An overestimation of 15% in the calculation of official reserves is not an easy task. The IMF’s findings in this regard are worrying. Prevented is warned, says an old proverb.
Reserve asset portfolios have special characteristics that distinguish them from other currency assets. There are internationally accepted accounting principles, detailed in the IMF’s Balance of Payments and International Investment Position (BPM6) Manual, which provide specific guidance for the compilation of reserve assets. The Bangladesh Bank (BB) follows the BPM6 conventions for recording and reporting international transactions in goods, services and assets.
Let’s get back to basics first.
What are official foreign exchange reserves?
These are external assets that are readily available and controlled by the monetary authorities to meet the needs of balance of payments financing, intervention in foreign exchange markets and other related purposes, according to the BPM6. Country data coverage on international reserves varies as some countries do not fully disclose their international reserves. Some define reserve assets differently for operational purposes. However, good practice requires consistency over time and full disclosure in accordance with accepted conventions.
In the context of Bangladesh, this means consistency with the conventions of MBP6. The accounting for reserves should include readily tradable foreign currency assets available and controlled by the BB and held as convertible (internationally tradable) and liquid currency claims on non-residents that are freely usable for the settlement of international transactions. .
The specific problems reported by the IMF on the treatment of several uses of reserves indicate significant deviations from these principles. Instead of being defensive, BB should take the recommended corrections seriously to avoid damaging the credibility of such a key indicator. Investors look at reserves to assess a country’s ability to manage external risks. Inflating reserves creates an exaggerated sense of comfort among macroeconomic decision-makers, let alone deceiving the markets at one’s peril.
What exactly went wrong?
The BB appears to include assets that are not easily convertible into reserve currencies when needed. BB financings for infrastructure, loans to resident banks guaranteed in local currency, foreign currency deposits with public banks, investments in substandard bonds and loans in Sri Lanka do not pass the tests for convertibility, liquidity and security to count them as foreign exchange reserve assets.
These assets held by BB are not at their actual disposal and therefore cannot be used if necessary. Putting reserves into illiquid and risky uses and yet counting them as official forex reserves is like having its cake and eating it too.
In BPM6, claims denominated in foreign currencies at resident banks are excluded from reserve assets because they are not freely usable for the settlement of international transactions. The potential for transferring assets to or from resident banks is too indirect. The bulk (86%) of the $ 7.2 billion reserve overstatement is made up of foreign currency loans to local banks.
Likewise, receivables repayable in non-convertible foreign currencies cannot be reserve assets. These include lines of credit that could be used and foreign exchange resources that could be obtained under swap agreements (such as loans in Sri Lanka). These assets are neither immediately repayable nor guaranteed in the same currency as the loan.
Of necessity, the accounting of reserve assets must be very careful, giving priority to liquidity and security. It should only include assets over which BB can exercise direct and effective control. The test of such control must be strictly applied.
Game exchange reserve accounting never helps
The valuation of reserves is essential to assess a country’s international investment position. Too few reserves endanger a country’s economy and finances. Too many reservations mean that a country relies excessively on demand from the rest of the world, rather than on its own demand. There is no scientific answer on how little is too little and how much is too much.
There are several basic rules. At a minimum, countries should have enough to pay for 3-6 months of imports of goods and services. This alleviates shortages of essential consumption, raw materials, intermediate inputs and capital goods. It should have enough to cover the country’s debt payments and current account deficits for 12 months or more. Reserves should be sufficient to cover more than 100% of short-term debt (based on original maturity). Last but not least, there is the metric of 20% or more reserves to broad money which measures the potential demand for foreign assets from domestic sources.
Based on data from July-August of this fiscal year, $ 39 billion is equivalent to 6.2 months of imports of goods and services and 54 months of current account deficit and debt repayment payments. Short-term external debt represents a little over 30% of reserves. The reserves / broad money ratio is around 21%.
Based on conventional ratios, reserves of $ 39 billion are indeed sufficient. It is therefore difficult to understand the indulgence in “creative” accounting to show a bloated reserve position. Even when reserves are insufficient, falsifying accounts will not help survive the market test. It can actually make matters worse.
Adequacy of the unsecured reserve
Countries hold reserves as a buffer to absorb or self-insure against balance of payments shocks, including sudden stops in international capital flows; providing foreign currency liquidity to banks in stressful situations; and mitigate volatility in foreign exchange markets. Bangladesh has seen bits of it all in recent months.
Rising international commodity prices led to an increase in the import bill of goods, remittances through formal channels slowed, the external current account deficit widened, and foreign portfolio investment remained consistently negative since July 2020.
The trajectory and outlook for reserves are influenced by many factors, but the phase of rapid reserve growth may be over. BB must reassess the balance of the various reserve management objectives. Recent developments highlight the importance of managing exchange rates, maintaining external liquidity and market confidence, and building an emergency reserve. These should inform the order of reserve management priorities: security, liquidity and yield.
In an uncertain world, “adequate” reserves are reserves considered sufficient to meet the worst-case demands in a troubled balance of payments. Central banks focus on performance when reserves are above that level, that is, when they have “excess” reserves. While different central banks have different risk tolerance, the excess part can be managed on a risk-return basis, rather than simply complying with safety and liquidity requirements. However, once they are engaged in high-return-high-low-risk liquid uses, they can no longer be counted as reserve assets.
Play within your limits
Central banks globally have moved towards a greater diversity of asset classes and a wider use of risky assets in recent years, with around 15% unconventional reserve instruments. Central banks are now important participants in capital markets. They hold about a third of all supranational debt and nearly a fifth of high-grade sovereign debt, according to the Forum of Official Monetary and Financial Institutions (2020).
The wider use of risky assets has not come at the expense of liquidity and security objectives. High-quality sovereign bonds issued in reserve currencies, gold and deposits with central banks still constitute nearly 80% of the global reserve portfolio.
Most central banks want to increase returns without compromising safety. The best way to do this is to diversify their portfolios if they have the capacity to manage.
BB is not there yet. Bangladesh has limited and uncertain access to international financial markets. Liquidity is therefore a priority. Next comes the need to manage and control risks to ensure that asset values are protected. The market and credit risks that accompany a wider use of risky assets can lead to sudden losses and harm liquidity. BB has limited expertise and limited IT capacity to play in these asset class markets.
Prudent reserve accounting is a sine qua non
Prudence in accounting practice goes beyond common sense to be fiscally prudent. Among other things, it is the practice of ensuring that foreign exchange reserves are not overestimated. Duly disclosed currency reserves play a stabilizing role in discouraging one-sided betting during episodes of financial stress.
Such disclosures may not win favor with Pollyannaish stakeholders, but they do give a realistic view of the country’s ability to meet both anticipated and unplanned external payment obligations. Reserve management is an essential part of our economic policies that has a good track record. Why scramble it?
Monetary and exchange rate management can derail if foreign exchange reserves are inflated and it takes no less than an institution like the IMF to know to what extent. How will policy makers ensure the availability of adequate reserves if reserve accounting is flawed? They cannot set their investment priorities without credible data on the level of available reserves.
The veracity of the data on foreign exchange reserves should be flawless not only as a virtue but as a necessity. BB plays an important role in shaping market expectations for exchange rates, interest rates and inflation. Macroeconomic stability becomes vulnerable if the credibility of the BB is called into question. Market reactions are directly linked to the way BB conducts its business. This includes an appropriate accounting of foreign exchange reserves as an essential prerequisite.