BEIJING May 12 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
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
"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?
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
"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
"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
"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
"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
Take China. Right now, its offshore wealth mainly comprises
safe, low-yielding foreign exchange reserves handled by the
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
Taking Japan as his rough benchmark, he estimates China
needs only $460 billion in reserves, not the current $1.68
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
-- For a breakdown of Asia's reserves, click on
-- Park's paper can be accessed here
(Reporting by Alan Wheatley, Editing by Sonya Hepinstall)