'Reserve' for the Rainy Day!
Foreign Exchange Reserves, though primarily serves the purpose of stabilization of a country’s exchange rates, is now increasing seen as a messiah to overcome a global crisis like the recent one. Various empirical evidences show that countries with higher level of reserves are better able to withstand panics in global financial markets and sudden reversal of capital flows. Anecdotal evidences even suggest that the countries with very high reserve base (viz. India and China) would actually wither the recession faster than any others. During periods of extreme uncertainty, reserves can be used to pay off short-term debt obligations or for that matter even purchase of essential imports.
The obvious question is why? More because, most of these reserves are invested into risk free instruments with sovereign guarantees, which yields almost nothing and thus comes with a huge opportunity cost attached with it. People argue that this is because of the self-insurance that the country wants to subscribe to, during recessionary times.
I concur. And I take you back to the 1997 Asian crisis in support of this.
During the month of July 1997, when the asset prices started crashing, there was a sudden reversal of capital flows and all the domestic Fx markets were flooded with local currencies thereby hugely depreciating it. During H2-97, the currency depreciations were Indonesia – 83%, Thailand – 53%, Korea – 46%, Malaysia – 45%, Philippines 32% and Singapore – 19%. All the central banks thus had to intervene in order to provide emergency support to their currencies.
The cumulative reserves for the worst affected countries during the month of July 1997 was around USD250bn, and in the succeeding 3 months, the total drop in reserves were by USD50bn (nearly 20% of total). This shows the desperation from the countries to help stop their currencies get devalued further. Not to forget that intervention in the Fx market was not the only instrument the central banks had used, they had also simultaneously raised their interest rate to very high levels. Bank of Indonesia maintained its benchmark rate at around 60-70% during this time. Such interest levels actually added to the woes and the impact on growth were severe. The heavy depreciation of the currencies also meant a huge rise in the foreign liabilities of these countries, when expressed in domestic currency terms causing bankruptcies and further deepening of the crisis.
Figure 2: % drop in the immediate 3 months
Figure 2: % drop in the immediate 3 months
The important thing to note is that such huge depreciations happened in spite of the huge reserve outgo. Obviously there seems to be room for more dilution of reserves as hardly around 40% were used in the worst cases (Philippines and Korea), but reason why the central bank stopped any further fall was the level of short-term debt and amount of essential imports during that time. The below table would prove this.
End 1996 | End 2008 | |||
STD/Res | Import Cover | STD/Res | Import Cover | |
China | 0.1 | 9.1 | 0.1 | 20.6 |
Korea | 2.3 | 2.6 | 0.8 | 5.5 |
Malaysia | 0.4 | 4.0 | 0.3 | 6.5 |
Philippines | 73.1 | 0.1 | 7.1 | 0.2 |
Thailand | 1.3 | 6.2 | 0.2 | 7.3 |
Indonesia | 1.9 | 5.0 | 0.02 | 4.6 |
Source: IMF, BIS and central banks
It is evident that for a country like Philippines, whose short-term debt obligations (maturing within 1 year) was 70 times the reserve it had at that time, and there was no way it could have used its reserves than the 40% it already did. Leaving aside China, for all the others, even before the crisis stepped in, the short-term external debt was much higher than what they have in reserves with their central banks. The scenario is completely different now though. Unprecedented rise in reserves has now given a much needed ‘feel-good factor’ to these countries and accordingly they are better prepared for any such repetition of a crisis.It is evident that these countries have piled up their reserves just to insulate themselves from any external shocks and the earlier theory of maintaining a level to account for the short-term debt repayments or essential imports (or current account transactions) doesn’t hold good anymore. The above table confirms a much better scenario for these countries, though the level of reserves is far too high, than the threshold/comfort level, but central banks would still like to enjoy the luxury as well as security, albeit paying a price. They still enjoy an insurance cover, can raise the sovereign credit ratings, provide higher stability to their currencies, and above all have a self sustained bailout package, which can avoid a repeat of the 1997 crisis.
The Asian Tigers have every reason to roar!
