Reserve management: The rise of official reserves

For many years, Belgium was praised by economists but without followers. When Japanese policy makers decided to pattern the statutes of the Bank of Japan  (BOJ) after the "ideal" case of the Bank of Belgium, they conspicuously avoided authorising the inclusion of foreign exchange within the official reserve, even when doing so was recommended in Count Matsukata's expert report in 1882 (Schiltz 2006). However, toward the end of the 19th century, and despite the continued ban from the banknote "reserve," foreign exchange nonetheless managed to infiltrate the portfolios of central banks.
As described by Lindert (1969), the years leading up to World War I saw a remarkable expansion of the practice of holding foreign exchange reserves. By 1910, the ratio of foreign exchange to gold reserves held by official institutions reached roughly 1:4. In the overwhelming majority of cases, this occurred not by including foreign exchange in statutory reserves but through the accumulation of a separate portfolio.
The dispersion of individual foreign exchange holdings was enormous. On the one hand, some countries such as Britain still did not hold foreign exchange. At the other extreme was the Bank of Japan, where, now emulating rather than shunning the Belgian example, the ratio of foreign exchange to gold reserves reached 1:1, a remarkable evolution given that those reserves were not part of the statutory gold reserve and had thus been accumulated despite the absence of any legal requirement or institutional incentive.
The accumulation of foreign exchange reserves centred on the handful of currencies that Lindert described as "key currencies," in descending order of importance: the British pound, the French franc and the German mark, all of which had exhibited stability in terms of gold (suggesting that the explicit rules that the Bank of Belgium had formulated were implicitly adhered to in other places). These currencies had special status in the international monetary system in that they were traded in the largest number of foreign exchange markets and were most liquid as a result. Analysis of interest rate differentials supports the view (often expressed by contemporaries) that the use of these currencies by institutional investors (public and private) in turn fed back on the liquidity of these currencies in a virtuous circle fashion (Flandreau and Jobst 2005, 2009).
THE POLITICS OF KEY CURRENCIES: The rise of key currencies as investment vehicles for central banks was supported by a combination of market forces, institutions and, not least, politics. Global trade expanded rapidly in the 1840s and 1850s. Traders made arrangements with correspondent bankers in leading centers where drawing facilities (which provided the ability to source trade credit and deposit receipts) were cheap and reliable. Correspondents securitised the resulting credits as "acceptances" and assisted with their placement and distribution. Money market funds were established and expanded to invest in these instruments, giving rise to a large shadow banking system. London and Paris were the leading centres for this process.
The 1866 crisis triggered by the failure of an important constituent of this shadow banking sector, Overend & Gurney, resulted in a liquidity crisis in London. The crisis was resolved by the Bank of England, which temporarily suspended the convertibility of notes into gold and distributed cash to all who could post adequate collateral. Because the subsequent resumption of convertibility was widely anticipated, this action addressed immediate liquidity needs without endangering the exchange rate. The episode heralded the subsequent rise of international currencies subject to complex commitments, rules and options (Bordo and Kydland 1995, Flandreau and Ugolini 2013).
An important document highlighting the political dimension of these arrangements is the circular that the British Foreign Secretary addressed to all diplomatic representatives a few days after the eruption of the crisis, asking British agents abroad to convey the message that British authorities were prepared to do whatever it took (to paraphrase Mario Draghi) to support the money market. The circular provided an account of the episode as a liquidity crisis and emphasised that the market was fundamentally sound. When making reference to the generous lending policy of the Bank of England, it emphasised that the policy of the Bank was fully endorsed by Her Majesty's Government, which was determined to act and would secure parliamentary support if need be. This was a powerful message. It signalled in unambiguous terms that when the soundness and continuity of operation of the London market was at stake, the British authorities would not be constrained by red tape or other formalities.
A second factor supporting the rise of key currencies in this period was the growth of overseas lending. The final decades of the 19th century saw an enormous increase in bond flotations on behalf of foreign and colonial borrowers in London, Paris and Berlin. Bonds floated in these centers on behalf of overseas borrowers were predominantly denominated in the currency of the lending country (Flandreau and Sussman 2005). This was a matter of convenience and tradition; it appealed to the domestic clientele of retail investors. When governments and private parties borrowed in, say, London, they incurred a sterling denominated liability. It thus made sense for their agent, the central bank, to hold sterling-denominated assets as insurance. These could then be lent to the principals in the event of liquidity problems affecting their ability to meet their debt service obligations. In the same way that the growth of foreign trade and foreign exchange reserve holdings went together, the growth of foreign lending and the holding of exchange reserves complemented one another.
Again, political factors lay behind the connection. While the British government generally took a hands-off policy toward overseas lending, the French and German governments actively promoted such lending as a means of strengthening diplomatic alliances. They were happy to see domestic capital flow to potential allies and for those allies, through their central banks, to in turn hold balances in foreign exchange in the respective financial centres.
Though sterling had few serious rivals, one significant rival was the French franc, as we saw in the case of Belgium; the same was true of a number of members of the Latin Union (Switzerland for example). In the years following the Overend & Gurney crisis, Paris as a financial centre was growing on the back of France's expanding trade and foreign capital exports, low interest rates and abundant gold reserves (Cameron 1960), the last of which enabled the Bank of France to set a narrower gold bid-ask spread than the Bank of England (Flandreau 2004). It almost seemed as if France and the franc were poised to threaten the dominance of sterling.
Thus, the international monetary and financial system might have developed in a different direction in the absence of the Franco-Prussian War of 1870-1 and the Paris Siege, which disrupted payments and led to a moratorium on the payment of French bills, dealing a blow to Paris' international financial aspirations. Another blow was the extended period of inconvertibility resulting from Germany's adoption of the gold standard and disposal of the silver standard (formally until 1876 but informally until 1873). In response, the Bank of France set out to stabilize the gold price of the franc. As Bagehot remarked:
"The note of the Bank of France has not indeed been depreciated enough to disorder ordinary transactions. But any depreciation, however small - even the liability to depreciation without its reality - is enough to disorder exchange transactions. They are calculated to such an extremity of fineness that the change of a decimal may be fatal, and may turn a profit into a loss. Accordingly London has become the sole great settling-house of exchange transactions in Europe, instead of being formerly one of two. And this pre-eminence London will probably maintain, for it is a natural pre-eminence. The number of mercantile bills drawn upon London incalculably surpasses those drawn on any other European city; London is the place which receives more than any other place, and pays more than any other place, and therefore it is the natural clearing-house."
Thus, those who held sterling bills payable in London knew that, in times of crisis, such bills would always be cashable at (that their liquidity would be guaranteed by) the Bank of England. They understood from their behaviour during the Overend & Gurney crisis that officials would strive to ensure that banknotes remained convertible into gold. Sterling was liquid and secure. The readiness with which a sterling bill could be cashed made it as good as gold. Indeed, the interest it threw off made it superior. In a famous passage in Lombard Street (1873), Bagehot described this mechanism as forming the heart of the ascent of sterling as the world currency:
"The whole liability for such international payments in cash is thrown on the Bank of England. No doubt foreigners cannot take from us our own money; they must send here value in some shape or other for all they take away. But they need not send cash; they may send good bills and discount them in Lombard Street and take away any part of the produce, or all the produce, in bullion. It is only putting the same point in other words to say that all exchange operations are centering more and more in London."
It is important to remember that Bagehot was not just a journalist but also a propagandist for the Liberal Party. He was involved in the political battle aimed at pushing the Bank of England to adopt a more aggressive role in dealing with crises. His claim that London was destined to dominate deliberately neglected the fact that any currency backed by a strong commitment to ensure its stability and liquidity could become eligible as "key currency." Thus, Bagehot did not anticipate or at least did not wish to acknowledge that by opening the door to the possibility of substituting for gold another asset with a higher return, sterling might eventually have to contend with competition from not just the French franc but also with the German mark, both of which were found in substantial amounts in the portfolios of official institutions on the eve of World War I. According to Lindert (1969), "while greater balances were held in London than in any other international financial centre, a larger share was held in France and Germany than has been generally realised. The frequent portrayal of London as the major reserve centre before WWI exaggerates somewhat."
Jamaluddin Ahmed, PhD FCA is the General Secretary of Bangladesh Economic Association and a
member of Board of Directors of Bangladesh Bank.
[email protected]