Central Bank reserve management

An unprecedented accumulation of foreign exchange reserves, especially made up of monetary authorities in EMC (Emerging Market Countries), has brought about some important issues. The second half of 1990 and the beginning of the 21st century crises in Mexico, Asia, Brazil, Russia, Turkey and Argentina caused liquidity problems. The rapid increase in reserves used as insurance to protect these countries against these financial crisis. Following these severe financial crises, many emerging market countries created foreign exchange reserves to deal more effectively with the potential risks of volatile exchange rates. However, the pragmatic bench marking approach that can be used for measuring the adequacy of reserves shows that in many EMC, especially in Asian countries, the level of foreign exchange reserves has reached a magnitude exceeding a reasonable required level of insurance. The reasons behind the accumulation of reserves which go beyond the need for protection against risks needs to be examined. In particular, the assertion that a number of countries make that they maintain exchange rates at a certain level in order to maintain the economic growth caused by exports. The accumulation of official reserves in large quantities can lead to increased currency diversity. The factors which determine the distribution of foreign exchange reserve assets into currencies are risk diversity, effective return, liquidity and asset diversity of financial markets in the foreign currency country where the reserve is held, geographical orientation of foreign trade and capital account transactions, external debt composition and possibly political concerns. Countries with very large reserves play an important role in using a significant portion of their foreign exchange reserves to finance the global foreign imbalances by investing their accumulated reserves to purchase the financial assets of the countries to which their reserves of currency belongs. Sustaining major global current imbalances and resulting massive reserve accumulation presented EMC with significant challenges. Monetary authority of these countries should take various actions to overcome these challenges. Looking at ten EMCs which have doubled their reserves since 1999, it will be seen that three different groups of channels have been created to accumulate reserves: (I) has current account surplus (Russia, Ukraine and Malaysia); (ii) has capital account surplus (Czech Republic, Mexico, Romania and South Africa); and (iii) have both current and capital account surpluses (China, India and South Korea). The division of rapid accumulators into groups is useful for structuring the discussion on the underlying causes of accumulation. It should not be forgotten that there is no direct causal relationship between large current accounts and reserve accumulation.