This article appeared originally in Gulf News: link to original article
A few might mistake the role of a central bank to purely oversee what investment and commercial banks are doing. Not so, and it never is limited to setting overnight rates or reserve ratios to partially ensure bank deposits against bank runs.
These and a few other processes work in harmony towards controlling the money supply or keeping inflation under control, which are two sides to a coin. The money supply works towards serving another role for the central bank, which is keeping inflation at an acceptable level. If achieved,
this serves one of its other roles, which is guarding the national currency’s value.
It’s the central bank that uses different monetary instruments to fulfil the role and set a basis for economic prosperity through carefully studied
strategies. These roles, however, cannot succeed on their own even though they do serve one another. And one that is essential in serving all of the above is the central bank’s role in acquiring and managing an appropriate portfolio of reserves that include foreign currencies, gold, bonds, commercial notes, and others.
This is probably one of the strongest bargaining points in all times. After the First World War, France threatened to exchange its huge reserves of sterling pounds for gold at England’s central bank. If this did not cause enough damage to the pound’s value, a consecutive run on the currency would have.
As a result, the country knowing what kind of damage it could cause the national currency, eventually acceded to the demands. Right now, there is
no such thing as claiming gold from a central bank. The myth says that you can, but you better not go for it.
What central banks do right now is entirely different from what may be the case. Business transactions carried out by different entities operating in a country bring in foreign currencies, which banks keep or exchange for the national currency, adding to foreign reserves with the central banks. When an outward series of business transactions takes place — foreign investments, purchases, hedging, etc — the currencies available in central banks’ reserves make all of it possible. I would like to call this the ‘Currency Reserve Standard’ as this is what backs different currencies. This is what can make central banks, and apparently countries, survive different sorts of hardships: revolutions, sanctions, etc.
Egypt, very recently, had currencies in its central bank’s reserve to cover no more than three months. On the other hand side, inflation was skyrocketing. Furthermore, the Egyptian pound was depreciating to a point that it scared off potential investors from approaching any investment
opportunities in Egypt. Hence, the very same reserves were not getting replenished.
Now allow me to explain. The protests that took place in Egypt were bringing the pound’s value down because of investors’ fears and the run on
the pound. Foreign reserves are used in such cases to stabilise a currency, but only for so long. As it went deeper into the mess of supporting its currency, Egypt spent no less than $20 billion (Dh73.4 billion) in addition to resorting to excessive overseas borrowing and deferred payments, according to Reuters.
The longer the protests or unease prevailed, the worse the situation. All stakeholders were affected based on their levels of exposure. The only ones winning were those participating in the black market that such circumstances create. To illustrate, the pound lost no less than 20 per cent against the dollar, allowing arbitrage opportunities for parties with significant holdings of the greenback. It allowed them to do profitable business with parties who were in need of dollars.
So, how do central banks protect a currency? How do they go about preventing a slide in value and the subsequent impact on the economy and of the national wealth? The $20 billion that Egypt spent to protect its currency led to repurchases of pounds from the market, decreasing its availability and pushing its value up.
But it is an unsustainable strategy based on the fact that reserves are not getting replaced. To support such a strategy, capital controls are imposed to prevent the flight of capital out of the country, especially in foreign currencies.
In Egypt, the central bank implemented a $100,000 cap on transfers out of the country while banks allowed no more than $10,000 in daily withdrawals.
You will probably remember here the capital controls that were imposed on funds in Cyprus and those India applied recently. The aid that Egypt received or would receive is in dollars, which would aid Egypt’s central bank into saving what is left of the pound’s worth. This would also help maintain a decent currency reserve to kick start growth and assure investors, consequently bringing in more currencies.
These, would, however, add to the central bank’s losses as it will borrow foreign currencies at higher than usual rates and liquidate its own assets.
My second example would be the Central Bank of Iran. Iran’s example is in fact unique. Sanctions imposed were aimed at limiting the central bank’s access to the foreign exchange markets, more specifically dollars.
Now the interesting part is that since July 2012, Iran has received no less than $6 billion worth of gold as payments for its energy exports. This was then exchanged for foreign currencies to add to the reserves. Another way to do this is by receiving payments in the form of different currencies, mainly countries that are still doing business with Iran and Iranian companies, and then using them to buy gold.
The end result is the same. The Central Bank’s reserves stood at $69.86 billion as of December 2012, according to the IMF. Also, the IMF estimated
that Iran held more than 300 tonnes of gold in 2007, up from 168.4 tonnes in 1996. As of 2012, it is believed that Iranians have 500-900 tonnes worth $21-$38 billion.
Even with further sanctions imposed in July, it will still take some time to estimate an approximate number of what are central bank’s actual holdings of gold and others. A random thought to consider here is the shock to gold markets if it decides to dump its holdings.
In a Financial Times article, Iran’s central bank was thought to have reserves of foreign currencies that can cover up to 10 months of imports. And
for the ignorant, this is considered a very healthy indicator for an emerging economy.
What is also surprising is that not only did the bank find ways to build on its reserves, the entire economy has transferred itself into a more diversified one by focusing on exports of other products or specialities: pistachio, carpets, and others. Collectively, diversification introduced additional methods of obtaining currencies in a country that enjoys good ties with a few neighbours.
Yes, inflation did skyrocket, but the economy found ways to keep growing. Non-oil exports grew by 20 per cent to partially cover the lost business in oil exports. In Iran, just like in Egypt, companies cannot send dollars out of the country that easily. Even though Egypt’s doing is that of despair, Iran has been more conservative in terms of capital flight, similar to countries like Sudan and Argentina.
Let me sum up. Above are two examples of countries and their central banks, with a microscopic focus on a key function to safeguard a nation’s
currency and its wealth. For that to be achieved, a central bank accumulates foreign currencies whenever possible and keeps inflation under control so as not to dilute a currency’s value.
The latter is by controlling money supply or the overnight rates. An example would be what China did by lifting its control over the minimum
interest rates charged by banks. This should increase spending and release pressure exerted on the yuan, letting the market determine its true
However, and with a market like China, the yuan’s value shouldn’t be heading upwards. Besides, China is adopting a strategy that establishes direct
exchange channels with countries like South Korea.
But if all countries establish direct channels like China has started doing, the term ‘floating’ would mean nothing.
In the post-First-World War era, countries used fixed exchange rates between each another and these were revised whenever deemed necessary
to forgive public debts or so. What was special and different then was what Germany did to restore faith in its mark by creating a new
one backed by lands. That is, you may exchange French francs and sterling pounds for gold, but you could also exchange German marks for land.
This, of course, did not prevail for too long. It was abandoned once the Mark’s value was restored. However, it did exist in history books as the weirdest example of a currency peg.
Now the last thought that I want to leave you with is this: why don’t central banks assess imports and build reserves based on these and the projected growth of such imports?