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Currency reserves are ...

(1) under a fixed exchange rate system, what allows a central bank of a currency zone to ensure that payments clear in the short term in the case of imbalances in payments that may require a revaluation if they persist into the longer term.

(2) under a floating exchange rate system, what allows a central bank of a currency zone to intervene in foreign exchange markets to prop up the value of a currency.

When the central bank in (2) is not targeting a specific rate, but is simply intervening to slow down the pace of exchange rate movements, this is called a "dirty float".

If the central bank of a currency zone wishes to maintain a stable exchange rate with another currency, or basket of currencies, then it can do so in the context of a floating exchange rate system by pegging at an undervalued rate (using the indirect foreign exchange rate to simplify the language ... that is, the currency in question as a commodity to be bought and sold in some foreign exchange market overseas somewhere).

Pegging at an undervalued rate is possible because defending against an increase can be done by issuing more domestic currency and using that to purchase foreign exchange.

Pegging at an overvalued rate is not sustainable in the long term, because it requires using foreign exchange reserves, and the central bank of a currency zone has no ability to create new foreign exchange. Since its not sustainable in the long term, it can also attract speculative activity, and since the defense against that speculative activity consumes the foreign exchange reserves at an even faster rate, the speculative attack itself is likely to attract further speculation, creating a "feeding frenzy".

And since pegging means that the exchange rate remains stable, while foreign exchange market valuations are intrinsically volatile, a peg that is "neutral on average" would part of the time be above market valuation ... so to maintain a peg, the discounted peg on the one hand reduces the frequency when the peg has to be defended against falling, and on the other hand results in accumulation of foreign exchange reserves, making speculators less confident that a speculative attack will succeed, making a speculative attack less likely.

Foreign exchange reserves normally only come into attention when there is a capital accounts crisis in a country with a sudden surge of capital outflows ... the immediate impact of that is a collapse in the exchange rate, which can interfere with essential imports (food, fuel, etc.), but the central bank can use the foreign exchange reserves to prop up the exchange rate and slow the decline while the government tries to sort out a more permanent fix.

Also, countries that try to maintain an overvalued exchange rate have to try to capture foreign currency inflows as they occur and ration that currency among competing uses ... they are the countries for whom "x days foreign exchange reserves", means effectively, "x days of hard currency in the bank".

That's what foreign exchange reserves are ... they are used when a central bank is propping up an exchange rate, and accumulated when pushing down exchange rates.  The exception are a range of fourth world countries whose domestic currency is mostly treated as worthless beyond its national borders, for whom foreign exchange reserves are basically the total amount of "international money" that its central bank has available to allow payments for imports and overseas income obligations to be made.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sun Jun 1st, 2008 at 11:07:02 PM EST
BruceMcF:
Pegging at an overvalued rate is not sustainable in the long term, because it requires using foreign exchange reserves, and the central bank of a currency zone has no ability to create new foreign exchange. Since its not sustainable in the long term, it can also attract speculative activity, and since the defense against that speculative activity consumes the foreign exchange reserves at an even faster rate, the speculative attack itself is likely to attract further speculation, creating a "feeding frenzy".
Explains Soros' ejection of the Pound from the European Monetary union as well as the Argentine corralito crisis and many others coming from pegging weak currencies to the dollar. It also might explain what happened in 1925 when Churchill as Chancellor of the Exchequer ignorantly set the exchange rate of the pound to the gold standard too high.

However, it is impossible for everyone to attempt a long-term peg of their currency as not every currency can be (slightly) undervalued at the same time. Was that the basic weakness of the gold standard and then of the bretton-woods systems before Nixon foated the dollar?

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes

by Carrie (migeru at eurotrib dot com) on Mon Jun 2nd, 2008 at 06:33:06 AM EST
[ Parent ]
... a peg within a floating point system, but rather its a fixed point system.

A fixed point peg can be defended from speculation, so long as the side under pressure to devalue is defended by the other central bank ... because the other currency is under upward pressure, and that central bank can create its own currency to defend against upward pressure.

When the pound was forced out of the ERM, the Bundesbank did not want to defend the ERM exchange rate of the pound, AFAIR because it was faced with the inflationary impact of the integration of East and West Germany, and the side effect of pushing down against that upward pressure is an increase in supply of reserves, pushing down the floor inter-bank reserve lending rate.

And the Bank of England AFAIR did not want to defend the pound by increasing interest rates, AFAIR because the UK was coming out of a recession, so as it defended the FXR with purchases of pounds using foreign exchange reserves, at the same time it issued pounds as reserves domestically to keep the interest rate down.

To be able to defend a system of pegged exchange rates, you either need the central banks on either side of the peg to put first priority on defending the exchange rates, or regulatory controls on flows of financial capital across international boundaries, or both. The EU eliminated the capital controls in transactions between ERM members, and as it turned out when push came to shove, the priority on defending the ERM was not there.

The break-down of Bretton Woods was similar ... in the original Bretton Woods system, all currency pegs were to gold, and net clearances were in gold. The use of US$ for clearances was a convention that developed, to avoid the inconvenience of net clearances between reserve banks in gold.

When France refused to accept that the US$ in the early 70's was at the correct peg to gold, and demanded clearances in gold, the US was faced with either an ongoing series of devaluations by the USG, a radical change in economic policy to reduce the downward pressure on the dollar which showed up in the requirement to pay net clearances, or else an abandonment of the Bretton Woods system. In the end, though it took a little while to play out, the last course was taken.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Mon Jun 2nd, 2008 at 09:44:10 AM EST
[ Parent ]
BruceMcF:
Foreign exchange reserves normally only come into attention when there is a capital accounts crisis in a country with a sudden surge of capital outflows ... the immediate impact of that is a collapse in the exchange rate, which can interfere with essential imports (food, fuel, etc.), but the central bank can use the foreign exchange reserves to prop up the exchange rate and slow the decline while the government tries to sort out a more permanent fix.
Does peak oil qualify as a sudden surge of capital outflows in energy-importing countries?

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Carrie (migeru at eurotrib dot com) on Mon Jun 2nd, 2008 at 06:34:31 AM EST
[ Parent ]
... therefore requiring either reduction in other current account outflows to balance it within the current account, or else an increase in capital account inflows ... as they say, "recycling the oil wealth".

For those who don't recall the debt crises of the 80's ... the push to recycle the current account surpluses of the OPEC oil exporters in the later 70's was a big part of laying the foundation for the debt crises of the 80's.

The first cabs off the rank in that series of debt crises were those developing nations like Brazil that has a strategy of relying on heavy foreign borrowing, where the knock on its current account from the oil price shocks suddenly left it unable to service its overseas obligations. But the push to recycle oil incomes made that worse as well ... when Brazil was in the stage of borrowing to meet existing debt obligations, the push by major money center banks looking to attract oil country funds by offering high returns meant that Brazil was able to dig itself far deeper into a hole than it should have been able to do.

The big change now is that we have just gone through a big wave of the same thing, except this time recycling the profit income gained by appropriating basically all productivity gains for nearly a decade, rather than splitting them with labor roughly 50:50 as under the Fordist regime. How the challenge of recycling oil incomes is going to work out in the current climate is anyone's guess.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Mon Jun 2nd, 2008 at 10:37:33 PM EST
[ Parent ]

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