International Reserves and Bank Reserves in Dollarized Economies Mercedes Da Costa and V. Hugo Juan-Ramón 1 Washington, D.C., October, 2011 This note analyzes the connection between a central bank holding of gross international reserves (or reserve assets) and reserve deposits form statistic and economic perspectives. We describe alternative procedures that countries use for recording those concepts. International Reserves The stock of gross and net international reserves hold by central banks is a subset of its net external assets account. In paragraph 6.64, the BPM6 defines reserve assets (gross international reserves) as: “external assets that are readily available to and controlled by the monetary authorities for meeting balance of payments financing needs, for intervention in exchange rate markets to affect the currency exchange rate, and for other related purposes (such as maintaining confidence in the currency and the economy, and serving as a basis for foreign borrowing).” The composition of reserve assets and short-term, reserve-related liabilities are shown in the box 1 below, which is a simplified version of box 6.5 in the BPM6. Box 1: Component of Reserve Assets and Reserve-Related Liabilities Reserve assets (gross international reserves) Monetary gold Special drawing rights Reserve position at the IMF Other reserve assets Currency and deposits Claims on monetary authorities and other entities Securities Financial derivatives Reserve-related liabilities to nonresidents (short-term on a remaining maturity basis) Credit and loans from the IMF Debt securities Deposits Loans Other short-term foreign currency liabilities to nonresidents Source: Box 6.5 in BPM6, page 112. 1

We are grateful to Antonio Galicia (IMF Senior Economist) for valuable comments and clarifications.

Although the recording of official reserve assets in external sector statistics is on a gross basis, an alternative concept of Net International Reserves (NIR) could be derived from the difference between the central bank’s reserve assets (or gross international reserves) and its short-term, reserve-related liabilities to nonresidents. The BPM6 stresses two key criteria to classify an asset as reserve assets: control and availability for use. On control, paragraph 6.67 states “In general, only external claims actually owned by the monetary authorities can be classified as reserve assets;” and on the issue of availability for use, paragraph 6.69 asserts that “Reserve assets must be readily available in the most unconditional form.” Bank Reserves Bank reserves are liquid assets held by banks to meet the demand for withdrawals of deposits in domestic and foreign currency. Bank reserves comprise currency held by banks in their vaults and deposits held by banks at the central bank. We consider an economy with a semi-dollarized financial system; that is, a segment of the financial system’s deposits and loans are denominated and settled in a foreign currency, such as the U.S. dollar. Bank reserves have two components: legal or required and voluntary or excess. Legal bank reserves are mandated by the central bank; that is, the fraction of deposits in domestic and foreign currency that banks must put away as bank reserves. Voluntary bank reserves include a fraction of deposits that banks decide to put away in addition to the legal ones. Connection between International Reserves and Bank Reserves The connection between international reserves and bank reserves arises in semi-dollarized financial systems. As mentioned, deposits in dollars are subject to legal reserve requirement, which has to be deposited at the central bank. The recording of this operation in the central bank balance sheet brings out a relevant question: how those deposits should be classified on the liability and asset side of the ledger? The matrix below shows plausible combinations.

Table 1: Matrix of Plausible Recording of Bank Reserves in the Central Bank Balance Sheet Accounts Domestic Assets

Bank Reserves Monetary (domestic Base currency)

Bank Reserves (foreign currency)

Gross International Reserves

Other External Assets

Other External Liabilities

Off Balance Sheet

*

Monetary Base

*

*

Other Liabilities

*

*

Off Balance Sheet

Shortterm External Liabilities

*

The matrix shows options for recording bank reserves in the central bank balance sheet. For example, cell (1,1) (raw 1 and column 1) shows deposits in domestic currency held by banks at the central bank, which are classified as central bank’s liability (concretely, a component of the monetary base) with a corresponding entry in domestic assets (cash for example). Thus, domestic currency bank reserves have not connection with international reserves. For foreign currency bank reserves, the matrix shows five recording options: i) monetary base with a corresponding entry in gross international reserves, cell (2, 2), ii) )monetary base and other external assets, cell (2, 3), iii) other liabilities and gross international reserves, cell (3, 2), iv) other liabilities and other external assets, cell (3, 3) v) cell (4, 6) shows an off balance sheet recording option. For example, the central bank still mandates banks to put aside a fraction of their foreign currency deposits as legal bank reserve; however, it authorizes banks to deposit those reserves in financial institutions abroad. Thus, the central bank requirement is fulfilled, although it does not show up in its balance sheet. The shaded cells highlight the fact that bank reserves in foreign currency are central bank’s liabilities with resident banks; therefore, they are not external liabilities (liabilities with no residents).

Statistic Perspectives The double-entry basis of recording balance of payments and monetary statistics allows for choices in classifying some operations. In this respect, the IMF’s balance of payment and monetary manuals adopt a flexible approach by providing useful guidelines and criteria, rather than rigid instructions. Thus, countries have latitude to decide on concepts and recording procedures. For example, taking the manuals’ criteria at face value, the “correct” option for recording foreign currency bank reserves would be the one showed in cell (2, 3); that is, monetary base and other external assets. Foreign currency bank reserves should be a component of the monetary base as it supports the monetary aggregate which includes all types of deposits. Put it differently, changes in the legal or excess ratios of bank reserves to deposits affect the monetary aggregate (multiplier effect) for a given monetary base. The corresponding entry in other external assets would be justified because they are external assets in possession of the central bank; however, they should not be classified as gross international reserves (or reserve assets) if one thinks that those assets do not strictly pass the criteria of control (i.e., being actually owned by the central bank) and availability for use (i.e., being readily available in the most unconditional form to be used by the central bank). Most countries, however, have opted for classifying foreign currency bank reserves as gross international reserves on the asset side of the central bank balance sheet (option shown in cell (2, 2)). This practice has been accepted by the IMF on the premises that, except for bank runs, foreign currency deposits in banks are fairly stable, which makes the foreign currency bank reserves in possession of the central bank fairly stable too, thus firming up the central bank’s control and availability for use those assets. Other options include classifying the foreign currency bank reserves as other liabilities instead of as a component of the monetary base; with the corresponding entry in either gross international reserves, cell (3,2), or other external assets, cell (3,3). In these cases, some IMF country reports follow this presentation, with a memo line for a broader definition of monetary based. A novel practice that has been recently adopted by few countries is shown in cell (4, 6). Under this innovative system, the central bank “outsources” the responsibility of receiving and managing the foreign currency bank reserves. Banks still have to put aside (deposit in financial institutions abroad) a fraction of their foreign currency deposits to comply with central bank regulations. Economic Perspective The main objective of most criteria for recording economic operations is to facilitate economic analysis. It might be that information presented in standard tables is not enough for this purpose and the analyst would need complementary information. This is why IMF country reports’ tables show off table memo lines. Some examples on the role of complementary information for economic analysis are discussed next.

As mentioned, NIR could be defined as gross international reserve minus short-term external liabilities. Suppose a central bank opts for recording foreign currency bank reserves as gross international reserves with the corresponding liability entry either as monetary base or other liabilities, cells (2,2) and (3,2), respectively. Under these recording strategies, NIR would increase when i) the central bank increases its legal foreign currency bank reserves requirement, for a given level of deposits, ii) the financial dollarization deepens, reveal as a shift from domestic currency deposits to foreign currency deposits. In these circumstances, some analysts might consider the NIR as upwardly biased. May be, that is why some countries and IMF country reports show as a memo item line the concept of “free international reserves” obtained by subtracting foreign currency bank reserve from gross international reserves. Another example arises from the analyses of the money supply and its multiplier. The economic consideration is that in a semi-dollarized financial system with fractional reserve banking, both domestic and foreign currency deposits enter in any definition of broad monetary aggregate. These deposits, net of reserve requirements, are inputs for bank loans and, as it is well-known, banks actually create money when they grant loans through a multiplier effect of a succession of deposit and loans. This feature is captured in the well-known decomposition of the money supply between the monetary base and the money multiplier, as shown in equation 1:

(1)

M =

(C / TD ) + 1 MB (C / TD ) + α ( R / D) + (1 − α ) ( R * / D*)

Where M is a monetary aggregate defined as C + D +E D* , MB stands for monetary base defined as C+R+ER*, E is the nominal exchange rate defined as the price of a U.S. dollar in terms of domestic currency; C/TD is the non-bank public’s desired ratio of currency to total deposits, R/D is the ratio of domestic currency bank reserves (legal plus excess) to domestic currency deposits, R*/ED* is the ratio of foreign currency bank reserves (legal plus excess) to foreign currency deposits; and α is the share of domestic currency deposits to total deposits. The main point is that the framework given by equation 1 is relevant to study changes in the money supply under any of the recording strategies shown in Table 1. For example, if a central bank decided to follow a recording strategy of not including R* in its definition of monetary base, the economic process of money creation by the banks via multiplier would still hold. As another example, if instead a central bank decided to follow the strategy shown in cell (4, 6) (off-balance sheet), again the economic process of money creation by the banks via multiplier would still hold. In both examples, information on R* will be needed for analyzing the money supply. An Officially Dollarized Economy A country is considered to be officially dollarized when its authorities unilaterally adopts the currency of another country, the U.S. dollar in this case. This is the case of El Salvador, for example, where the U.S. dollar is the legal currency. The methodological issues discussed for a semi-dollarized financial system applies for a fully dollarized economy. All deposits and loans are now in foreign currency as well as the

bank reserves. The central bank faces the same options for registering those reserves, for example, it includes them in the monetary base with a corresponding entry in gross international reserves; and again, a memo item line with the concept of “free international reserve” might be appropriate. Currency held by the non-bank public, U.S. dollar bills and coins, is not part of the monetary base anymore as currency is not a central bank liability anymore. Besides, if the central bank opted for “outsourcing” the responsibility of receiving and managing bank reserves, there would be no monetary base from a statistic viewpoint. However, changes in the public’s desired ratio of currency to deposits would still affect the money supply via multiplier effect; similarly changes in either the legal reserve ratios or the banks’ desired excess reserves ratios, would affect the money supply via multiplier effect. Thus, regarding of the chosen recording strategy, the multiplier effects are the same as those in nondollarized economy. The analyst could use complementary information of an off-balance monetary base defined as MB* = C* + R*, and a broad money supply defined as M* = C* + D* to view the money supply as a multiplier times the monetary base, as shown in equation 2: (2)

M *=

(C * / D*) + 1 MB * (C * / D*) + ( R * / D*)

Of course, the monetary base is not under the control of the monetary authority, it can only change via balance of payments; however, changes in the key ratios of currency to deposit and bank reserve to deposit will affect the broad money supply.