Wednesday, September 29, 2010
Excess reserves
Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations, however, other government funds that are counted as liquid assets that can be applied to liabilities in times of crisis include stabilization funds, otherwise known as sovereign wealth funds. If those were included, Norway and Persian Gulf States would rank higher on these lists, and UAE's $1.3 trillion Abu Dhabi Investment Authority would be second after China. Singapore also has significant government funds including Temasek Holdings and GIC. India is also planning to create its own investment firm from its foreign exchange reserves.
Costs, benefits, and criticisms
Large reserves of foreign currency allow a government to manipulate exchange rates - usually to stabilize the foreign exchange rates to provide a more favorable economic environment. In theory the manipulation of foreign currency exchange rates can provide the stability that a gold standard provides, but in practice this has not been the case. Also, the greater a country's foreign reserves, the better position it is in to defend itself from speculative attacks on the domestic currency.
There are costs in maintaining large currency reserves. Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. Even in the absence of a currency crisis, fluctuations can result in huge losses. For example, China holds huge U.S. dollar-denominated assets, but if the U.S. dollar weakens on the exchange markets, the decline results in a relative loss of wealth for China. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates. Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets.
There are costs in maintaining large currency reserves. Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. Even in the absence of a currency crisis, fluctuations can result in huge losses. For example, China holds huge U.S. dollar-denominated assets, but if the U.S. dollar weakens on the exchange markets, the decline results in a relative loss of wealth for China. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates. Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets.
Changes in reserves
Changes in reserves
The quantity of foreign exchange reserves can change as a central bank implements monetary policy. A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower). In a flexible exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or selling the foreign currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations to maintain the targeted exchange rate within the prescribed limits .
Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: An exchange rate target cannot be independent of an inflation target. Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that strictly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements.
To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency, which will increase the sum of foreign reserves. In this case, the currency's value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).
Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls). In practice, some central banks, through open market operations aimed at preventing their currency from appreciating, can at the same time build substantial reserves.
In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years to become evident, changes in foreign reserves and currency values in the short term may be quite large as different markets react to imperfect data.
The quantity of foreign exchange reserves can change as a central bank implements monetary policy. A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower). In a flexible exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or selling the foreign currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations to maintain the targeted exchange rate within the prescribed limits .
Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: An exchange rate target cannot be independent of an inflation target. Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that strictly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements.
To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency, which will increase the sum of foreign reserves. In this case, the currency's value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).
Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls). In practice, some central banks, through open market operations aimed at preventing their currency from appreciating, can at the same time build substantial reserves.
In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years to become evident, changes in foreign reserves and currency values in the short term may be quite large as different markets react to imperfect data.
Foreign exchange reserves
Foreign exchange reserves (also called Forex reserves or FX reserves) in a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, mostly the US dollar, and to a lesser extent the euro, the UK pound, and the Japanese yen, and used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.
History
Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves, and after 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, no major currencies have been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves.
Purpose
In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or fiat currency as IOUs). This action can stabilize the value of the domestic currency.
Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates.
History
Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves, and after 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, no major currencies have been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves.
Purpose
In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or fiat currency as IOUs). This action can stabilize the value of the domestic currency.
Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates.
Foreign exchange controls
Foreign exchange controls are various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents or on the purchase/sale of local currency by nonresidents.
Common foreign exchange controls include:
Banning the use of foreign currency within the country
Banning locals from possessing foreign currency
Restricting currency exchange to government-approved exchangers
Fixed exchange rates
Restrictions on the amount of currency that may be imported or exported
Countries with foreign exchange controls are also known as "Article 14 countries," after the provision in the International Monetary Fund agreement allowing exchange controls for transitional economies. Such controls used to be common in most countries, particularly poorer ones, until the 1990s when free trade and globalization started a trend towards economic liberalization. Today, countries which still impose exchange controls are the exception rather than the rule.
Common foreign exchange controls include:
Banning the use of foreign currency within the country
Banning locals from possessing foreign currency
Restricting currency exchange to government-approved exchangers
Fixed exchange rates
Restrictions on the amount of currency that may be imported or exported
Countries with foreign exchange controls are also known as "Article 14 countries," after the provision in the International Monetary Fund agreement allowing exchange controls for transitional economies. Such controls used to be common in most countries, particularly poorer ones, until the 1990s when free trade and globalization started a trend towards economic liberalization. Today, countries which still impose exchange controls are the exception rather than the rule.
Managed currency mortgages
Managed currency mortgages can help to reduce risk exposure. A borrower can allow a specialist currency manager to manage their loan on their behalf (through a limited power of attorney), where the currency manager will switch the borrower's debt in and out of foreign currencies as they change in value against the base currency. A successful currency manager will move the borrower's debt into a currency which subsequently falls in value against the base currency. The manager can then switch the loan back into the base currency (or another weakening currency) at a better exchange rate, thereby reducing the value of the loan. A further benefit of this product is that the currency manager will try to select currencies with a lower interest rate than the base currency, and the borrower therefore can make substantial interest savings.
There are risks associated with these types of mortgages and the borrower must be prepared to accept an (often limited) increase in the value of their debt if there are adverse movements in the currency markets.
A successful currency manager may be able to use the currency markets to pay off a borrower's loan (through a combination of debt reduction and interest rate savings) within the normal lifetime of the loan, while the borrower pays on an interest only basis.
There are risks associated with these types of mortgages and the borrower must be prepared to accept an (often limited) increase in the value of their debt if there are adverse movements in the currency markets.
A successful currency manager may be able to use the currency markets to pay off a borrower's loan (through a combination of debt reduction and interest rate savings) within the normal lifetime of the loan, while the borrower pays on an interest only basis.
Foreign currency mortgage
A foreign currency mortgage is a mortgage which is repayable in a currency other than the currency of the country in which the borrower is a resident. Foreign currency mortgages can be used to finance both personal mortgages and corporate mortgages.
The interest rate charged on a Foreign currency mortgage is based on the interest rates applicable to the currency in which the mortgage is denominated and not the interest rates applicable to the borrower's own domestic currency. Therefore, a Foreign currency mortgage should only be considered when the interest rate on the foreign currency is significantly lower than the borrower can obtain on a mortgage taken out in his or her domestic currency.
Borrowers should bear in mind that ultimately they have a liability to repay the mortgage in another currency and currency exchange rates constantly change. This means that if the borrower's domestic currency was to strengthen against the currency in which the mortgage is denominated, then it would cost the borrower less in domestic currency to fully repay the mortgage. Therefore, in effect, the borrower makes a capital saving.
Conversely, if the exchange rate of borrowers domestic currency were to weaken against the currency in which the mortgage is denominated, then it would cost the borrower more in their domestic currency to repay the mortgage. Therefore, the borrower makes a capital loss.
When the value of the mortgage is large, it may be possible to reduce or limit the risk in the exchange exposure by hedging
The interest rate charged on a Foreign currency mortgage is based on the interest rates applicable to the currency in which the mortgage is denominated and not the interest rates applicable to the borrower's own domestic currency. Therefore, a Foreign currency mortgage should only be considered when the interest rate on the foreign currency is significantly lower than the borrower can obtain on a mortgage taken out in his or her domestic currency.
Borrowers should bear in mind that ultimately they have a liability to repay the mortgage in another currency and currency exchange rates constantly change. This means that if the borrower's domestic currency was to strengthen against the currency in which the mortgage is denominated, then it would cost the borrower less in domestic currency to fully repay the mortgage. Therefore, in effect, the borrower makes a capital saving.
Conversely, if the exchange rate of borrowers domestic currency were to weaken against the currency in which the mortgage is denominated, then it would cost the borrower more in their domestic currency to repay the mortgage. Therefore, the borrower makes a capital loss.
When the value of the mortgage is large, it may be possible to reduce or limit the risk in the exchange exposure by hedging
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