A new International Monetary Fund study may fuel an uneasy feeling stirring in financial markets that some Asian central banks are drawing down their currency reserves a bit too fast for comfort. In a challenge to conventional wisdom, including that of the Fund, two IMF researchers say the huge war chests are not too big to begin with in most Asian countries in light of the potential for capital flows to come to a screeching halt.
"Except in China and possibly Malaysia, reserves in emerging Asia cannot be considered excessive, when compared to what would be optimal from a precautionary motive standpoint," Marta Ruiz-Arranz and Milan Zavadjil write in a working paper. Asia's reserves have quadrupled since the region's financial crisis a decade ago. Even excluding China, they have more than doubled in nominal terms, a build-up that remains controversial.
As far back as mid-2003, the fund's chief economist at the time, Ken Rogoff, memorably said that putting aside reserves for a rainy day was one thing; building Noah's Ark was another. Topping up stockpiles depleted by the crisis as self-insurance against a repeat of that trauma was a natural policy response. But the reserves then kept growing as central banks intervened to hold down their exchange rates.
In doing so, critics say, Asia built up external surpluses that exacerbated global imbalances, paid for American consumers to live beyond their means for too long and bottled up inflationary pressures at home that are at last bursting forth.
And now developed economies seem to be chasing other into recession as banks unwind the lax lending, to subprime mortgage borrowers and others, that Asian vendor financing made possible. It is quite a charge sheet, so it's all the more refreshing to find a stout defence of reserve accumulation from the IMF itself.
For a start, Ruiz-Arranz and Zavadjil say the reserve build-up has reduced Asia's vulnerability to the fall-out of the global credit crunch and so is helping to maintain financial stability in the region.
"Not only are individual economies better prepared to weather a sudden stop of capital flows, but the risk of financial contagion in the region may have decreased as a result of the reserve accumulation," the IMF researchers say. Furthermore, they present evidence that holding reserves significantly lowers the interest rate that private borrowers pay on their foreign debt because lenders are more confident they will be repaid - a factor not normally considered when assessing the opportunity cost of holding reserves. "This effect continues to be important even at relatively high levels of reserves," Ruiz-Arranz and Zavadjil conclude.
Asia may be drowning in reserves as measured by conventional yardsticks: the ratio of reserves to three months of imports; to external debt due within a year; to broad money; and to gross domestic product. But these benchmarks are out of date, Ruiz-Arranz and Zavadjil argue. In an era of footloose money, when an abrupt reversal of capital flows can have a major impact on output and consumption, they say it makes more sense to judge the adequacy of reserves against a country's gross external liabilities.
Seen through this prism, reserves currently cover less than one-third of emerging Asia's external liabilities. What's more, the ratio has been slowly declining or has held steady across Asia, except China and Malaysia, Ruiz-Arranz and Zavadjil say.