Today I will finally bring to a close this chapter on the foreign currency fiasco. Of course, if need be, I will return to it at some point. But before I begin today’s discussion, I wish to make one other important point that space would have precluded me from doing last week. Some analysts might argue against instituting capital controls in support of a free market regime.
One of the important lessons learned from the most recent global financial crisis is that some level of regulation is necessary to ensure financial stability. It would be appalling to allow a financial system to collapse, for such an outcome would be phenomenally catastrophic. In this respect, my contention of imposing capital control on the level of foreign investments by commercial banks constitutes only one facet of capital control, and hence this concept can be deemed meritorious and thus worthy of some degree of attention. Thus it is my view that commercial banks should not be allowed to engage in foreign investments, as this distorts the local foreign currency market. They should be allowed only to have foreign assets to fund their customers’ foreign currency transactions.
Further, if one were to advance this debate in a microscopic manner, one would find that out of six commercial banks, only two engage in large foreign investments with foreign currencies they would have acquired with resources originating in the local economy. This also means that public sector funds deposited with the commercial banks are misused – meaning that funds are used to purchase foreign assets which are then invested in foreign markets to capitalise on large profits at the cost of depriving the local private sector from accommodating foreign trade transactions. This practice, in turn, hurts the local economy.
The other four commercial banks have very small amounts of investments abroad, and they also engage in more prudent and sensible lending in the local market, as well as investment instruments right here in the domestic market.
What is reserve management, and why is it important?
Reserve management is the process that ensures official public sector foreign assets are adequately and readily available to, and are controlled by, the authorities for meeting a defined range of objectives (IMF, 2013). Foreign exchange reserve objectives include (cited from IMF Position Paper, 2013):
* Support and maintain confidence in the policies of monetary and exchange rate management, including the capacity to intervene and support the national currency.
* Limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis, or when access to borrowing is curtailed; and in so doing:
* Provide markets with a level of confidence that a country can meet its current and future external obligations;
* Demonstrate the backing of domestic currency by external assets; assist the government in meeting its foreign exchange needs and external debt obligations; and
* Maintain a reserve for national disasters or emergencies.
Underpinning the importance of employing sound reserve management practices is the fact that it increases a country’s overall resilience to shocks. Experiences (with other countries) have highlighted that risky or weak reserve management practices could restrict authorities from responding effectively to a financial crisis, which may accentuate the severity of the crisis. Moreover it can also have significant financial and reputational costs.
Sound reserve management policies and practices support, but do not substitute for, sound macroeconomic management.
Moreover, inappropriate policies (fiscal, monetary, exchange rate, and financial) can pose serious risks to the ability to manage reserves. Thus, appropriate portfolio management policies concerning the currency composition, degree of credit risk exposure, choice of investment instruments, and acceptable duration of the reserves portfolio should reflect a country’s specific policy settings and circumstances, and ensure that assets are safeguarded, readily available, and support market confidence.
The IMF working paper (2015) on capital controls and macroprudential regulations sought to address the optimality of imposing capital controls, or should policy makers rely on domestic macroprudential regulation? This was developed against the background of international capital flows, which could create financial instability in emerging economies on account of pecuniary externalities linked with exchange rate movements. The paper presented a tractable model, supporting the notion that it is desirable to employ both types of instruments. Capital controls increase the aggregate net worth of the economy and simultaneously stimulate savings. On the other hand, macroprudential controls reduce borrowing. It was found that the higher both policy measures are set, the greater becomes an economy’s debt burden and the higher becomes its domestic inequality. The role of capital control subsides in countries where the risk of sharp exchange rate depreciations are more limited; however, macroprudential regulations remain essential to mitigating booms and busts in asset prices.
