Foreign exchange reserves are hot hot hot

by Rebecca

The G7 G20 Leader’s statement, number 20., regarding the IMF’s mission and governance (bold font by yours truly):

The IMF should continue to strengthen its capacity to help its members cope with financial volatility, reducing the economic disruption from sudden swings in capital flows and the perceived need for excessive reserve accumulation. As recovery takes hold, we will work together to strengthen the Fund’s ability to provide even-handed, candid and independent surveillance of the risks facing the global economy and the international financial system.

Last week I was in New York talking with Emerging Market strategists and economists. Most of them attended the IMF meetings in Istanbul, Turkey – according to them, the monster takeaway from the meetings was that the sky’s the limit in terms of FX reserve accumulation (in EM economies). Put this way, the IMF is unlikely to be successful in its aforementioned goal of preventing the “need” of excess reserves, at least over the near term.

Key markets in Asia (China, or South Korea) and Latin America (Brazil) remained rather resilient to the credit crunch late in 2008 due to sufficient (even excessive) reserves holdings. Brazil, for example, was able to supply private-sector financing needs by draining FX ($USD) reserve holdings. South Korea and other Asian economies, too.

The chart below illustrates reserve holdings across key countries in LATAM (Latin America) and Asia – notice the sharp drop at the end of 2008.

It’s an incredulous thought: that policy makers in EM countries – whether the reserve accumulation was for precautionary reasons (LATAM) or stemming from export-led growth (Asia) – won’t be filling the reserve coffers at increasing rates; the process is already underway.

Reserves in Brazil are now 230% higher than they were in 2007 (January), 197% in China, 190% in Thailand, and 163% in Hong Kong. Hong Kong is interesting; amid their strict dollar peg, the Hong Kong Monetary Authority is accumulating reserves faster than most countries (Hong Kong will be the country to watch as the peg against the dollar is sure to result in some inflationary pressures, given that Hong Kong’s economic fundamentals are stronger than those in the US at this time – another post).

Record inflows of late into EM financial markets (bonds and equities) are providing plenty of liquidity and contributing to reserve accumulation of late. However, having sufficient FX reserves has proven to be the best insurance out there against a stoppage in external financing. And as long as inflation pressures remain muted, acquiring reserves is not too costly economically (there are administrative costs, though, from sterilization when US Treasury rates are near zero).

The Treasury recently released the Semiannual Report on International Economic and Exchange Rate Policies; it states that officially no foreign central bank has explicitly manipulated their currency since 1994 but pointed the finger at China for their currency policies that inhibit the unwinding of global current account imbalances. An excerpt from page 3:

Although China’s overall policies played an important role in anchoring the global economy in 2009 and promoting a reduction in its current account surplus, the recent lack of flexibility of the renminbi exchange rate and China’s renewed accumulation of foreign exchange reserves risk unwinding some of the progress made in reducing imbalances as stimulus policies are eventually withdrawn and demand by China’s trading partners recovers.

It’s farcical to think that the G7 can browbeat EM countries into curtailing excessive reserve accumulation. To be sure, export growth is simply not going to grow China at rates sufficient to maintain jobs growth (9% or so) and reserve balances are likely to be increasingly focused inward domestically (supporting the financial system, local governments, etc.). However, what seems to be very real is that targeted reserve accumulation, in whatever currency but still heavily weighted in $US, buffered EM countries from catastrophe and is not going away.

Rebecca Wilder

P.S. for those of you who want to know a bit more about reserve accumulation in China, Brookings wrote a nice topical piece earlier this year.