ANALYSIS-Asia's surplus FX reserves: a problem of plenty

BEIJING Mon May 12, 2008 9:44am IST

BEIJING May 12 (Reuters) - Money can't buy you love, sang the Beatles. Nor, as Asia is discovering, can $4 trillion in foreign exchange reserves pave a swift path out of poverty.

If the Chinese government has set up a sovereign wealth fund, and India's is debating whether to follow suit, it is because they cannot tap at will the fabulous sums in the coffers of their central banks to finance badly needed development spending.

This is not really the people's money.

Reserves accumulated from fiscal surpluses -- think Singapore's Temasek Holdings -- or from a bonanza of natural resource revenues, as with Gulf oil funds, do represent genuine "sovereign wealth" that can be spent without incurring debt.

But Asia has built up its reserves mainly through intervention by its central banks, which buy dollars by issuing debt or local currency.

In other words, the foreign-exchange assets have counterpart liabilities. What if, to simplify things, the exporter that sold dollars to its local central bank asked to buy them back? So if a government wants to spend the reserves, it must first buy them.

"If China's reserves were like Saudi Arabia's, like manna from heaven or 'free' fiscal assets, then of course they could pour billions into strengthening the pensions system, the health system, the education system or any other socially productive investment," Donghyun Park, an economist with the Asian Development Bank, said in an interview from Manila.

"But unfortunately for China, its reserves are not free fiscal resources. They're central bank reserves," said Park.

As such, if policy makers are wondering how they can use excess reserves, they are asking the question too late.

Instead of piling up reserves that go to finance U.S. overspending, governments should tweak policy to import more goods and services and reduce high national savings rates, which are the statistical counterpart of current account surpluses.

"The obvious 'first-best' solution to the problem of too many reserves is not to accumulate them in the first place," Park wrote in a recent paper on the topic.

So what are the second-best solutions?

CREATIVE SOLUTIONS

In Park's view, spending surplus reserves at home has superficial appeal but is messy and economically risky.

Government borrowing to buy foreign currency from the central bank boosts public debt. And then selling the dollars requires renewed intervention to prevent a rise in the nominal exchange rate, bringing the reserves back onto the central bank's books.

"If a government wants to spend on domestic infrastructure, it would be much simpler and more transparent to do so through orthodox domestic-debt-funded fiscal operations," Park wrote.

That is not to say there is no scope for innovation.

China has diverted over $100 billion of reserves to recapitalise state-owned banks and brokerages, while India's finance ministry and central bank are exploring a complicated mechanism to use a sliver of its $313 billion of reserves to fund infrastructure investment without the risk of monetary expansion.

"Those are creative ways of deploying the reserves domestically and other creative ways need to be found," said PK Basu, chief economist for Asia ex-Japan at the Daiwa Institute of Research in Singapore.

Nonetheless, the policy priority must be to earn as much as possible on the bulk of the surplus reserves that are invested overseas. For, while the reserves themselves are not free fiscal assets, the income streams they generate can be spent as governments please.

"Obviously, the reserves now held by Asian central banks exceed any reasonable level that one would expect to be necessary as insurance against future financial crises or runs on the currency," Basu said.

He estimated that China and India have at least 30-40 percent more reserves than they would need for the rainiest of days.

"For that excess portion, there needs to be a way to maximise returns and also diversify risk and therefore reduce the volatility of those returns. And that's where a sovereign wealth fund comes in," Basu said.

And that's why, even as Western governments fret at the influence such funds may come to wield, the mouths of the world's money managers are watering at the business they will bring in.

CHINA RISING

Take China. Right now, its offshore wealth mainly comprises safe, low-yielding foreign exchange reserves handled by the central bank.

But as China Investment Corp, the sovereign wealth fund, takes wing and channels for private capital outflows are liberalised, the potential for diversification is huge, TJ Bond, Merrill Lynch's chief economist for Asia, said in a report.

Taking Japan as his rough benchmark, he estimates China needs only $460 billion in reserves, not the current $1.68 trillion.

To allocate its overseas assets in the same proportions as Japan, China would need to invest $970 billion in overseas stocks over the next decade and $3.2 trillion in foreign bonds; its direct investments overseas would jump $760 billion and Chinese banks would increase overseas lending by $1.2 trillion.

"Over time, as China's financial institutions mature and its capital account opens up, Chinese savings will play an even more important role in global markets than they do today," Bond said.

-- For a breakdown of Asia's reserves, click on [ID:nSP32091]

-- Park's paper can be accessed here (Reporting by Alan Wheatley, Editing by Sonya Hepinstall)

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