Tuesday, June 5, 2018

No, International Reserves are NOT Government Savings

I’m starting to read this in social media comments about Malaysia’s public debt. That the government doesn’t have reserves; no, that Malaysia has plenty of international reserves; but Singapore has more reserves than we do! etc.

This is almost wholly nonsense.

First of all, international reserves cannot be used in a domestic setting – they are, after all, denominated in foreign currency. Some people might quibble that they could be used to pay off the foreign currency liabilities of the government. Only problem is, it’s not the government’s assets to use, as reserves are the assets of the central bank.

Second, the buildup of international reserve assets always involves the creation of an equal and opposite amount of domestic liabilities. Using international reserves requires offsetting these liabilities first, in one way or another.

To understand why, let’s examine the mechanism by which foreign reserves are acquired. I’ll gloss over here the difference between fixed and floating exchange rate regimes.

An increase in reserves is achieved by a central bank purchasing (or forcibly acquiring) foreign currency off the open market. This is paid for by the simple expedient of crediting the selling bank’s account at the central bank. In other words, the central bank just prints money (which is a liability on the central bank balance sheet). So an increase in international reserves is always associated with an equal and corresponding increase in central bank liabilities.

Since this can reduce interbank interest rates (and is potentially inflationary), such increases are typically “sterilised” by the issuance of central bank debt, which then reduces market liquidity. But sterilisation, or lack thereof, doesn’t really add much to the story, so you can pretty much ignore it for understanding what’s happening here.

This mechanism is why Singapore simultaneously has giganormous reserves and an equally giganormous government debt ratio, despite constantly running a budget surplus – the debt is a direct consequence of acquiring the assets, and has nothing to do with government assets, debt, reserves or anything else. [Note: unlike every other central bank which issue their own debt liabilities, the Monetary Authority of Singapore uses Singapore Government Securities to sterilise forex intervention. Only relatively recently has the MAS started using its own MAS Bills].

Using international reserves requires putting the above transactions in reverse – US dollars or Euros or Yen are sold into the banking system in return for domestic currency. For the government to use these funds would then require them to issue an IOU to the central bank. But you can avoid all this rigmarole by the government issuing an IOU and the central bank buying it with money created out of thin air, without going through the all the tiresome intermediate transactions involving foreign currency.

The bottom line here is that international reserves say nothing about the ability of a government to finance itself. For that matter, as long as a country is a monetary sovereign, reserves denominated in domestic currency aren’t, strictly speaking, necessary either.

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