More Reserve Gibberish

Scenario 1:

I borrow $100 from my neighbour Adam for a month and give him an IOU. In my books, I’ll have $100 in liabilities to Adam that I have pay back in 30 days, while Adam has an asset of $100 that he can claim from me. Adam is however short of cash, and sells my IOU to Chong across the street a week later. In my books, I still owe $100 in 3 weeks time, but this time to Chong. From my point of view, it hardly matters where the money came from – I still have to pay it back based on the IOU. The important point here is that the debt outstanding remains $100. The transfer of the debt liability from Adam to Chong doesn’t constitute an increase in my borrowing.

Scenario 2:

Muthu is going on holiday and wants my help to take care of his cat. So for a week, I will have a cat around the house that I’m responsible for, at the end of which I’ll have to return it to him. During that week, my balance sheet will show that I have a “debt” of 1 cat to Muthu (it shows as an asset on his balance sheet). He’ll be very upset if I don’t have it when he returns.

However, my kids are allergic to cats, so Malik offers to take care of the cat instead. Malik has a couple of guinea pigs, which might be at risk with the cat around. So I take on the guinea pigs in exchange for the cat during the week.

So now, Muthu has an asset (1 cat on loan to me), I have a couple of debts (1 cat owed to Muthu and 2 guinea pigs owed to Malik) and an asset (1 cat owed from Malik), while Malik has a couple of assets (1 cat that has to be returned to me, 2 guinea pigs I have to return to him).

If you managed to follow what I’ve laid out above, the following sounds nonsensical (excerpt, emphasis added):

Egypt Fuels Record Reserves With External Debt Surge: Chart

Egypt’s net foreign reserves have been rising steadily, hitting a record in July. The increase has been driven by heavy external borrowing as investors pour money into Egyptian assets following the government’s lifting of most currency restrictions and the IMF’s approval of a $12 billion loan. A total of $14 billion have flowed into Egyptian treasury bills, which are among the highest yielding in the world.

We have a terminology problem here folks. Foreign investors buying into a country’s assets don’t constitute “borrowing” except in the most superficial sense. It certainly increases external liabilities of a country, but is not an increase in the total liabilities of a country. It’s just a transfer in the ownership of IOUs.

Neither the Egyptian government nor certainly the central bank increased their borrowings to increase reserves (unless of course its sterilised; see below) – an increase in reserves is similarly a transfer of ownership of foreign assets from private to public hands. That last point is important – the increase in external “debt” through capital inflows is necessarily also an equal and simultaneous increase in external “assets”, and this is true regardless of whether the central bank responds by increasing reserves or not.

If I were to put it terms of scenario 2, the reason why central banks increase reserves when there’s an inflow of capital is because I might be tempted to loan out the cat to someone else in the neighbourhood who might not be so trustworthy, and have no cat on hand when Muthu returns. Malik in that sense stands as guarantor that Muthu gets his cat back, because I might not be so trustworthy. In other words, even though I might have sufficient assets to pay off my “debt” to Muthu, but it would be in assets that would be unacceptable to him – he wants his cat back.

Sterilisation of reserve accumulation changes the story somewhat, because it does mean the central bank is “borrowing”. However, it’s closer to the banking system being forced to lend money to the central bank, rather than the central bank borrowing from the system. Again using scenario 2, it’s like Malik taking back the guinea pigs and giving me an IOU for them – and I’ve probably stretched that analogy to the edge of incomprehension.

Regardless, the terminology of “external debt” really needs to be changed. The term gives laymen the totally wrong connotations – heck, it fools a lot of financial analysts and journalists as well. Misleading terms result in misunderstandings, which can lead to policy mistakes. Too big a price to pay for what amounts to a mistake in “framing”.