Reserve management: A historical perspective

Borio, Claudio, Gabriele Galati and Alexandra Heath (2008) in an insightful survey of the Bank for International Settlements several years ago reflected on trends in foreign reserve management. They noted an alignment of central banks' portfolio management strategies and standards with those of the private asset management industry. Central banks, they concluded, were increasingly concerned with profitability along with other traditional balance-sheet motives. They used many of the same standards and strategies as private fund managers in their efforts to pursue it. At the same time that reserve managers sought to balance returns with liquidity and safety, the authors went on, they also exhibited greater transparency and organisational transformations aimed at strengthening internal decision-making.
Borio et al. noted further that while these trends were visible for their population of central banks, there was also significant cross-sectional variation in central bank practice. This subsection is to provide a historical perspective on central bank foreign exchange management, spanning the 150 plus years since the middle of the 19th century. Compared to today, the issues then surrounding the holding of foreign assets by banks of issue, as central banks were known, were so simple and looked like almost rudimentary. Until the late 19th century, foreign exchange reserves were a minor component of central bank balance sheets. National banks of issue, the majority of which were privately-owned, government-chartered companies, did in fact hold international reserve assets but principally in the form of bullion housed domestically or abroad. The so-called "reserve" was a guarantee of the circulation of banknotes and was made up of gold or silver bullion. This was a zero interest yielding asset, essentially dead weight for the profit and loss account.  Information on the reserve was deemed of great importance, although not all central banks were forthcoming about their holdings. Similarly, it was thought to be necessary and desirable to impose regulatory requirements on what could be held as reserves, and where they could be held.
The historical image, if we contrast it with modern practice as portrayed by Borio et al., is not of revenue-seeking asset managers engaging with international capital markets as part of their search for revenue, but rather of institutions connected to the external sector and to other central banks solely through fluctuations in their bullion reserve and the rules of convertibility. Central banks already possessed some policy room for maneuver even when reserves were held wholly or principally in specie and strict gold standard rules tied the note circulation to the bullion reserve (Eichengreen and Flandreau 1997 is the distillation of this literature).
There was an evolution in the reserve management practices from the late 19th century away from holding the reserve entirely in bullion toward holding also foreign exchange reserves and using them to actively intervene in foreign exchange markets. The forms and patterns through which central banks were connected to the global economy were profoundly transformed over this longue durée.
Barry Eichengreen and Marc Flandreau June (2014) described the story of this transformation. While several previous studies have sketched the quantitative dimensions, much remains to be done in terms of tying the successive periods to one another and illuminating longer term economic and institutional developments. The study explained by developing three themes:
n The first theme traces the evolution of the principal reserve assets: the dominance of sterling before 1914, the rise of the dollar as a competing reserve currency in the 1920s, the retreat of sterling and then the dollar in the 1930s, and finally the persistence of sterling as a reserve asset followed by the dominance of the dollar after World War II.
n The second theme emphasised on the rise of active reserve and portfolio management. The evolution we trace singles out the decades leading up to World War I as a first key period when a growing number of central banks accumulated foreign exchange reserves and began using them, via intervention in the foreign exchange market, in pursuit of a range of objectives. The central banks of Belgium, Austria-Hungary, Portugal, Spain and France emerge as key players in this period.
n The third theme was the influence of politics. This link is evident before World War I in the dominance of sterling in the foreign exchange holdings of Britain's formal and informal empires (Mclean 1976). It is evident in the 1920s, when the Bank of England under Montagu Norman and Federal Reserve System under the leadership of Benjamin Strong competed in creating spheres of influence for sterling and the dollar (Chandler 1958). It is evident in the 1960s, when liquidation of dollars by the Bank of France reflected the aspirations of the French Republic to reassert its geopolitical influence in the face of American dominance, as well as familiar doubts about whether the dollar would hold its value. The question raised by this final theme is whether and how geopolitical considerations might now affect the reserve holding behaviour of central banks going forward.
EARLY HISTORY OF CENTRAL BANK RESERVE: The starting point for our narrative is the mid-19th century, when "reserves" (or, more precisely, the "reserve") meant coins and bars made of precious metals.
a) Reserves equal bullion: The practice of holding reserves grew naturally out of central banks' role as banks of issue. In more economically advanced countries, early modern monetary systems rested on legal tender laws that recognised coins made of gold and/or silver bullion as instruments for settling debts. To the extent that a bank of issue was allowed to issue notes without legal tender status, such notes were claims on specie. A critical element, therefore, was ensuring their quality by guaranteeing their convertibility. Convertibility meant that notes could be redeemed at the central bank's window and were thus "as good as gold (bullion)." For this to work, the central bank had to make good on that commitment. This is the standard explanation for how it was that early central banks held reserves in the form of gold and silver coins and bars. Rules determining the requisite quantity of reserves differed across countries. In Britain and other countries following its example, a fixed amount of free issue was authorised, beyond which every banknote had to be fully backed by reserves (these were countries with so-called fiduciary systems). Alongside there also existed systems where a maximum ratio of circulation to reserves was specified (so-called proportional systems). There could be further constraints. For example, the 1874 Spanish Law under which the Bank of Spain secured a monopoly of note issue stated that notes could not exceed four times bullion reserves and five times paid-in capital. Martín-Aceña, Martínez-Ruiz and Nogues-Marco (2011) show that in practice the binding constraint was the latter and not the former.
As a result, the asset side of the balance sheet of a typical national bank showed the "reserve" (essentially bullion), a "portfolio" of short-term bills that mostly included domestic instruments, and finally other investments, including domestic government debt, mortgage debts and so forth. The liability side showed capital, deposits, retained earnings, profits, and the value of outstanding banknotes. Contemporary analysis (e.g. Juglar 1862) suggested that this should be compared to the reserve to gauge the strength or willingness of the central bank to deliver on its commitments.
An implication of holding reserves entirely in bullion was that central banks, even when they transacted with one another or intervened on the foreign exchange market, transacted almost entirely in specie. Examples of this were instances of central bank swap lines (or central bank cooperation) in which one central bank lent reserves to another one (Eichengreen 1992, Flandreau 1997, 2004). These operations were conducted through the intermediary of a merchant bank, which would supply the foreign exchange counterpart. Central banks exchanged bullion against bills in domestic currency. Merchant banks stood between the principals and undertook the exchange of, say, francs for sterling.
b) The mystery of bullion: Convertibility and hence the reserve were so important because reliance on bullion was a technology for delegating authority to the central bank while still maintaining control of its actions. There was no consensus on alternative metrics, beyond the reserve, for measuring central bank performance. Specifically, there was no consensus on measuring prices: in the early 19th century, for instance, it was felt that commodity prices were too volatile for "index numbers" of such prices to constitute a proper target for monetary policy. Ricardo's attacks on the Bank of England during the inconvertible paper currency period that coincided with the French Wars illustrate the enormous concern that early political economists and policy makers felt about the prospect of a central bank running monetary policy in the absence of proper rules.
Thus, the central bank's mandate was to target the value of the domestic currency in terms of an asset (gold or silver) whose price was readily observable and free of manipulation. The convertibility rule was a monetary policy target (preserving the external value of the currency) similar, in essence if not in methods and objectives, to modern inflation targeting. In practice the target was met by having the central bank standing ready to buy or sell bullion against notes at prescribed prices. That this target produced stable exchange rates when two or more central banks adopted it was incidental, just as the tendency for two countries to both pursue explicit inflation-targeting regimes to enjoy relatively stable exchange rates vis-à-vis one another (Eichengreen and Taylor 2004) is incidental.
This interpretation is consistent with the famous British monetary policy debates of the first half of the 19th century, with counterparts in other countries, which can be interpreted as disputes about the optimal contract for central bankers (see Fetter 1978). One view, associated with the Currency School, was that monetary and banking systems would be most resilient in the long run if money creation was tied to specie reserves. Members of this school essentially sought to transform the central bank into a currency board and supported the introduction of quantitative targets.
Because this was opposed by members of the Banking School, who favoured a more flexible monetary policy attuned to the liquidity needs of the banking and financial system, a compromise, Peel's Act, was reached in 1844. This created in the Bank of England an Issue Department separate from a Banking Department, with the former in charge of issuing notes in amounts matching the bullion reserve, after allowing for an unbacked fiduciary issue of £14 million, while the latter was responsible for discounting bills, i.e. providing short-term secured loans to bankers, to the shadow banking system (leveraged bill brokers like Alexanders and Gurneys), and select commercial customers (Sayers 1932).
All this renders somewhat puzzling why central banks were still reluctant to hold - and sometimes prevented from holding -- foreign exchange reserves. This is puzzling insofar as foreign exchange markets were far from primitive. The practice of holding foreign exchange bills and trading them in distant foreign exchange markets had been routine in banking circles since the Commercial Revolution of the 15th and 16th centuries. Every financial centre of consequence had an active market for bills denominated in foreign currency. It was not unusual for private banks to accept payment in foreign exchange. Foreign exchange yielded positive interest when the nominal return on bullion was zero. Since the overwhelming majority of early central banks were privately owned, one would expect the profit motive to have prevailed.
One explanation for why foreign exchange could not be counted as part of the statutory reserve is that central banks faced stiff resistance from a banking system fearing competition. Central banks were tolerated as necessary sources of market liquidity, especially during crises, but they were not welcome competitors. The example of the Second Bank of the United States, which faced fierce opposition from banking circles and, not incidentally, engaged in the practice of selling foreign exchange to customers, illustrates the point (Bordo et al. 2007). It may be that central banks were prevented from including foreign exchange in their portfolios precisely because dominance of this market was a valued prerogative of other banks.
Another explanation is that holding foreign-currency-denominated claims required acquiring information about foreign correspondents, foreign signatures, etc., something that was not the comparative advantage of central banks. Rothschild and Morgan, in contrast, could rely on family links and personal connections abroad. That the problem was one of expertise explains why, as indicated above, central banks turned to leading private banks (that self-same Rothschild and Morgan) to assist them in market interventions as soon as they went beyond the comparatively simple task of managing a bullion reserve and ascertaining the quality of the financial instruments they discounted and took as collateral.
A third answer is that law- and policy-makers hesitated to give central banks discretion over risk taking, given their responsibility for the convertibility of the currency.
As we explain later, problems associated with investments in foreign exchange would indeed develop in the interwar years, when they resulted in major losses to central banks, in some sense vindicating earlier concerns. Contemporaries did not want central banks taking excessive risk that might jeopardise the value of the currency of which they were custodians. Profitability was therefore sacrificed in the interest of transparency, security and predictability.
c) The Belgian exception: An early exception to these practices was the National Bank of Belgium (Conant 1910, Ugolini 2011, 2012). Founded in the aftermath of the 1847-1848 crisis with the goal of stabilising the Belgian franc, the National Bank engaged virtually from the start in the practice of holding foreign exchange reserves. For accounting purposes, the Belgian central bank's foreign exchange reserves were kept separate from its specie reserve and reported along with domestic bills. When its charter was renewed in 1872, however, the statute was modified, allowing the Bank to hold foreign exchange as part of its official reserve.
The creation of the National Bank exhibited the interplay of competing interests and a general reluctance on the part of powerful discount banks to allow the new bank compete in the markets. Ugolini (2012) describes the "gentleman's agreement" between the government and the Bank, which had the Bank accepting, beyond its obligation to convertibility, a second, informal mandate of keeping market interest rates at low levels. Belgium had two very active foreign exchange markets, Brussels and Antwerp, that acted as hubs in the European money market. Interest rates there were sensitive to changes abroad because of pervasive arbitrage business (resembling the modern carry trade), in which investors shifted from low-return to high-return ones (De Cecco 1990, Flandreau 1995). If one wanted to prevent the depreciation and increase in yields on Belgian francs that inexorably followed increases in yields abroad, the central bank had to sell foreign exchange and buy francs. But for this to happen, the central bank had to accumulate foreign exchange in the first place. Hence, the modification in its statute.
Ugolini describes the National Bank's reserve portfolio in 1851-53 as dominated by French francs, British pounds, Dutch guilders, and three German currencies (the Hamburg mark banco, Frankfurt guilder and Prussian thaler). While the identity of these currencies is not unexpected, the proportions in which they were held is striking. By far the most important foreign asset was the French franc (which made sense insofar as Belgium and France shared the same specie standard). French francs were the foundation of the National Bank of Belgium's foreign exchange portfolio and were held throughout. The proportions in which other currencies were held were adjusted in response to changes in yields. Interestingly, the pound sterling was only a minor reserve asset and wholly absent from the Bank's portfolio for much of the period.
The National Bank also set limits on the types of currencies that could be held. From the mid-19th century it committed not to hold inconvertible currencies in its investment portfolio (although such currencies could be posted as collateral with the Bank - see Ugolini 2011, p. 9). When in 1872 the Bank was permitted to include foreign exchange in the reserve, its charter still explicitly excluded inconvertible currencies, referring to "valeurs commerciales sur l'étranger, payables en numéraire" ("foreign trade bills, payable in specie"). This illustrates how contemporaries saw guaranteeing the value of the currency in terms of bullion and the holding of inconvertible currencies in the reserve as incompatible with one another. [The third article of the series will appear on Saturday, August 27.]
Jamaluddin Ahmed, PhD FCA is the General Secretary of Bangladesh Economic Association and a member of Board of Directors of Bangladesh Bank.
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