Pre-WWI accumulating motives

Traditional explanations of the accumulation of foreign reserves have emphasised rising entanglements between politics and money management. Because the export of capital had significant implications for the management of sterling, the Bank of England played an increasingly important role in colonial finance from the 1890s onward. Through the agency of the Crown Agents and London brokers and its influence over colonial governments, the Bank sought to restrain capital exports when money was tight and, conversely, provided inducements to borrow when it was abundant. Ability to follow such early and unconventional open market interventions intended to increase the effectiveness of official discount rate changes was evidently a product of Empire - of the leverage which London political and monetary authorities had over overseas borrowers (Sayers 1936, Sunderland 2004).
The result was a close relation with Empire, which de Cecco's pioneering study served to highlight (de Cecco 1974). In de Cecco's account, this connection resulted from the happy coincidence of the need to manage the convertibility of sterling on a "thin film of gold" with the structural position of the less developed countries under British political influence. Members of Britain's formal and informal empires borrowed from London in sterling and warehoused the receipts there. This was convenient from the standpoint of transactions; their sterling could be drawn on to service debt and pay for imports. It was also rational from the standpoint of hedging exposures. In other words, sterling balances in London served as an effective hedge against sterling-denominated debts.  De Cecco gives a special place to India, emphasising "the basic importance of India as the main stabilising element." Through its London deposits, India (and other less advanced countries like Japan) permitted London to act as an intermediary in the short-term capital market.
a) Self-insurance: Another important motive for accumulating gold reserves is illustrated by the case of Russia, which was, along with Japan and India, one of the principal holders of foreign exchange in the pre-1914 period. Domestic opposition painted as an absurdity the maintenance by Russia of enormous short-term deposits in Paris at 2.0 per cent when the Bank of France's lending rate was 3.0 per cent and the Paris market was lending to Russia at 4.0 per cent. In response, Russian authorities emphasised the perils of political conditionalities to which the country would be subject if it had to borrow in an emergency. Self-insurance was therefore advisable. The argument thus anticipated on the modern interpretation that saw in the accumulation of Chinese reserves in the late 1990s a response to the Asian crisis (see Aizenman and Lee 2005).
In one of the rationalisations he provided for his government's extensive holding of foreign exchange reserves, the Czar's Finance Minister Sergei Witte clearly referred, in the language of his time, to the risks of "political conditionality" in situation of sudden stops:
"Generally, needs resulting from political events are unpredictable and when they occur, absolutely urgent. From [which] we can see that, if we did not have [foreign exchange] reserves, we would see ourselves, in such a circumstance, [having] either to sacrifice political interest or to borrow at any price. But then experience shows that states, like individuals, are often offered loans at attractive prices when they have not use for them, while by contrast, regardless of their solvency, they sometimes just can't find resources at an affordable price, when they need [them] urgently. In such situations, the lack of a pecuniary reserve might cause to the State a political prejudice."
Thus, when it comes to the insurance motive for holding foreign reserves (as an alternative to recourse to IMF or ESM assistance), there is little new under the sun.
b) Interest-rate smoothing: Studies of experiences of Belgium, the Austro-Hungarian Empire and France point to the utility of foreign exchange reserves as an instrument for smoothing interest rate fluctuations. Historical evidence is indicative of widespread concern over sharp changes in interest rates (Conant 1910, Patron 1910, White 1930, Einzig 1931, Kauch 1950, Bordo and McDonald 2012). As Reis (2003) describes, sudden increases in interest rates were unpopular and triggered protests because they were perceived as "depress[ing] business, reduc[ing] trade and production and provok[ing] urban unemployment and possibly unrest." A further complaint about sharp changes in interest rates, especially in the upward direction, was that they had an adverse impact on the price of government bonds.
Fortunately, the gold standard left some room for intervening in the foreign exchange market to smooth such fluctuations, taking advantage of minor frictions and the limited exchange rate flexibility that existed within "gold points." Because shipping gold between markets entailed costs, exchange rates were only fixed up to the cost of shipping gold. Pushing the exchange rate down toward the gold export point created the expectation that it would revert toward the middle of the band; this expectation of subsequent appreciation in turn led investors to accept lower interest rates (Keynes 1930, Eichengreen and Flandreau 1997). Interest rate effects of this sort seem to have been the main reason for the Bank of Belgium's policy of holding foreign reserves and intervening in the foreign exchange market. The impression that its intervention was successful (as manifested in the fact that the secured interest rate on Belgian francs was often lower than rates in other leading markets) encouraged emulation.
One emulator was France. Contamin (2003) shows that interest-rate- smoothing motives help to explain why the Bank of France began acquiring sterling assets in the Paris foreign exchange market from private banks around the turn of the century. Because sterling paper was the most liquid global instrument and was held by all internationally-active banks, liquidity shocks in the London money market that forced the Bank of England to raise its discount rate could put pressure on the Bank of France. To prevent this, the Bank of France conducted countercyclical interventions on the Paris money market, buying sterling when the banks were selling and vice versa (Flandreau and Gallice 2007).
The behaviour of the Austrian-Hungarian central bank was not dissimilar. Along with Japan, India and Russia, the Austro-Hungarian bank was one of the key holders of foreign exchange in this period. Einzig (1931), Flandreau and Komlos (2006) and Jobst (2009) describe its foreign exchange policy. The Austro-Hungarian bank was hailed by inter-war economists like Keynes (who had already been editor of the Economic Journal before World War I, in whose pages these issues had been discussed) as an exemplar of successful monetary management for the way it relied on the foreign exchange market and in particular on forward market intervention in order to avoid having to continually adjust its interest rate to foreign levels (von Mises 1909; Keynes 1930).
Jobst shows that this was done using a range of sophisticated foreign exchange instruments that included the forward market and foreign exchange repo contracts. When British interest rates increased, the Austro-Hungarian central bank let the florin depreciate against the pound while intervening to push it up in the forward market, thus compensating investors in florins for the lower interest rates and preventing further fluctuations. Jobst also finds that during most of the period, the Austro-Hungarian bank was the main participant in the market for foreign exchange.
c) Carry trades: A third motive for investing, or borrowing, in foreign exchange reserves may be described using the modern expression of carry trades a trading strategy that relies on perceived mispricing of interest rate differentials and exchange rates. In cases, foreign exchange reserves entered in both the asset and liability side of a central bank's balance sheet.
Jamaluddin Ahmed, PhD FCA  is the General Secretary of Bangladesh Economic Association and a member
 of Board of Directors of
Bangladesh Bank.
[email protected]