The size of foreign reserves

inSight

08 Jun 2006

The size of foreign reserves

The strength and well-being of an economy cannot be measured by how much foreign reserves it holds.

Hong Kong has seen a drop in its ranking among holders of official foreign reserves in recent years, from the third highest in the world in 1997 to the eighth now. Some people seem to be disappointed about us having been overtaken by other economies. This is perhaps understandable since, rightly or wrongly, the amount of foreign reserves is often seen as a measure of financial strength or perhaps even the well-being of an economy. As you would expect, my response is that this is not necessarily the case.

The financial robustness of an economy cannot be measured by the amount of foreign reserves it holds. The Mainland now tops the ranking, with over US$875 billion in foreign reserves, but there is still considerable room for improvement in its financial system. The abundance of foreign reserves certainly makes things easier: indeed, large amounts have been used to recapitalise the state-owned banks. It also strengthens the ability of individual jurisdictions to deal with a financial crisis. The Asian financial crisis has certainly underlined the strategic need to build up foreign reserves as ammunition for possible (and perhaps, in these days of globalisation, probable) battles in the fight for monetary and financial stability. The way we defended ourselves during 1997-98 supported this view. But financial robustness is founded upon prudent macroeconomic policies, strong institutions and systems, and many other factors. The fact that the developed economies in Europe and North America are all down the list - some of them way down - illustrates this quite clearly, although the macroeconomic policies of some are not exactly unquestionable.

The amount of official foreign reserves of a particular jurisdiction has a lot to do with its exchange rate policy, as well as whether or not there are exchange controls. In general, when a central bank intervenes in the foreign exchange market to influence the path of the exchange rate, the amount of foreign reserves will be affected. For example, in a currency board system like the one we have in Hong Kong, the volume of foreign reserves is determined automatically by the operations in the foreign exchange market required to stabilise the exchange rate.

With exchange controls, in which all foreign exchange has to be bought from and sold to the exchange control authorities, an imbalance in international payments will lead to a change in the amount of official foreign reserves, with the extent of the change depending on the exact form of the exchange controls. For example, a current account surplus or a net positive foreign direct investment will lead to an equivalent increase in official foreign reserves. Official foreign reserves will also increase if the market expects an appreciation of the exchange rate, to the extent that market participants collectively switch their foreign currencies into the domestic currency or take a long position in the domestic currency. It is not difficult to see that a large current account surplus; large net inflows of foreign direct investments; and a flexible (but not freely floating) exchange rate policy, for which the authorities declare an objective of maintaining "relative" exchange rate stability in the light of strong political pressures for appreciation, will result in a rapid build-up of official foreign reserves. This is what has been happening on the Mainland.

The build-up of official foreign reserves is not necessarily a good thing, despite the comfort of having more ammunition in the monetary armoury. Corresponding to the foreign reserves on the asset side of the balance sheet of the central bank, there are liabilities in the domestic currency, typically in the form of a large monetary base, or more precisely a large aggregate balance of the banks from which the foreign reserves were bought. This is "high-powered" money. An abundance of liquidity in the banking system encourages credit creation and monetary expansion, which may lead to inflation. The liquidity can be siphoned off the interbank market, as central banks often do, through the "sterilisation" process, in which the liquidity is substituted by other central bank liabilities such as debt issued by the central bank. However, this process can be quite costly. Although sometimes profits can be made if domestic interest rates are lower than the yield of the foreign reserves, this is unlikely in the longer term, particularly if the exchange rate is appreciating, meaning the value of the foreign reserves in domestic currency terms is likely to fall. The situation will be even more difficult if domestic interest rates need to be raised or kept high to cool an overheated economy because it will attract even more inflows and further increase the cost of sterilisation. There is also the difficult task of deciding what assets to hold with all those foreign reserves. Obviously there is a danger of putting too many eggs in one basket, when the scope for diversification may be limited. But this is a topic best left for another occasion.

Joseph Yam

8 June 2006

Click here for previous articles in this column.

Document in Word format

Latest inSight
Last revision date : 08 June 2006