Smith and Nugee: The changing role of central bank foreign exchange reserves

From the Foreword by David Marsh:

This report by Gary Smith and John Nugée, two seasoned master craftsmen of reserve currency management, investigates the lessons learned from the accumulation of foreign currency reserves over the past 20 years. It is published at an intriguing time. After two decades of rises that the authors justly qualify as unintentional, unforeseen and unprecedented, official foreign assets around the world are starting to decline in many important countries, led by the biggest reserve owner, China.

This partly reflects a large shift of funds out of emerging market economies into the dollar in advance of the first rise in US interest rates for nine years. It is also the result of the sharp fall in the oil price which is one of the reasons for economic setbacks in countries like Russia, Venezuela and Malaysia, and has caused the governments even of the largest Gulf oil producers to dip into reserves to protect revenues. None of these recent developments counters the main assertion of the Smith-Nugée report, namely, that nearly all countries’ believe they need a far larger stock of reserves than earlier thought necessary as buffers against future turbulence.

Backing this contention, Smith and Nugée describe how some large economies with freely floating exchange rates, of which the UK is a foremost example, are making deliberate efforts to build reserves, both to bolster economic stability and also, in some cases, to add to the International Monetary Fund’s fire-power for international balance of payments assistance. The authors highlight an IMF report from April 2015 suggesting that developed countries as well as emerging market economies need to hold adequate reserves to guard against disorderly markets. Moreover, with the growth in the renminbi as a reserve currency, we have seen further significant moves towards the development of a multicurrency reserve system. This is likely to be still more volatile than the dollar- D-mark-sterling system that developed during the 1970s and 1980s and the dollar-euro system from the late 1990s – and thus provides yet another reason why reserves in future may continue to rise.

Smith and Nugée have chosen here to illuminate past trends as a way of exploring what may happen in the future. With the aid of reserve asset case studies among nations as diverse as China, Russia, the UK, Ireland and Iceland, the Smith-Nugée report provides new information on the wide and growing variety of uses to which reserves are put, and of the motivations for which they are held. The authors’ conclusion is that most countries will continue to practise the strategy of ‘self-insurance’ against turbulence, which will lead them to continue to acquire reserves – and find new ways of managing them. Once the world passes through the present phase of reserve weakness, the rebuilding seems likely to start anew.


Available for download here.