International Foreign Reserves: Solving the Global Reserve Problem

The Asian financial crisis in 1997 marks an end to an era of unrestricted capital flows and unprecedented economic growth in Asia. Before the crisis, countries in Asia excluding the Middle East were export-oriented economies with huge exposures to foreign currency denominated debt (especially in U.S. dollars). Together with government-directed capital allocation like those previously seen in South Korea, these economies were fostering huge asset price bubbles and overvalued currencies. All these factors contributed in setting the stage for a very destructive financial crisis to happen.

When the Chinese yuan depreciated against the U.S. dollar by 25%, exports from China became relatively cheap compared to exports from East Asia. This economic situation raised the competitiveness of Chinese exports at the expense of East Asia and placed immense pressures on the currencies of East Asia to depreciate.

The waves of currency selling came and countries with huge short-term debts in U.S. dollars, found that they were unable to service their debts. This caused a round of capital flights out of the region. The Thai baht, Indonesian rupiah, Malaysian ringgit, Philippine peso and South Korean won depreciated 40 percent to 80 percent apiece! By the end of the Asian financial crisis, countries in East Asia found their banking systems and economies heavily disrupted.

Source: IMF

There are many hard lessons learnt during the Asian financial crisis of 1997. Among them was the need for a strong central bank to be a lender of last resort during times of financial distress. Besides that, the crisis also highlighted the danger of international capital flows that could exit a country as fast as they could enter it. Furthermore, foreign currency denominated debts are highly volatile and can be the cause of negative external shocks to a country’s real economy. The answer to these problems was simple. Central banks should accumulate large international foreign reserves to act as a cushion against detrimental external shocks to the economy.

Source: IMF, Economist

East Asia has since then emerged from the ashes with the fervour and determination to not repeat the same mistakes of the 1990s. Most of the countries that were severely affected have seen their Real GDP increase to overtake the levels seen before the Asian financial crisis. However, this economic revival is not without a cost. According to data obtained from the International Monetary Fund (2009), serious current account imbalances have accompanied the economic recovery seen in the countries of Asia. The reason for these persisting imbalances is due to the relatively undervalued Asian currencies measured according to their purchasing power parity.

Source: Sovereign Wealth Fund Institute

In the interval between the Asian financial crisis to the Sub-prime mortgage crisis, countries in Asia have been keeping their currencies artificially low. This made exports from Asia relatively cheap and have worked to foster larger accumulations of international foreign reserves. According to Alan Greenspan (2007) the East Asian economies have dramatically remedied their shortfall of foreign exchange reserves and reduced their borrowings denominated in foreign currencies. The international foreign reserves in emerging Asia have doubled to US$ 1 trillion from 2000 to 2003. To date, the foreign exchange reserves of China and Japan alone amount up to US$ 3 trillion!

In recent years, countries in Asia have realized that their international foreign reserves are more than sufficient to act as a cushion against external financial and economic shocks. Governments across Asia have since then utilize these surpluses of funds by transferring assets from central banks and other government institutions to sovereign wealth funds (SWT) which would then use these funds for further investment in the financial markets. According to the International Monetary Fund, the current estimated assets under the management of sovereign wealth funds are around US$2-3 trillion. This is an astronomical figure considering that the total amount of assets under the management of hedge funds is around US$ 1.9 trillion.

Source: Bloomberg

Over the years, the role of Asian central banks has evolved. While having twin objectives to promote sustainable economic growth and to maintain price stability, central banks are now no longer restricted to domestic monetary policy (open market operations, overnight policy rates, reserve requirements and discount rates). Through sovereign wealth funds, governments in Asia and their central banks have gained excess to financial markets and have invested in equities, sovereign debt, corporate debt, real estate and infrastructure. In the recent sub-prime mortgage crisis, we see sovereign wealth funds like Temasek Holdings and Abu Dhabi Investment Authority buy into foreign banks like Union Bank of Switzerland (UBS) and Citigroup.

The Asian financial crisis can sometimes be seen to be a blessing in disguise as many countries in East Asia, like China and Malaysia, have found themselves better able to withstand detrimental external shocks to their economies in the recent global economic slowdown. However, having large international foreign reserves may also prove to be a problem. Recent data indicates that Asian countries have pumped in their liquidity into low yield U.S. treasury securities. China, Japan and OPEC countries alone hold more than US$ 1 trillion of U.S. treasury securities.

According to Nobel laureate Joseph Stiglitz (2007), the United States cannot live within its means and borrows some US$ 2 billion a day from poorer countries! This situation is weird indeed as money is flowing uphill, from the poor to rich. To illustrate this further, the trade surpluses in exports are being recycled back into the United States by buying U.S. treasury securities. In other words, poor Asian countries are financing the huge budget deficits of the United States! The reason for this is that US treasury securities, especially short-term US treasury bills, are highly liquid. This means that they can be sold quickly whenever Asian countries need cash. Furthermore, the United States is attracting world reserve funds because it is the world’s number one military and economic power. Yet with the US dollar volatile as it is, would it still be wise to hold onto US treasury securities?

Source: IMF (2008)

They are numerous challenges that we will face in the coming years of the next society. We are likely to see the BRIC (Brazil, Russia, India and China) countries becoming economic powerhouses. The economies of both China and India have both respectively emerged from the global economic slowdown relatively unscathed and are projected to continue to grow rapidly. According to Peter Drucker (2002), virtual banks are also becoming increasingly significant as E-commerce activities create virtual money. Islamic financing have also grown immensely with estimates from Standard and Poor stating that around US$ 750 billion assets are under shariah-compliant management. Last but not least, the Guardian (21 July, 2009) states that the world is reaching a landmark in aging population as the global population of 65 and over is set to outnumber children under the age of five.

The liquidity that Asian central banks have accumulated opens many opportunities on the road ahead. First and foremost, investments in the telecommunication industry would increase worker productivity and encourage countries like Malaysia to become a regional financial centre. According to last month’s Economist magazine, China is now the largest mobile telephony market while India is the fastest growing one. Second, third world countries have underdeveloped infrastructures. Development, for example, in public transportation like roads and rails would encourage more trading activities.

Third, prices of commodities both in agriculture and raw materials are likely to increase in the near future because of inflation and supply shortages. Besides that, international foreign reserves can also be invested in higher education and to build schools. Peter Drucker (2002) noted the decline in manufacturing and the increase importance of knowledge products such as education which have tripled in cost in recent years. Lastly, some of the surplus reserves can be used to establish countries like Malaysia as an Islamic banking hub. This would enable Malaysia to take advantage of the petro-dollars coming from the Middle East.

To facilitate these developments, Asian central banks or sovereign wealth funds can support local commercial banks or help companies that are involved in these activities. This can be done by helping them raise capital through the purchase of their bonds or equities. The upside of this approach rather than investing directly in these areas is that Central banks or sovereign wealth funds would be insulated from adverse forces affecting these industries.

Bill Gates once said that success is a lousy teacher because it seduces smart people into thinking they cannot lose. As Asian economies have weathered the global economic downturn more successfully as compared to the Asian financial crisis we are reminded by Peter Drucker that only the fairy tale ends, ‘happily ever after’. What we need now is to continuously improve our economic systems by working together for a better future. In saying so, we need to find new opportunities to invest our excess international foreign reserves.

~ Ee Suen Zheng