Imploding Euro, Exploding Foreign Reserves

by Alaistair Chan, Moody’s Analytics, 17 June 2010

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Rising foreign reserves in Asia represent a surplus of savings.
Reduced reserve accumulation could weaken the euro and dollar, but this would be a positive development.
Stronger currencies in Asia will not slow growth if accompanied by greater investment.

Sovereign debt troubles in Europe have led to rumours that holders of foreign exchange reserves could shift out of euro-denominated securities, which would lower the euro’s value dramatically and compound European countries' troubles in financing their debt. Asian officials in charge of foreign reserves have insisted no such shift will happen, but there would be potential benefits if Asian countries such as China accumulated reserves more slowly.

Asia holds the biggest proportion of the world’s foreign reserves, and they have surged in recent years. Asia's nine biggest reserve holders collectively hold around US$5 trillion of the world's $8.4 trillion in foreign reserves. China holds the most and accounts for most of the growth in reserves, but reserves have also grown from a low base in other countries. Moreover, these official reserves exclude those held by sovereign wealth funds and, in the case of China, by state banks and companies.

Asian countries' main rationale for accumulating foreign reserves is safety. After the 1997 financial crisis, Asia began building substantial foreign reserves as an insurance policy, and despite Asia’s rapid development and improved regulation and economic policy since then, reserves are still helpful in times of market uncertainty.

South Korea used a quarter of its reserves in 2008 to supply liquidity to firms that had borrowed in dollars and needed to roll over loans. The governor of the Bank of Korea recently stated that South Korea’s foreign reserves, the sixth largest in the world at US$279 billion in April, are still inadequate.

Given this risk aversion, it is conceivable that countries will reallocate their portfolios away from the sovereign debt of some European nations. The Bank of Korea has noted that the debt of some European nations lowers the euro's attractiveness as a reserve currency, although that view has been countered by Chinese officials.

However, a shift into dollars would re-concentrate risk. Although Asian foreign reserve funds began shifting away from the dollar and towards the euro around 2003, dollar holdings remain the biggest portion for most countries; an estimated 70% of China's reserves are dollar-denominated. Despite their desire to diversify away from the dollar and Europe's debt problems, Asia's foreign exchange managers have few options that could accommodate the large amount of reserves their policies generate.

What to do with all this money?

Slower accumulation of foreign reserves would be a positive development for the world economy. A sustainable global recovery is likely to require stronger Asian currencies and weaker currencies in the developed world, which would raise net exports in the U.S. and Europe and cool inflation pressures in Asia.

Assertions that Asia's foreign reserves are far higher than necessary find support when measured by traditional means such as the ratio of reserves to months of imports or reserves to percentage of external debt liabilities. Clearly, countries have a second reason for the build-up: keeping their currencies stable to promote exports.

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