Are Asian FX reserves really big enough?

We have in recent times hold on to the believe that many Asian foreign exchange reserves are in a healthy pink and are likely weather the worse of economic storm. Over the past decade, the governments in countries like China, Taiwan, Malaysia, South Korea, Thailand and Philippines have been building up extensively the reserves account via increased trade and investment (and possibility hot money). The large reserves have enabled countries like South Korea, Thailand, Philippines and Indonesia to sell off part of their USD holdings in a bid to improve their currency in order to fight the ever increasing inflation. A recent study conducted by IMF challenges the above notion. IMF has proposed a newer and reflective way to analyse foreign exchange reserves by comparing it against the gross external liabilities rather than with imports, debts due within a year or broad money supply and GDP. It is always difficult to get reliable data on gross external liabilities as it comprises private and public borrowings (ie debts), equity claims and real estate investments. So this study done by IMF is a good source of information and reference.

Reuters: A new study by the International Monetary Fund could fuel an uneasy feeling already 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 in most Asian countries are not too big in light of the potential for international 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 wrote in a working paper. Asian currency reserves have quadrupled since the financial crisis in the region a decade ago. Even excluding China, they have more than doubled in nominal terms, a buildup that is still controversial. As far back as mid-2003, Ken Rogoff, the fund's chief economist at the time, memorably said that putting aside 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 in the currency markets 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 now bursting forth. And developed economies seem to be chasing each other into recession as banks unwind the lax lending, to subprime mortgage borrowers and others, that Asian vendor financing made possible. It's quite a charge sheet, so it is all the more refreshing to find a stout defense of reserve accumulation from the IMF itself.

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For a start, Ruiz-Arranz and Zavadjil wrote, the reserve buildup has reduced Asia's vulnerability to the fallout of the global credit crunch and so is helping to maintain financial stability in the region. What is more, 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. Asia may be flooded with 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 supply; 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 cause output and consumption to slump, they say it makes more sense to judge the adequacy of reserves against a country's gross external liabilities. Just how much a country should hold back for that rainy day depends, they say, on the nature of its liabilities - foreign direct investment cannot turn tail in the same way bank deposits can - and on how volatile they are. While a one-size-fits-all benchmark is inappropriate, they calculate that reserves currently cover less than a third of emerging Asia's external liabilities. And that ratio has been slowly declining or has held steady across Asia, except in China and Malaysia, Ruiz-Arranz and Zavadjil say.

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An estimate by Reuters puts the region's total reserves at $4.35 trillion at the end of June. That is up $425 billion so far this year compared with a year earlier. But Sue Trinh, a currency strategist at RBC Capital Markets in Sydney, said reserves in Asia excluding China had shrunk by about $70 billion since April as central banks sold dollars to prevent their exchange rates from falling even faster. "It's just as well that they've built up all these FX reserves in the past few years because they're now much better positioned to use them as needed," she said. Asia is not running out of reserves. For now, the cloud of anxiety is no bigger than a handkerchief. But traders are on their guard. "When markets question the sustainability of policy choices, they don't wait for the actual breaking point," said Daniel Hui, a currency strategist at HSBC in Hong Kong. "They extrapolate out and say 'is this sustainable?"'

* Bloomberg: Australia's central bank says it may cut rate "soon" to shore up growth. Its interest lending rate is now at 7.25%.

* Forbes: Japan is widely expected to hold on to its super low interest rate of 0.5%. The central bank has today warned that its economy will remain sluggish in the near term.

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* TheEconomicTimes: JP Morgan says China is mulling an economic stimulus package of at least USD30-60b and may ease monetary policy by the end of the year.