Asia’s Emerging Market Currencies are sliding as the coronavirus outbreak threatens to slow the region’s economy and drives outflows into the dollar.
Investors may consider the region’s copious foreign-exchange reserves to be a buffer against severe economic dislocation, capital flight and currency fluctuations. That would be a mistake.
Asia’s reserves have expanded vastly since the 1997-98 financial crisis to reach more than $5 trillion, 40% of the global total. Often cited as a strength, they may prove of limited value in any future crisis.
First, reserves aren’t profits. In addition to net export payments, they include foreign investment. The asset (reserve investments) is offset by a liability (the amount owed to foreign investors).
China is the world’s biggest holder of reserves, with $3.1 trillion as of the end of January. While that looks substantial in dollar terms, it considers only one side of the coin. Since 2009, growth in China’s foreign-exchange assets has tracked accumulated investment liabilities.
Based on International Monetary Fund criteria used to calculate the minimum required level of reserves, China needs around $3 trillion roughly what it has now. The IMF calculations factor in short-term foreign-denominated debt, portfolio liabilities, broad money supply and the cover necessary for trade payments. Similar vulnerabilities exist in Indonesia, India and South Africa, because foreign-currency, especially short-term, borrowing is high.
Some analysts have suggested that China could use its reserves to recapitalise the banking system, which is sure to be hit by the economic shutdown that authorities have imposed in an effort to slow the spread of the virus.
Assuming a level of bad debts comparable to that of the late 1990s, the losses and recapitalisation requirements would absorb around half or more of China’s total reserves.
That would leave the country’s foreign exchange chest below the IMF minimum
In addition, reserves can be volatile. Intervention to support a currency can reduce holdings rapidly, as the recent experience of Turkey and Argentina shows.
It is difficult to estimate unexpected outflows from disinvestment, an unwinding of carrying trades, exchange-traded fund redemptions or contingent payments such as collateral calls or derivative settlements. For example, potential claims on Chinese reserves from its Belt & Road Initiative and other international obligations are poorly understood.
Reserve investments are also difficult to realise. Most are in government bonds and other high-quality securities denominated in so-called G3 currencies the U.S. dollar, euro and Japanese yen.
The size of the holdings means that governments couldn’t sell them without a collapse in the price of assets such as U.S. Treasuries and the dollar. That would inflict large losses on Asian investors.
Granted, many central banks have expanded the type of assets they buy. China has redirected its reserves into real investments in advanced economies and strategic projects such as Belt & Road.
However, these aren’t liquid and are risky. China faces challenges in obtaining repayment of loans to developing countries. Such investments are also exposed to potential interference by the host country, especially during geopolitical or trade conflicts.
A further drawback of using reserves is that managing their currency and domestic liquidity effects is cumbersome. Repatriating realised reserves will force the domestic currency to appreciate, decreasing the nation’s international competitiveness. It will also reduce the value of foreign investments when measured in a country’s home currency.
Large-scale accumulation and spending of reserves affect the money supply. While central banks can manage this through sterilisation operations, conflicts between reserve management and monetary policy objectives will create economic and financial instability.
Finally, the economic model underlying the reserves creates a complex financial interdependence between Asian central banks and advanced economies, termed the “fatal embrace” by the late Paul Volcker, former chairman of the Federal Reserve.
Foreign Exchange reserves represent advances allowing the importing country to buy the exporter’s goods and services on credit. Withdrawing support would risk destroying the value of existing investments and damaging the borrowers’ real economy and export demand.