Bangkok--Feb 8--Aziam Burson Marsteller
Just as the billowing US current account deficit is unsustainable, so, in
our view, is Asia's rapid buildup of foreign exchange (FX) reserves. China seems most vulnerable, with its FX reserves rising exponentially in 4Q, exacerbated by hot money inflows.
Diminishing benefits
Total FX reserves in Asia surged by US$532bn in 2004 to a record high
US$2.4tr. Asia was responsible for 76% of the increase in world FX reserves in 2003, and the share is set to be even higher in 2004. Within the region, Japan's FX reserves shot up by US$154bn in 1Q 2004, but since then the Ministry of Finance has refrained from FX intervention. But other Asian monetary authorities have continued to intervene. FX reserves in China rose by US$207bn in 2004, with an eye-popping US$95bn increase in 4Q 2004. The sum of FX reserves in the rest of Asia surged by US$155bn in 2004, and is actually larger than China's or Japan's.
The buildup of Asian FX reserves is due to the region's balance of payments surplus and the reluctance of Asian policymakers to let their currencies
appreciate freely. All Asian countries have current account surpluses, but hot money inflows have also been an important driver of the region's balance of payments surplus. For example, of China's US$95bn increase in FX reserves in 4Q 2004, US$28bn was attributable to the trade surplus and US$12bn to FDI inflows; the residual US$55bn was due to a combination of hot money inflows, exchange rate valuation effects from the weakening US$, and reinvested earnings. Assuming that 70% of China's FX reserves are held in US$, we estimate that about 30% of the increase in China's reserves last year was due to exchange rate valuation effects and reinvested earnings.
This suggests that China's net hot money inflows totaled a hefty US$27bn in 4Q 2004.
By accumulating FX reserves, a country can minimize the risk of a currency crisis, improve its sovereign credit rating upgrades, and lower its
overseas borrowing costs. Asian policymakers were keen to rebuild FX reserves after the Asian crisis, but by any yardstick reserves have now risen far beyond optimal levels. FX reserves comprise over 30% of GDP in most Asian countries. The region has been rewarded with a slew of sovereign credit rating upgrades and capital inflows have returned. The danger of continuing to build FX reserves is that the diminishing marginal benefits will be dwarfed by the rising potential risks. We see five main ones.
Rising potential risks
First, sustained FX intervention has kept Asia's currencies artificially
undervalued ever since 1998. With the region's economies now outperforming the rest of the world's, protectionist pressures stand to rise.
Second, to avoid purchases of FX reserves from increasing domestic
liquidity, central banks typically try to neutralize the impact through a
reduction in their net domestic assets. They do this by selling domestic
government securities that they hold, or by issuing central bank bills. The
problem is that it is not always easy to completely sterilize FX intervention in this way. China is a case in point. In 2003, perhaps partly due to the SARS shock, the People's Bank of China (PBoC) did not match the increase in its net foreign assets with a decrease in net domestic assets, and consequently the money base surged by 7% of GDP, contributing to excessive money and credit growth and the overheating of the economy In the first ten months of 2004, the PBoC seems to have been more judicious with its sterilization operations, but it seems to have had its work cut out in the final two months. Data on the PBoC's balance sheet are only available up to October 2004, but judging from the surge in China's FX reserves in November and December, we estimate that the PBoC's net foreign assets shot up to 11.7% of GDP in December 2004 . To avoid this leaking into the money supply, massive sterilization operations are necessary, and this seems to have occurred: the new issuance of central bank bills by the PBoC totaled a record US$61bn in 4Q 2004.
Third, even if central banks successfully sterilize their heavy FX
intervention, it can be costly and risky. The central banks may have to offer higher interest rates in order to induce domestic investors to continue adding central bank securities to their portfolios. Higher domestic rates raise the fiscal costs of sterilization, and could also spark a vicious spiral by attracting further capital inflows.
Fourth, to the extent that FX reserve accumulation reflects exchange rate
rigidity, it could increase vulnerability to crisis by giving the impression to speculators that buying the local currency is a one-way trade (hot money inflows suggest this is happening in China), or by discouraging firms from hedging against FX variability.
Yet another risk arises from the exposure of Asian central banks to
potentially large losses on their FX reserves. If Asia's total FX reserves
continue rising at their current pace, they will total US$3.1tr at the end of 2005, and US$4.0tr by the end of 2006. If Asian currencies were to appreciate sharply against the US$, or the US bond market were to sell off, Asian central banks' foreign assets could lose substantial value in local currency terms. Governments may have to draw on their own finances to recoup the capital losses of central banks. Alternatively, central banks could print additional money to make up for their capital losses, at the cost of higher inflation. The risk exposure for Asian central banks is already significant. Given FX reserve holdings at the end of 2004, we estimate that a 10% appreciation of local currencies against the
US$ would result in latent capital losses in domestic currency terms of 7.4% of GDP in Singapore, 5.3% in Taiwan, 2.6% in China, and 1.9% in South Korea.
Bottom line: we see little additional benefit from further FX reserve
accumulation in Asia ex-Japan; rather, we see rising potential economic risks, including the danger of losing monetary control. The obvious remedy is to allow currency appreciation. End.