The article last week  discussing the goings-on in mortgage portfolios that have caused significant losses for various holders of fixed-income securities, including pension funds and central banks, raised an obvious question, which is why so many central banks continue to hold large foreign-exchange reserves. The answer is often quite complicated, but in essence relates to three issues.
The primary purpose of reserves relates to the level of external debt that a country has, which needs to be covered by foreign-currency holdings in case credit is not rolled over. The second is to provide the central bank with a useful hedge against weakness of the domestic financial sector. The third factor is perhaps the most important for Asia, and that is the accumulation of reserves for the purposes of currency manipulation, namely to set an exchange rate that is thought to further the interests of the country’s exporters at large.
I’M Finished, or IMF for short
The first two factors underpinning Asian reserves were courtesy of the International Monetary Fund’s insistence on countries setting a pattern of adequate saving at the sovereign level to pay for their continued import of foreign capital. The orthodoxy at the IMF (and its sister institution, the World Bank) resulted from the problems faced by emerging markets such as those in Latin America during the 1980s and Asia in the late 1990s.
Of the two factors, debt coverage and banking-sector risks, I am more understanding of the latter,  as it remains a key problem in various countries that suffer from underpaid bankers trying to implement interventionist government policies. But even then it is difficult to justify the level of foreign-exchange reserves in Asia.
Strangely, this orthodoxy from the IMF does not extend to the countries with the greatest imbalances in the world today, most notably the United States. In a past article, I envisaged some scenarios of the IMF actually trying to help the US,  even if this was only intended to provide some comic relief to the otherwise bromide existence of IMF and World Bank staffers. Still, the points raised in that article, namely that the US lives way beyond its means funded mainly by Asian savings, remain unquestioned.
As we look at a spectrum of global imbalances, it is clear that Asian currency manipulation occupies the other side of the spectrum from US over-consumption. The comfortable fallacies at the heart of this muddle are, first, that Asia needs to keep selling to North America and Europe to generate jobs internally and, second, that holding foreign-exchange reserves represents a diversification of risk.
The IMF’s sage advice may have worked at some point in the past few decades, but it clearly failed to take into account the consequences of an excess buildup of savings. In the manner of Japanese households that literally piled up cash under their mattresses after the horrific losses sustained in that country’s property and stock markets during the 1990s, Asian savers have blithely accumulated foreign-exchange reserves ever since the Asian financial crisis broke out in 1997. Much as excess savings in Japan helped to drive down real returns and in turn prolonged the country’s recession, so too will Asian savings prove to be the main cause of the next global recession.
Risk and returns
So many central bankers around the world are convinced about the benefits of holding American and European government bonds in large quantities that it seems futile even to argue the point with them. Stepping back from the textbooks, though, it is perhaps prudent to ask the key question: How does one quantify the benefits of holding foreign-exchange reserves?
In the old days, when the US dollar was spectacularly strong, it made all the sense in the world for profit-seeking bankers to accumulate securities in that country. In the current environment, though, those calculations do not make much sense. For example, the Indian rupee has appreciated some 10% against the US dollar over the past four months alone. This means that the required return for an Indian investor to hold US government bonds would be well over 10% – indeed, much higher if one thought about annualizing returns. Instead, even long-dated US bonds get returns around the paltry 5% level.
There is no argument that, once properly accounted, Asian central banks have lost billions by holding US government securities, and this is before considering the actual investment losses that must be borne in key areas, including mortgages, that I brought up in last week’s comment.
Then there is the argument that is made by many of the apologists for holding large foreign-exchange reserves, that Asians and other exporters have to subsidize American consumers so that they can keep buying products such as cars and washing machines. I find those arguments one-sided, because of the underlying assumptions that sales even at marginal losses are a good thing and, second, that Asians cannot consume these goods themselves.
The latter assumption is perhaps the most disturbing. Say for argument’s sake that China floats its currency against the US dollar tomorrow.  Over a period of time, Chinese consumers will benefit from rising purchasing power, which will help them improve their standards of living. Meanwhile, Americans will see prices rise in their country, which will necessitate monetary tightening by their central bank that in turn will encourage greater saving than spending. Over a period of time, excess consumption is replaced by rising production as the key growth engine for the US economy. Perhaps it’s just me, but there don’t appear to be many losers in this scenario.
Where it all fails in practice, though, is that Asian politicians and central bankers have little vision, compounded by substantial fears. American business people and the financial media help to play up such fears, and in essence maintain the IMF-inspired orthodoxy that actually forces Asian savers to lose money hand over fist, quarter after quarter.
To put it more bluntly, Asians are paying an excess tax to Americans and Europeans to maintain the status quo. This is a questionable aim at the best of times, but is made even worse by the rapidly worsening demographics of both the US and Europe. As Asians buy the debt issued by a graying American population, they must expect to lose money over a period of time. The same problem, only slightly worse, pervades investments in bonds issued by Japan and Europe.
Compare those billions being squandered by Asian central banks to the real problems of the major economies.  Media reports this week highlighted that almost a million Chinese were dying prematurely every year because of rampant pollution – and yet China fails to find the money that can fund cleanups across its major cities and countryside. India’s infrastructure problems are too numerous and well known to account again here, but the real tragedy is the millions of children left without proper water, food and – most important to breaking the vicious cycle of poverty – education.
For all intents and purposes, the above reads as a litany of abuses that Asian countries have accepted for the well-being of American and European consumers. If that’s not imperialism by another name, what is?
1. The robbery of the century, Asia Times Online, July 14, 2007.
2. Chinese, Indian banks plunge at different rates, ATol, August 3, 2006.
3. A good use for the IMF: Bail out America, ATol, March 17, 2007.
4. Pegged problems, ATol, May 25, 2007.
5. Two Roads to Hell, Part 1: Caste-away, ATol, June 15, 2007; Part 2: Pork-barrel politics, June 16.