November 24, 2005

The Secret Life of Foreign Reserve Dollars

From the comments forum:

Is it really correct to say they haven't saved? They have $30 billion in foriegn reserves. A few years ago it was only $12 billoin.
Marc | 11.24.05 - 1:17 pm | #


This is a common misconception. But foreign reserves are not government savings. Ni es lo mismo ni es igual.

It gets a bit abstract, but I think the easiest way to grasp this is to follow the path of a dollar from a foreign consumer's pocket into the Venezuelan economy.

When you buy gas at a Citgo station, you give PDVSA a dollar. PDVSA has to pass your dollar on to the Venezuelan government. But the Venezuelan government doesn't spend dollars, it spends bolivars. It has no use for your dollar until it's been turned into bolivars.

So what happens? PDVSA takes your dollar to the Venezuelan Central Bank and exchanges it for 2150 bolivars. PDVSA gives the 2150 bolivars to the government, and the government spends them.

What happens to your dollar? The Central Bank puts it in the Foreign Reserves account so that holders of bolivars who want to buy that dollar in the future can do so. This, actually, is the economic sense of having dollars in foreign reserves - they're the asset that backs the value of the bolivars in circulation.

The point here is that the dollars in the Central Bank's Foreign Reserve account represent bolivars the government has already spent.

That's why you can't think of them as government savings.

FIEM dollars are something else altogether. The point of FIEM was to keep some dollars obtained when oil prices are high from becoming bolivars until the price of oil drops again.

In high-oil years, the Central Bank was supposed to set aside part of the dollars PDVSA earned. Instead of issuing bolivars against those dollars right away, the Central Bank was supposed save them in a special fund designated FIEM. Only when oil prices dropped was the Central Bank supposed to issue bolivars against those dollars so the government could spend them.

At that point, the dollars would be moved from the FIEM account to the Foreign Reserves account.

Incidentally, this framework also explains why traditional economists were aghast at Chavez's call to spend "excess foreign reserves." Though details were murky for a long time, the government seemed to be asking the Central Bank to hand your dollar back to PDVSA so PDVSA could turn right around and buy bolivars from the Central Bank with your dollar again.

In effect, Chavez was asking the Central Bank to issue bolivars against the same dollar twice.

When you think it through, you realize that, if you do that, the total number of dollars in Central Bank Reserves stays the same, but the total number of bolivars in circulation grows.

Economist after economist had a conniption trying to explain that this was just a fancy way of asking the Central Bank to print new bolivars that weren't backed by anything to finance a government spending binge.

As every economist knows, this is how hyperinflations start.

Because once you start down that path, there is nothing to stop the government, six months down the line, from saying "well golly gee, look at those foreign reserves, they're still mighty high! We want to spend them again! Come on, Central Bank, cough up some more bolivars!..." Once you've set that precedent, that's a game you can keep playing again and again and again...

The last I heard of this absurd little spat is that the Central Bank and the government reached a compromise on "excess reserve" spending. The government agreed to use existing Foreign Reserves only for dollar-denominated purchases (to import food, for instance, or to fund Chavez's various foreign allies), and not to issue new bolivars against old dollars.

This is a fudge, since under normal circumstances foreign reserve dollars aren't free: the government has to buy those dollars from Central Bank using the bolivars it has. The compromise is the mirror image of the situation described above - by spending "excess reserves" this way, the number of bolivars in circulation stays the same, while the number of dollars in foreign reserves will drop. You're still fiddling with the ratio of bolivars-in-circulation-to-dollars-in-foreign-reserves in a pretty dubious way. But it's probably less damaging than flooding the domestic economy with lots of new bolivars created out of thin air.