Rapid accumulation of foreign reserves may complicate monetary management.
The accumulation of foreign reserves by emerging economies, particularly those in Asia, has been getting a lot of attention recently. The accumulation has been quite rapid over the ten years since the Asian financial crisis. This is, perhaps, understandable given the desire to build up a war chest to help deal with macroeconomic or financial instability. But questions have been raised about whether there is a limit to this accumulation and its impact on global finance. Associated with these questions is the call for greater flexibility in exchange rates to help reduce the large external imbalances that led to the accumulation of large foreign reserves in the first place. There have also been concerns about the management of large pools of foreign reserves, the so-called Sovereign Wealth Funds, and calls for controls to safeguard the national interests of the jurisdictions in which these funds are invested.
Interestingly, though, there have been encouraging signs of an orderly correction in the external imbalances in the past few years. Appreciation of the exchange rates of jurisdictions running large current-account surpluses may have helped, but the more important reason was probably the income effect. Economic growth in the emerging markets has been faster than that in the developed markets running current-account deficits, and this has encouraged consumption and investment, and therefore demand for imports, in the emerging economies. Hopefully this orderly correction will continue, although it is not clear how it will be affected by the current turbulence in the credit markets.
Something that is often overlooked is that the accumulation of foreign reserves incurs domestic costs in the form of greater difficulties in monetary management. The accumulation of foreign reserves has to be matched by an increase in liabilities in the domestic currency on the balance sheet of the central bank, initially in the form of larger balances in the clearing accounts held by the commercial banks with the central bank. To limit monetary expansion, the central bank has to “sterilise” these balances, by increasing the reserve requirement or issuing central bank paper, or both. The costs of sterilisation can be substantial, particularly when the interest rates of the domestic currency, together with the effect of the appreciation of the exchange rate, are higher than the rate of return on holding foreign assets. These costs serve to limit the desire to accumulate foreign reserves beyond the level considered to be prudent.
Whether the authorities should allow the exchange rate to appreciate to slow down or even reverse the accumulation of foreign reserves is debatable. The current-account balance is not necessarily sensitive to changes in the exchange rate and large movements could lead to macroeconomic and financial instability.
The impact of foreign-reserves accumulation on global finance should generally be favourable because the management of official reserves is usually more stable than the management of private capital. On the subject of securing the national interests of jurisdictions in which large amounts of funds are invested and the behaviour of the Sovereign Wealth Funds, this can be dealt with internationally through the promulgation of codes of conduct. The International Monetary Fund has been doing interesting work in this area.
It should be made clear that Hong Kong has not been accumulating foreign reserves. We run a rule-based, highly credible fixed-exchange-rate system. There is usually no need for intervention in the foreign-exchange market to maintain exchange-rate stability. To the extent that we run a current-account surplus, foreign assets are accumulated by the private sector, rather than the public sector.
Joseph Yam
28 August 2008
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