An article in The EastAfrican of March 29-April 4 said that African central banks hold nearly $200 billion in foreign banks “because they fear to invest locally owing to rising risks at home.”

It further argued, citing the UN Economic Commission for Africa, that the investment of these reserves abroad denies African countries funds that could be used to finance infrastructure.

The article seems to misunderstand why central banks hold foreign reserves and why this means that they cannot be invested at home in infrastructure projects.

Sub-Saharan African (SSA) countries currently hold total foreign exchange reserves of $208 billion, of which almost half is held by Nigeria and South Africa.

Foreign reserves are held as protection for the balance of payments (BoP).

They provide a buffer of resources that can be used, if there are shortages of foreign currency in the economy, to ensure that sufficient foreign currency is available to allow normal foreign exchange transactions to take place, such as the purchase of imports and the servicing of foreign currency debt.

If there were no such buffers, shortages of foreign exchange would be very disruptive for the economy.

For example, there were serious fuel shortages last year in Malawi because the country did not have enough foreign exchange to pay for fuel imports.

Economies that do not hold sufficient foreign exchange reserves are vulnerable to a balance of payments crisis, such as those that hit several emerging market economies in the mid-1990s.

To be useful as a buffer to protect the BoP from foreign exchange shortages, foreign reserves must fulfil three basic criteria: They must be held in hard currency (currencies such as the euro or US dollar, which are readily accepted as a means of payment all over the world); they must be highly liquid, so that they can be accessed at any time at short notice; and they must be held in the form of very safe assets, so that they cannot be lost because of, for example, a fall in stock prices or the failure of a commercial enterprise.

As such, central banks all over the world, not just in Africa, invest their foreign exchange reserves in liquid, investment grade, foreign currency denominated assets such as developed country government debt and bank deposits in international banks.

This investment strategy is not motivated by any fear of risks in the home countries of the central banks; it is simply that developed economies offer the type of assets that are most suitable for the investment of foreign currency reserves.

The article in The EastAfrican implies that some countries in Africa are holding excess foreign reserves that could be used to finance infrastructure. The notion that there are excess foreign reserves in sub-Saharan Africa is not tenable.

The adequacy of foreign reserve cover is usually evaluated in relation to the number of months of imports it could finance.

At the end of 2012, the median level of reserves in SSA was only 3.6 months of imports (the five EAC countries held slightly more with an average of 3.9 months of imports).

This is low by international standards. Developing countries in Latin America and the Caribbean hold foreign reserves that average 9.4 months of their imports while the foreign reserves hold by developing countries in East Asia and the Pacific average 17 months of their imports.

Emerging markets in Latin America and Asia learned a painful lesson in the 1990s when they suffered balance of payments crises. They have subsequently built up large buffers to protect themselves from further BoP crises. Holding strong buffers of foreign exchange reserves brings benefits beyond protecting the BoP.

Credit rating agencies use the level of foreign reserves as one of the criteria for determining sovereign credit ratings.

Countries without adequate foreign reserve cover will not be able to command a good sovereign credit rating; this will raise the cost of mobilising finance for both the public and private sectors in those countries. 

Dr Louis Kasekende is Deputy Governor of the Bank of Uganda