Holding International Reserves in an Era of High Capital Mobility

Last September, as calls grew louder for European Central Bank (ECB)intervention to reverse the euro’s fall, the lead of an Economist article asked, “If central banks are so reluctant to intervene in foreign-exchange mar-kets, why do they still hold so many reserves? ” The article went on to say that at the time, the ECB and the euro area’s national central banks together held about $226 billion of foreign-exchange reserves, not counting their sizable gold holdings.1 The question is being asked more often these days. The Economist sug-gested that the idea of having an abundance of reserves is partly a carryover from the Bretton Woods system, when central banks were obligated to defend their parities against the dollar through intervention and so needed a lot of reserves. Yet, as the Economist noted, Bretton Woods broke down thirty years ago, and today many fewer countries peg their exchange rates. Indeed the cur-rency and financial crises of the 1990s have led some observers to conclude that in a world of high capital mobility, fixed exchange rates such as the Euro-pean exchange-rate mechanism or the East Asian pegs before 1997–98 cannot work for long.2 As a result, more countries have shifted to floating exchange rates. With less need to hold reserves to defend currency values, one would expect global reserve holdings to decline. But just the opposite has occurred— world reserve holdings are at record levels. Figure 1 shows that global reserve holdings (excluding gold) were equiv-alent to seventeen weeks of imports at the end of 1999, almost double what