TCS Daily

Excessive Asian Reserves?

By Christopher Lingle - April 12, 2005 12:00 AM

Reflecting a fetish for hard currency similar to the Mercantilist obsession with gold, East Asia's foreign-exchange reserves have more than doubled since the turmoil in 1997-98. Japan's foreign reserves of over $840 billion were the highest in the world for the 63rd straight month while China has the world's second-largest foreign reserves of almost $610 billion of the end of 2004.

Taiwan has the third largest reserves of around $242 billion, exceeding half the size of its GDP. South Korea is fourth on the list with foreign reserves up by $3 billion from late December to $202.1 billion as of the end of February, about 29 percent of its GDP.

In turn, Asian central banks collectively hold about $2.4 trillion worth of US Treasuries and other securities. These foreign exchange balances provide a cushion so that importers have adequate access and that there are sufficient fund to repay overseas creditors. At the same time, a large stock of hard-currencies tends to ward off currency speculators.

Unfortunately, these continuously rising reserves push up the cost of holding them while central banks show growing valuation losses on their balance sheets from a depreciating dollar.

Various factors contributed to the recent increase in reserves. Initially, declining business investment after 1997-98 accompanied by high household savings rates allowed East Asian economies to move from external deficits to external surpluses. These large current account surpluses and net capital inflows were boosted by remittances from expatriate workers.

Recent rises of the value of the euro and yen against the dollar also increased the dollar value of assets denominated in other foreign currencies. But most importantly, interventions in foreign-exchange markets to curb appreciation of their currencies contributed to the increase in reserves held in Asia by about 35 percent during 2003.

Continued attempts to weaken their currencies while attempting to boost exports will cause further build-up of their dollar holdings that transfer purchasing power to Americans. If Asian central banks allow their currencies to appreciate, they will experience significant losses since most of their assets are in dollars while their liabilities are in the local currency.

Currency market interventions have caused many Asian currencies to be "undervalued" relative to the dollar. Conversions of foreign funds to local currencies tend to fuel growth in local money supplies that push up loan growth and contribute to investment bubbles.

This untenable condition can lead to the sort of turmoil in foreign currency markets last seen in 1997-98. Massive currency realignments and high volatility devastates balance sheets, especially in those countries with weak financial sectors and poor corporate governance.

China faces the biggest problems with its policy mix. An estimated inflow of $50 billion of "hot money" to gamble on the revaluation of the renminbi has contributed to a growth in the domestic money supply and contributed to price instability.

It is estimated that the interest paid by China's central bank on the debt it sold to keep its currency pegged during 2004 was about 22 billion yuan ($2.6 billion). Meanwhile, China has been buying dollar inflows and then selling bonds and bills to restrain excessive growth in the money supply.

It is impossible to know the "optimal" level of foreign currency reserves, but there are signs that the levels of reserves held in many Asian countries is excessive. On the positive side, growing foreign reserve assets make these countries less dependent upon foreign borrowing and allow net capital exports to more developed economies. These reserves also provide a safety net against external shocks like speculative attempts to force changes in currency valuations, steps that are admittedly unnecessary unless currencies are pegged at untenable levels.

In all events, indefinite accumulation of dollar assets (or denominated in any other foreign currency) weakens domestic monetary systems of these economies. This is because the rapid growth and current high level of reserves will exacerbate instability in consumer and producer prices while increasing the likelihood of an asset bubble.

When exports exceed imports, the accumulation of reserves requires a decline in domestic consumption and investment. Building reserves from a trade surplus means that export earnings are unavailable for private investment.

Central banks usually purchase foreign currency from exporters by issuing bonds denominated in domestic currency that pay interest rates higher than it receives on its reserves. Since larger reserves mean that fewer funds are used to pay off foreign debt or to buy higher-yielding foreign assets, domestic interest rates may be higher or not fall as much as elsewhere. Thus, large reserves act as a tax on businesses that must pay higher interest rates to buy inputs to produce the goods that create the reserves.

Reserves can be accumulated without reducing domestic investment. On the trade side, imports can be increased through reduction in trade-inhibiting public policies. On the capital side, more capital outflows could be allowed or reserves could be invested in overseas assets with longer-term maturities. All these would increase the demand for dollars and decrease demand for local currencies.

It turns out that most Asian companies and governments have placed their reserves in low-yielding US assets. For example, Asians hold about 20 percent of the debt of Freddie Mac, the American mortgage-finance company.

Purchases of US securities are part of an unsustainable shell game whereby Asians finance the large external deficit of the US so Americans can buy more Asian exports. The key to this global Ponzi scheme is a flood of liquidity from the US due to "cheap credit" orchestrated by the Fed's monetary pumping. Of course, this orgy is rapidly coming to an end.

If they insist on holding such massive reserves, East Asian countries should manage them more effectively. They would lower unexpected currency risks by divesting US assets that already have low interest rates. And the costs of holding foreign reserves can be reduced if lent to private entrepreneurs since private investors always seek the highest returns for a given risk while governments do not.

Christopher Lingle is Global Strategist for eConoLytics.



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