial think tank OMFIF, have assets under management of around $8.5 trillion. However in the current twin crises it is our view that FX reserves, which total a further $14 trillion, should also be considered as part of the solution. And if the two are combined, the total firepower available in national wealth accounts comes to a number that equates to almost 20% of global GDP. This is a sizeable war chest that should not be idle at this critical moment.
The changing role of FX reserves
In the 20th century reserves were seen as providing protection against short term economic problems, usually related to exchange rate volatility. They were a tool to buy time, to restore order. But FX intervention on its own seldom enabled a country to overcome structural weaknesses and maintain a chosen exchange rate over the long term in the face of ongoing imbalances. Even though in the 21st century FX reserves have grown to levels that were once unimaginable, that inability for them to be used to overcome structural weaknesses remains.
So why did they grow? The primary reason for this stems from a collective loss of confidence in the global financial system’s mutual insurance arrangements for the currencies of emerging nations (most notably the IMF’s support mechanisms) after the 1997 Asian Financial Crisis. Nations chose to stockpile reserves in the hope that they would free themselves from reliance on outsiders. This became a “space race” as other countries felt obliged to follow. No country wanted to be identified as being under-resourced versus their peers and thus “the weakest link” and the target for speculative attack.
As reserves have grown, they have often been charged with an additional role as an endowment/trust fund for future generations (see “Assessing Reserve Adequacy”, an IMF paper issued in 2015, available via https://www.imf.org/external/np/spr/ara/#polpapers). Some nations have used FX reserves to fund a SWF, some nations have allowed their reserves managers to incorporate investments typical of a SWF. We would argue that as they have swelled, many central bank FX reserves portfolios now share many of the characteristics of a “rainy day” fund.
This mission creep has not been matched by a similar evolution of central bank thinking about how to fund, manage or deploy reserves. It is time that this was addressed.
But dare we use them?
We have commented in previous articles, that the race to build reserves has had two unexpected consequences. Firstly, and perniciously, for some nations they have become too important to risk losing. Just as the German High Seas Fleet was kept in its home bases after the Battle of Jutland in 1916, because to lose it in a full naval engagement with the British Grand Fleet would have been an unimaginable disaster, so reserves are often protected and kept safe, away from any deployment and risk of loss. Secondly, as a consequence of this reluctance to use them, the world has begun to question what role they really play.
The argument against using FX reserves lies in a desire to maintain self-insurance. But it has led to a situation where nations have found themselves in the uncomfortable position of being unable to say that any level of FX reserves is enough, because in the absence of any agreed definition of reserves adequacy – and to their shame academics and policymakers alike have signally failed to establish one – to declare that one has enough is merely to make an unsubstantiated statement of opinion and invite the world’s speculators to test you.
Worse than this, there is evidence that employing FX reserves for their traditional purpose – defending the currency – is an admission of weakness and in many cases can actually contribute to undermining confidence in the currency being defended. Even the $1 trillion that China spent in 2014/16 did not prevent a 20% slide in the value of the Renminbi.
We are in an extraordinary situation where nations are stockpiling huge if not excessive FX reserves out of caution but in many cases dare not ever use them. In a world of limited resources and large government deficits, holding huge reserves which are often expensive to fund, which have multiple unclear objectives, and which might not even be employable simply does not make sense: it is neither sustainable nor justifiable, and there has to be a better way. Indeed, a failure to contemplate new uses for FX reserves would represent a stagnation in central bank thinking.
The opportunity to launch a new multipolar currency infrastructure
There is evidence that swap lines have been more effective in supporting currencies under pressure than the deployment of FX reserves (as South Korea proved in late 2008 in their successful operations to defend the Won). However, these examples have been US dollar swap lines, of finite maturity, and in the gift of the US to grant them. They accentuated rather than alleviated the issue of dollar hegemony in the international monetary system.
It is here that a coordinated multi-currency network of swap lines, perhaps under the auspices of a neutral authority such as the IMF, could both help the system from being dominated by a single currency, and remove the temptation for swap providers to view it as a means to project soft power (for example the US’s “dollar diplomacy”, and denial of dollar facilities to countries it disapproves of such as Iran, and also China’s RMB swap lines, access to which is linked to Belt and Road priorities).
In addition, compared to the sterilisation costs associated with the accumulation of FX reserves, and the costs of managing them, currency swap lines are cheap. A swap line represents the right to access financial resources; but crucially without the obligation to hold and therefore finance those resources pending their use.
Could swap lines be depoliticised? One solution could be the coordinated extension of swap lines by all of the reserve currency issuers, administered by the IMF. The existence of multiple swap lines might lessen the political power conferred on a single swap line issuer. Multiple swap lines could herald the dawn of a new period of financial cooperation, an antidote to the “my country first” politics of recent years.
If not now, when?
The challenge for anyone, whether at the personal level or the national, who has built a fund for use in emergencies is to recognise when “The Emergency” – the big crisis for which the funds have been so carefully assembled – is upon them. It is always tempting to say “we must not use it yet, as things might get worse”; but in avoiding using the fund too soon, the greater danger is that it is never used at all.
We would argue that 2021 presents a uniquely clear case where The Emergency really is upon us, indeed it is staring the world in the face. Addressing the economic consequences of the pandemic and implementing a green energy agenda are issues an order of magnitude larger, and more global in their reach, than the world has seen in modern economic history. Future generations will not thank us if alongside the large trust fund that they inherit because we didn’t dare spend it, they also inherit a ruined world; no-one is well served by a stockpile of gold at the central bank when the world is in flames.
The rainy day is here. The status quo is not sustainable. Rules can and must be rewritten to allow FX reserves to join the fight. Central banks must listen to “the Urgency of Now”.
 See for example:
Smith & Nugée, “The changing role of CB Foreign Exchange reserves”, 2015
Smith & Nugée, “FX reserves in a volatile world”, 2016
Smith & Nugée, “The changing importance of FX reserves”, 2018
All papers available from OMFIF (www.omfif.org)