Business | Investment
Asian forex war chest not big enough
A new International Monetary Fund study may fuel an uneasy feeling stirring in financial markets that some Asian central banks are drawing down their currency reserves a bit too fast for comfort.
- By Alan Wheatley, Reuters
- Published: 23:51 August 22, 2008
A new International Monetary Fund study may fuel an uneasy feeling stirring in financial markets that some Asian central banks are drawing down their currency reserves a bit too fast for comfort.
In a challenge to conventional wisdom, including that of the Fund, two IMF researchers say the huge war chests are not too big to begin with in most Asian countries in light of the potential for capital flows to come to a screeching halt.
"Except in China and possibly Malaysia, reserves in emerging Asia cannot be considered excessive, when compared to what would be optimal from a precautionary motive standpoint," Marta Ruiz-Arranz and Milan Zavadjil write in a working paper.
Asia's reserves have quadrupled since the region's financial crisis a decade ago. Even excluding China, they have more than doubled in nominal terms, a build-up that remains controversial.
As far back as mid-2003, the fund's chief economist at the time, Ken Rogoff, memorably said putting aside foreign exchange (forex) reserves for a rainy day was one thing; building Noah's Ark was another.
Topping up stockpiles depleted by the crisis as self-insurance against a repeat of that trauma was a natural policy response. But the reserves then kept growing as central banks intervened to hold down their exchange rates.
In doing so, critics say, Asia built up external surpluses that exacerbated global imbalances, paid for American consumers to live beyond their means for too long and bottled up inflationary pressures at home that are at last bursting forth.
And now developed economies seem to be chasing other into recession as banks unwind the lax lending, to subprime mortgage borrowers and others, that Asian vendor financing made possible.
It is quite a charge sheet, so it's all the more refreshing to find a stout defence of reserve accumulation from the IMF itself.
For a start, Ruiz-Arranz and Zavadjil say the reserve build-up has reduced Asia's vulnerability to the fall-out of the global credit crunch and so is helping to maintain financial stability in the region.
"Not only are individual economies better prepared to weather a sudden stop of capital flows, but the risk of financial contagion in the region may have decreased as a result of the reserve accumulation," the IMF researchers say.
Furthermore, they present evidence that holding reserves significantly lowers the interest rate that private borrowers pay on their foreign debt because lenders are more confident they will be repaid - a factor not normally considered when assessing the opportunity cost of holding reserves.
"This effect continues to be important even at relatively high levels of reserves," Ruiz-Arranz and Zavadjil conclude.
Asia may be drowning in reserves as measured by conventional yardsticks: the ratio of reserves to three months of imports; to external debt due within a year; to broad money; and to gross domestic product.
But these benchmarks are out of date, Ruiz-Arranz and Zavadjil argue. In an era of footloose money, when an abrupt reversal of capital flows can have a major impact on output and consumption, they say it makes more sense to judge the adequacy of reserves against a country's gross external liabilities.
Seen through this prism, reserves currently cover less than one-third of emerging Asia's external liabilities. What's more, the ratio has been slowly declining or has held steady across Asia, except China and Malaysia, Ruiz-Arranz and Zavadjil say.
A Reuters tally put the region's total reserves at $4.35 trillion at the end of June.
That is up $425 billion so far this year. But Sue Trinh, a currency strategist at RBC Capital Markets in Sydney, said Asia ex-China's reserves had shrunk by about $70 billion since April as central banks sold dollars to prevent their exchange rates from sinking faster.
"It's just as well that they've built up all these forex reserves in the past few years because they're now much better positioned to use them as needed."
Daniel Hui, a currency strategist at HSBC in Hong Kong, said the speed at which some countries were drawing down reserves was impressive.
South Korea's reserves fell $10.58 billion in July to $247.52 billion, the biggest monthly drop on record, while Hui estimated that the Philippines' reserves, after accounting for transactions in the forward market, had fallen 25 per cent this year.
"When markets question the sustainability of policy choices, they don't wait for the actual breaking point. They extrapolate out and say 'is this sustainable?'. And if it's not, then there's a trade to be done," Hui said.
Anxiety
Asia is not running out of reserves. The cloud of anxiety for now is no bigger than a handkerchief. But the market's new-found focus on sustainability makes the IMF paper timely.
Even the People's Bank of China, sitting atop $1.81 trillion in reserves, felt moved to warn, in its latest monetary report, about the risk of huge capital outflows. So how much should a country hold back for that rainy day? It all depends, Ruiz-Arranz and Zavadjil say, on the nature of the liabilities - foreign direct investment cannot turn tail in the same way bank deposits can - and on how volatile they are.
"While it is not possible to calculate a benchmark for an adequate level of reserves compared with external liabilities, current reserve levels in most Asian economies do not appear excessive against historical levels given the size of gross liabilities and the increased volatility of gross flows," they write.
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