A recent article by Mr. Abu Saeed Islahi, in EBR, highlighted the need to enlighten the general public on the role and importance of foreign exchange reserves in a country’s economy. This article attempts to address that need, with particular reference to Pakistan.

The standard definition of reserves, put forward by G-10 and quoted in Williamson (1991) is, “those assets of a country’s monetary authorities that can be used, directly or through assured convertibility into other assets, to support its rate of exchange when its external payments are in deficit”.

Data on the composition of reserves of developing-countries, indicate these to consist primarily of dollar-denominated liquid assets— notably US treasury bills and bank deposits, currencies of other important industrial countries, such as yen, sterling and now Euro, SDRs issued by the IMF, and gold.

As Mr. Islahi points out, the composition and choice of reserve assets for a particular country, is a very important issue, and gold, as he points out is an asset that has a zero nominal interest rate or negative, if one includes storage costs. Of course the choice of reserve assets is a matter for the SBP, to carefully consider,and we shall not delve on it here anymore.

This article primarily deals with highlighting the purpose of holding reserves, and the factors governing the choice of the appropriate level of reserves that a country like Pakistan should hold. Each of these are discussed in turn.

Purpose: As Williamson (1991) points out, reserves nowadays, are held, primarily to function as inventories to absorb shocks. That is, the central bank accumulates reserves, when inflows of foreign exchange exceed outflows, and draws down its stock in the reverse situation, thus helping to stabilize the domestic economy and the exchange rate.

Reserves have two potential shock absorbing roles. First, arises in an economy where the balance of payments is in long run equilibrium, but is bombarded by a series of temporary shocks, such as fall in major commodity export prices that threaten to destabilize the economy. Here an independent monetary policy has a potential role. The central bank can help counter the effects of the fall in export earnings, by helping run a fiscal deficit.

The central bank, can replace its foreign assets by government paper, thus preventing, or at least mitigating, the impact of export decline on the economy till such time that exports pick up again, and the national income is stabilised.

The second and the more relevant shock absorbing role from the point of view of Pakistan, is that reserves can permit a measured pace of adjustment. This pace of adjustment for Pakistan relates to its persistent current account deficits mainly, due to high debt servicing costs and dwindling offsetting inflows on capital account due to substantial, and possibly long lasting, fall in forex inflows.

Hence, the reserves that the SBP is currently accumulating, can help reduce balance of payments (BoP) deficits, by helping to meet its future debt servicing obligations as they fall due. This is probably the main reason why the SBP is building up its forex reserves by soaking up the excess domestic liquidity from the domestic financial market. It is important to note, however, that this effort at adjustment to persistent deficits is coming primarily as an expenditure reducing strategy, that is, through building of foreign assets at the expense of reducing domestic expenditure, both public and private.

This is evident by the attempt to restrict both fiscal deficit and causing relatively high interest rates thus also limiting investment expenditure.In the long run, this practice of building reserves by soaking up domestic liquidity, cannot be a desirable and sustainable course of action, as the need today is not for expenditure reduction but expansion, if we are to come out of the current prolonged recession.

It is to be noted that the SBP is now easing the interest rates as the process of reserve building through outright purchases has slowed down. There are indications that home remittances as well as exports are picking up. If this becomes a sustainable trend, the need for accumulation of reserves should diminish accordingly.

This leads us to the second important question, that what should be the norm or target for reserves that a country should hold. This issue of the norm for reserves is closely inter-linked with the choice of speed of adjustment to shock that a country would choose to follow. The two are inversely related. A greater willingness to adjust rapidly (reduce domestic expenditure) in the face of payments deficit, reduces the need for higher level of reserves.

Norm for reserve stock: Generally speaking, the target for reserve stock depends upon four factors:

First, the vulnerability of the balance of payments to shocks - greater the vulnerability, higher the norm required. Consideration of the source of vulnerability, whether internal or external is also important. For a country like Pakistan, both internal and external sources of shock are relevant. Internal weaknesses stem from heavy dependence on a narrow export base (predominantly cotton based). External sources of shock involve unfavourable export and import prices; exchange rate movements; and unfavourable political developments that adversely affect the inflow of foreign exchange in the country, such as sanctions imposed on Pakistan, now and again. Pakistan’s balance of payment being particularly vulnerable would suggest the need for a higher level of reserves.

Second, the cost of reserve holding. The cost of holding reserves is an opportunity cost. In other words, the decision to hold reserves has to be weighed in terms of what is to be done with the cash involved, if it were not to be held as reserves.

For a country like Pakistan, which is compelled by the shortage of forex to cut its imports (including imports of intermediate and capital goods needed for investment), the opportunity cost of reserves is indeed quite high. Not only does it force us to reduce domestic consumption but more importantly to reduce domestic investment, thereby restricting output and economic growth.

Another aspect to this cost comes from borrowing long term as Pakistan has done, at usually higher interest rates and putting the liquid reserves at short term low interest rates (as in US treasury bills, for example), thus entailing a difference of between 2-4 percent on borrowing and lending. Thus, the higher the level of reserves, the higher this cost.

Third, the speed of adjustment. An important determinant of the optimal norm for the stock of reserves is the speed with which a country is prepared to adjust its balance of payments when the need arises. The more rapidly a country aims to adjust its balance of payments, the more likely it is to incur higher costs of adjustment. These costs include, first, import cutbacks. For Pakistan the costs of import cutbacks are indeed very high, as 85 per cent of our imports consist of raw materials for consumer and capital goods as well as capital goods).

Second for a country like Pakistan, even if it has a high short run elasticity in the export demand side, it is usually constrained from expanding its exports due to low short run elasticity of supply. A third factor affecting cost is the exchange rate regime of a country. It is a general presumption that the more flexible the exchange rate regime, the more conducive it is to rapid adjustment. In other words, a devaluation in the face of BoP deficits would automatically cut imports, and encourage exports. An opportunity which a country is denied, if it follows a fixed rate regime. This reasoning however is not so valid for Pakistan, as devaluations tend to increase our external debt servicing costs, while having little impact on our exports.

Fourth and final consideration is the costs of reserve depletion. Following the nuclear tests, sanctions and subsequent freezing of resident foreign currency accounts in May 1998, Pakistan experienced a sharp decrease in its forex inflows. Thus necessitating the need for debt rescheduling and IMF assistance.

Since May 1998, Pakistan has paid a heady price for its weak external position involving reserve depletion in the form of various high conditionality loans from the IMF. Essentially these arrangements have involved severe deflationary conditionalities (devaluations, fiscal deficit cuts) resulting in sharp drop in output. Our GDP growth rate slowed down to an all time low of 2.6 per cent in FY01. The thrust of the IMF conditionalities has been on securing a rapid turnaround in balance of payments including the ability to service external debts.

No doubt a comfortable reserve position at the moment (crossing $ 9 billion) has not been achieved without paying a heavy price in terms of domestic contraction, but a crucial question now is how long this position would last? Or even whether it should last. What are our priorities? A weak internal with a strong external position as is now, or a stronger internal position, involving monetary easing, lower interest rates and higher investment, both public and private.