Mumbai: Official external reserves are only one part of sovereign creditworthiness, Standard & Poor's said in a report, Official Reserves: Flexibility Is More Important Than Size.

"The benefit of official foreign exchange reserves derives from the flexibility they afford policymakers," said John Chambers, chairman of Standard & Poor's sovereign rating committee. "This flexibility does not expand linearly with reserves, and at some point can even begin to decline as reserves increase," he added.

Eight central banks or their governments hold two-thirds of the world's official external reserves: Japan, China, Hong Kong, Taiwan, India, Korea, Singapore, and Russia. Only one of these eight sovereigns - Singapore - is rated 'AAA'; one - India - is even rated noninvestment grade. Although a strong external position is a credit strength for a sovereign, other factors such as economic structure, prudent economic policies, and deep and healthy financial systems are equally important. "Two main motivations appear at work in building these high reserves," Mr. Chambers explained. "For all of these countries, a high level of reserves appears to be an outcome of their foreign exchange regime. For some of these countries, it is also an insurance policy against sudden stops of capital flows," he said.

The article points out that there are diminishing returns to stockpiling official reserves, as well as ancillary costs. Official reserves are usually held by the central bank and are assets that need to be funded - either through monetary emission (which can be inflationary), open market operations (which often have a negative cost of carry), or government deposits at the central
bank or central bank capitalization (both of which take resources from taxpayers). By reducing pressure on the currency to appreciate, the sovereign also relieves pressure on exporting firms to seek productivity gains other than those achieved through a depreciated currency.

"One has to ask if the current trend of reserve accumulation is sustainable and, if not, what is next. At some point, external creditors will reach their limit of desired U.S. dollar holdings, the dollar's value will then fall, and the U.S. current account will narrow," Mr. Chambers noted.

"Unless other major economic blocks pick up the slack, the global adjustment will be painful. Countries that rely heavily upon net exports will be particularly hurt, although most nations will find themselves at a lower growth equilibrium," he concluded.