The article last week [1]
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, [2] 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, [3] 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. [4] 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.
Entrenched imperialism 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. [5] 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?
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