A 15% overstatement in counting official reserves is no trivial matter. The IMF findings in this regard are concerning. Forewarned is forearmed, says an old proverb.
Reserve asset portfolios have special characteristics that distinguish them from other foreign currency assets. There are internationally accepted accounting principles, detailed in the IMF Balance of Payments and International Investment Position Manual (BPM6), which provide specific guidelines for the compilation of reserve assets. The Bangladesh Bank (BB) follows BPM6 conventions in recording and reporting international transactions in goods, services, and assets.
Let's step back a little to the basics first.
What are official foreign exchange reserves?
These are external assets readily available to and controlled by the monetary authorities for meeting the balance of payments financing needs, intervention in foreign exchange markets, and for other related purposes, according to BPM6. Coverage of countries' data on international reserves varies because some countries do not fully disclose their international reserves. Some define reserve assets differently for operational purposes. However, good practice requires consistency over time and full disclosure in accordance with the accepted conventions.
In the Bangladesh context, this means consistency with BPM6 conventions. Accounting for reserves should include easily marketable foreign currency assets available to and controlled by the BB and held in the form of convertible (internationally tradable) and liquid foreign currency claims on nonresidents that are freely useable for settlements of international transactions.
The specific issues flagged by the IMF on the treatment of several uses of reserves point to significant departures from these principles. Instead of being defensive, BB should take serious cognizance of the recommended corrections to prevent damage to the credibility of such a key indicator. Investors look at reserves to assess a country's ability to manage external risks. Inflating reserves creates an exaggerated sense of comfort among the macroeconomic policy makers, not to speak of misleading markets at one's own peril.
What exactly went wrong?
The BB appears to be including assets that are not easily convertible into reserve currencies as and when needed. BB financing for infrastructure, loans to resident banks collateralized in local currency, foreign currency deposits with state-owned banks, investments in non-investment grade bonds and lending to Sri Lanka do not pass the convertibility, liquidity, and safety tests for counting them as forex reserve assets.
These assets owned by BB are not at their effective disposal and hence not available for use should the necessity arise. Putting reserves into illiquid and risky uses and yet counting them as part of official forex reserves is akin to having your cake and eating it too.
In BPM6, claims denominated in foreign exchange in resident banks are excluded from reserves assets because they are not freely usable for settlements of international transactions. The potential for transferring assets to or from the resident banks is too indirect. The bulk (86%) of the $7.2 billion reserve overstatement is foreign currency loans to local banks.
Similarly, claims redeemable in nonconvertible foreign currencies cannot be reserve assets. These include lines of credit that could be drawn on and foreign exchange resources that could be obtained under swap agreements (such as loans to Sri Lanka). These assets are neither immediately redeemable nor collateralized in the same currency of the loan.
By necessity, reserve asset accounting must be highly conservative, prioritizing liquidity and safety. It should encompass only those assets over which BB can exercise direct and effective control. The test of such control must be applied strictly.
Gaming forex reserve accounting never helps
Assessing reserves is essential to evaluating a country's overall external position. Too little reserves put a country's economy and finances at risk. Too many reserves imply that a country is relying excessively on the rest of the world's demand, rather than its own demand. There is no scientific answer on how little is too little and how much is too much.
There are several rules of thumb. Countries should, at a minimum, have enough to pay for 3 to 6 months of imports of goods and services. That buffers shortages of essential consumption, raw materials, intermediate inputs, and capital goods. It should have enough to cover the country's debt payments and current account deficits for 12 months or more. Reserves should be sufficient to meet over 100% of short-term debt (based on original maturity). Last but not the least, there is the 20% or more of the reserve to broad money metric which measures the potential demand for foreign assets from domestic sources.
Based on data in July-August this fiscal year, $39 billion is equivalent to 6.2 months of imports of goods and services and 54 months of current account deficit and debt amortization payments. Short-term external debt is slightly over 30% of reserves. Reserve to broad money ratio is about 21%.
Going by conventional ratios, the $39 billion reserves are indeed adequate. It is, therefore, hard to understand indulgence in "creative" accounting to show a bloated reserve position. Even when reserves are inadequate, fudging accounts will not help survive the market test. It may in fact make it worse.
Reserve adequacy not guaranteed
Countries hold reserves as a buffer to absorb or self-insure against the balance of payment shocks, including sudden stops in international capital flows; provide foreign currency liquidity to banks in stressed situations, and mitigate volatility in foreign exchange markets. Bangladesh has been experiencing bits of all of these in recent months.
International commodity price increases have led to a surge in merchandise import bills, remittances through formal channels have decelerated, external current account deficit has widened, and foreign portfolio investments have remained persistently negative since July 2020.
The path and outlook for reserves are influenced by many factors, but the phase of rapid reserve growth may be over. BB needs to reassess the balance of different objectives of reserve management. Recent developments highlight the importance of exchange rate management, maintaining external liquidity and market confidence, and keeping an emergency reserve. These should inform the ordering of reserve management priority: safety, liquidity, and return.
In an uncertain world, 'adequate' reserves are reserves considered sufficient to meet the worst-case scenario requirement in a balance of payments distress. Central banks focus on return when reserves are higher than this level, that is when they have "excess" reserves. While different central banks have different risk tolerance, the excess portion can be managed on a risk-return basis, rather than just complying with safety and liquidity requirements. However, once they are committed to high return-high risk-low liquid uses, they can no longer be counted as reserve assets.
Play within your limits
Central banks globally have moved towards greater diversity of asset classes and a broader use of risk assets in recent years, with roughly 15% in unconventional reserve instruments. Central banks are now significant capital markets participants. They hold about a third of all supranational debt and nearly a fifth of high-grade sovereign debt, according to the Official Monetary and Financial Institutions Forum (2020).
The broader use of risk assets has not been at the expense of liquidity and safety objectives. High-grade sovereign bonds issued in reserve currencies, gold and deposits with central banks still constitute almost 80% of the global reserve portfolio.
Most central banks want to boost returns without compromising safety. The best way to do that is to diversify their portfolios if they have the capacity to manage.
BB is not there yet. Bangladesh has limited and not fully certain access to international financial markets. Liquidity, therefore, gets priority. The need for the management and control of risks to ensure that asset values are protected comes next. Market and credit risks that come with broader use of risk assets can lead to sudden losses and impair liquidity. BB has limited expertise and constrained IT capacity to play in such asset class markets.
Prudent reserve accounting is a sine qua non
Prudence in accounting practice goes beyond the common sense of being fiscally conservative. Among others, it is the practice of ensuring that forex reserves are not overstated. Appropriately disclosed foreign currency reserves play a stabilizing role by discouraging one-way bets during episodes of financial stress.
Such disclosures may not curry favour with the Pollyannaish stakeholders, but it provides a realistic view of the country's ability to meet both anticipated and unanticipated external payment obligations. Reserve management is one critical part of our economic policies that has a good track record. Why muddy it?
Monetary and exchange rate management can go off track if forex reserves are inflated and it takes no less than an institution like IMF to know to what extent. How will the policy makers ensure the availability of adequate reserves if the reserve accounting is distorted? They cannot set their investment priorities without credible data on the available level of reserves.
The veracity of data on forex reserves should be beyond reproach not just as a virtue but as a necessity. BB plays an important role in shaping market expectations on matters of exchange rate, interest rate, and inflation. Macroeconomic stability becomes vulnerable if the credibility of the BB is in question. Market reactions are directly related to how the BB conducts business. That includes proper accounting for forex reserves as an essential prerequisite.