challenges and opportunities in managing foreign exchange reserves

1

Challenges and Opportunities in Managing Foreign Exchange Reserves

S. Ghon Rhee, Ph.D.S. Ghon Rhee, Ph.D.K. J. Luke Distinguished Professor of Finance K. J. Luke Distinguished Professor of Finance

Executive DirectorExecutive DirectorAsia-Pacific Financial Markets Research CenterAsia-Pacific Financial Markets Research Center

University of HawaiUniversity of Hawai‘‘ii

The 5th Seoul International Financial ForumApril 27-28, 2004, Seoul, Korea

Asia-Pacific Financial Markets Research Center, University of Hawaii

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Capital Flows to Asia+

20012001 20022002 2003*2003* 2004**2004**

Current Account BalanceCurrent Account Balance 48.248.2 71.9 73.4 56.9 71.9 73.4 56.9Direct Foreign InvestmentDirect Foreign Investment 51.7 55.9 55.7 59.851.7 55.9 55.7 59.8Portfolio InvestmentPortfolio Investment 12.4 2.6 27.7 25.212.4 2.6 27.7 25.2Private CreditsPrivate Credits -13.1-13.1 6.3 27.9 11.7 6.3 27.9 11.7Official Capital FlowsOfficial Capital Flows -8.1 -15.5 -12.6 -5.4-8.1 -15.5 -12.6 -5.4Resident Lending/Errors &Resident Lending/Errors &OmissionsOmissions -20.9 -9.5-20.9 -9.5 15.0 15.0 -5.6-5.6Total InflowsTotal Inflows 70.3 111.9 187.1 142.570.3 111.9 187.1 142.5

** EstimateEstimate**** ForecastForecast++ China, India, Indonesia, Korea, Malaysia, Philippines, ThailandChina, India, Indonesia, Korea, Malaysia, Philippines, Thailand

Source: Institute of International Finance Source: Institute of International Finance (2004)(2004)

US$ BillionUS$ Billion


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Increasing Capital Inflowsto the Region

Not Necessarily Good News Not Necessarily Good News

a. Appreciate the local currencya. Appreciate the local currencyb. Undermine the competitiveness of b. Undermine the competitiveness of

export industries export industries c. Cause inflation to rise c. Cause inflation to rise d. Too much liquidity encourages d. Too much liquidity encourages over-investment and overheating over-investment and overheating of the economyof the economy


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Case In Point: Challenges Facing People’s Bank of China

Foreign Exchange Reserves: Increased by $120 billion in 2003Foreign Exchange Reserves: Increased by $120 billion in 2003 Speculative Hot Money ($25 - $40 billion): Happy Depositors in Speculative Hot Money ($25 - $40 billion): Happy Depositors in

RMB AccountsRMB Accounts Reckless Lending: Major Concern Given Too Much Liquidity in Reckless Lending: Major Concern Given Too Much Liquidity in

the Banking Sectorthe Banking Sector Issuance US$-Denominated domestic bonds: Under PlanIssuance US$-Denominated domestic bonds: Under Plan PBOC issued its short-term notes in amount of 1 trillion RMB or PBOC issued its short-term notes in amount of 1 trillion RMB or

US$121 billion so far to reduce liquidity since its introduction in US$121 billion so far to reduce liquidity since its introduction in 2003; Increase Discount Rate (2% to 2.5%); Increase Reserve 2003; Increase Discount Rate (2% to 2.5%); Increase Reserve requirements (6% to 7% in Sept 2003 and to 7.5% for weak banks requirements (6% to 7% in Sept 2003 and to 7.5% for weak banks in March 2004)in March 2004)

Open Market Operations: Now twice a week since Feb. 25, 2003Open Market Operations: Now twice a week since Feb. 25, 2003


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Dilemma for Central Banks

a.a. Drives up short-term interest ratesDrives up short-term interest rates

b.b. Encourages further capital inflowsEncourages further capital inflows

c.c. More Pressure on Currency AppreciationMore Pressure on Currency Appreciation

d.d. Heavy burden on government debt Heavy burden on government debt servicing costservicing cost

Deepening conflicts between monetary Deepening conflicts between monetary policy and fiscal policy implementationpolicy and fiscal policy implementation

Tight Monetary PolicyTight Monetary Policy


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Separation of Government Debt Management from Monetary and Fiscal Policies

Fiscal PolicyFiscal Policy

MonetaryPolicy

MonetaryPolicy

GovernmentDebt Mgmt

GovernmentDebt Mgmt

Aggregate DebtAggregate Debt

Optimal Cost/Risk Trade-off

Optimal Cost/Risk Trade-off

Price StabilizationPrice Stabilization


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Open Market Operations with Fully-Developed Government Bond Market

1.1. The central bank can expand or contract bank The central bank can expand or contract bank reserves and money supply and transmit its policy reserves and money supply and transmit its policy signaling through open market operationssignaling through open market operations

2.2. Two Alternatives in Setting:Two Alternatives in Setting: a.a. Target Amount of Bank Reserves with Short-Term Target Amount of Bank Reserves with Short-Term Interest Interest Rate Fluctuating Rate Fluctuating

b.b. Target Short-Term Interest Rate with Bank Reserves Target Short-Term Interest Rate with Bank Reserves Fluctuating Fluctuating

With well-functioning government bond markets, second With well-functioning government bond markets, second alternative becomes the norm among industrialized countriesalternative becomes the norm among industrialized countries

3.3. Open Market Operations: Open Market Operations: Secondary MarketSecondary Market

Government Debt Management:Government Debt Management: Primary MarketPrimary Market


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Open Market Operations with Under-Developed Government Bond Market1.1. Capital Inflows are Sterilized as part of Open Market Capital Inflows are Sterilized as part of Open Market

OperationsOperations2.2. Central BanksCentral Banks prefer s prefer short-term or floating-rate hort-term or floating-rate

domestic debt; inflation-indexed bonds; and foreign domestic debt; inflation-indexed bonds; and foreign currency debtcurrency debt

3.3. Government Debt Management OfficesGovernment Debt Management Offices do not do not prefer these instruments due to rollover risk triggered prefer these instruments due to rollover risk triggered by external shocksby external shocks

4.4. Rollover RiskRollover Risk Emerges as the Main Concern while Emerges as the Main Concern while Market Risk Remains Important and Market Risk Remains Important and Conflicts DeepenConflicts Deepen between monetary policy and government debt between monetary policy and government debt managementmanagement


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Alternative Policies to Sterilization 1.1. Fiscal AdjustmentFiscal Adjustment2.2. Switch Government Deposits from Commercial Banks Switch Government Deposits from Commercial Banks

to Central Banksto Central Banks3.3. Ease Restrictions on Capital OutflowsEase Restrictions on Capital Outflows4.4. Flexible Exchange Rate RegimeFlexible Exchange Rate Regime5.5. Accelerate Trade LiberalizationAccelerate Trade Liberalization6.6. Variable Reserve Requirements on Certain Categories Variable Reserve Requirements on Certain Categories

of Foreign Borrowingof Foreign Borrowing7.7. Develop Long-Term Government Bond MarketsDevelop Long-Term Government Bond Markets

But All of Them Represent Slow ProcessesBut All of Them Represent Slow ProcessesExcept Alternative No. 2Except Alternative No. 2


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Foreign Exchange Reserves(As of March 2004)

Japan US$826.6 billionChina 439.8Taiwan 226.5Korea 163.6Hong Kong 123.8India 110.3Singapore 102.8 (Preliminary)Germany 94.5 (as of February)United States 84.7 Russia 83.7-------------------------------------------------------------------------------------Malaysia 51.3Thailand 42.9Philippines 15.7------------------------------------------------------------------------------------- Total ( 10 Asian Economies) $2,103.3


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Foreign Holdings of US Securities

by Selected Asian Economies (June 2002)


TotalTotal CommonCommonStocksStocks

TreasuryTreasuryBondsBonds

Gov't Gov't AgencyAgencyBondsBonds

Corp. &Corp. &Muni Muni

BondsBondsTreasuryTreasury

BillsBills

ChinaChina 181.48 181.48 4.03 4.03 95.20 95.20 58.61 58.61 10.90 10.90 12.74 12.74

Hong KongHong Kong 84.16 84.16 15.33 15.33 37.45 37.45 12.38 12.38 4.75 4.75 14.26 14.26

JapanJapan 636.94 636.94 118.59 118.59 259.89 259.89 88.08 88.08 62.82 62.82 107.56 107.56

KoreaKorea 43.94 43.94 0.48 0.48 30.59 30.59 7.63 7.63 1.10 1.10 4.14 4.14

MalaysiaMalaysia 9.65 9.65 0.37 0.37 6.10 6.10 2.61 2.61 0.23 0.23 0.33 0.33

TaiwanTaiwan 70.0470.04 4.754.75 34.49 34.49 25.3025.30 2.95 2.95 2.55 2.55

ThailandThailand 18.0818.08 0.220.22 12.7812.78 0.030.03 0.110.11 4.944.94

TotalTotal 1044.281044.28 143.78143.78 476.48476.48 194.64194.64 82.8582.85 146.53146.53

US$ BillionUS$ Billion

Source: US Department of TreasurySource: US Department of Treasury

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Foreign Holdings of US Treasury Securities US$ BillionsUS$ Billions 20042004 20032003 20022002 20012001 20002000

#*#* EconomyEconomy FebFeb DecDec DecDec DecDec DecDec

11 JapanJapan 607.90 607.90 545.20 545.20 378.10 378.10 317.90 317.90 317.70 317.70 22 ChinaChina 145.00 145.00 149.20 149.20 118.40 118.40 78.60 78.60 60.30 60.30 33 United KingdomUnited Kingdom 137.30 137.30 113.30 113.30 80.80 80.80 45.00 45.00 50.20 50.20 44 Caribbean Econs. Caribbean Econs. 74.10 74.10 69.10 69.10 49.50 49.50 33.60 33.60 37.40 37.40 55 Hong KongHong Kong 61.00 61.00 57.50 57.50 47.50 47.50 47.70 47.70 38.60 38.60 66 TaiwanTaiwan 50.60 50.60 46.30 46.30 37.40 37.40 35.30 35.30 33.40 33.40 77 GermanyGermany 45.70 45.70 44.80 44.80 37.30 37.30 47.80 47.80 49.00 49.00 88 OPECOPEC 43.40 43.40 44.50 44.50 50.30 50.30 46.80 46.80 47.70 47.70 99 SwitzerlandSwitzerland 41.50 41.50 39.60 39.60 34.00 34.00 18.70 18.70 16.40 16.40 1010 KoreaKorea 37.10 37.10 43.40 43.40 38.00 38.00 32.80 32.80 29.60 29.60 1414 SingaporeSingapore 22.10 22.10 17.70 17.70 17.80 17.80 20.00 20.00 27.90 27.90 1818 ThailandThailand 14.70 14.70 11.00 11.00 17.20 17.20 15.70 15.70 13.80 13.80

Total 7 East Asian Total 7 East Asian countriescountries 938.40 938.40 870.30 870.30 654.40 654.40 548.00 548.00 521.30 521.30

Grand TotalsGrand Totals 1629.60 1629.60 1531.10 1531.10 1238.60 1238.60 1040.10 1040.10 1015.20 1015.20

-Of which official-Of which official 947.80 947.80 893.90 893.90 763.10 763.10 619.40 619.40 609.20 609.20 *Rankings are of the year of 2004. Source: US Department of Treasury *Rankings are of the year of 2004. Source: US Department of Treasury wwwww.treas.gov/tic/mfh.txt


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Utilization of Reserves for Various Purposes

a.a. KoreaKorea$20 billion investment in Korea Investment $20 billion investment in Korea Investment

Corporation Corporation

b.b. ChinaChina$45 billion diverted for Restructuring of State Banks$45 billion diverted for Restructuring of State BanksAdditional $40 billion for the same purpose?Additional $40 billion for the same purpose?

c.c. ThailandThailandUnspecified amount diverted to buy machinery or license Unspecified amount diverted to buy machinery or license intellectual property for local corporationsintellectual property for local corporations

d.d. Taiwan Taiwan $10 billion allocated to banks to participate in major investment $10 billion allocated to banks to participate in major investment projects relating to overall domestic economic development projects relating to overall domestic economic development


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Korea Investment Corporation

a.a. Capital:Capital:$20 billion from the BOK’s FX reserves; $20 billion from the BOK’s FX reserves;

Additional capital may be drawn if reserves Additional capital may be drawn if reserves reach $200 billion reach $200 billion

b.b. “Cashing Contract”:“Cashing Contract”:KIC’s assets be cashed when necessary KIC’s assets be cashed when necessary upon request from BOKupon request from BOK

c.c. Initial Investment: Initial Investment: Financial AssetsFinancial Assets d.d. Critical Vehicle: Critical Vehicle:

To Attract Global Asset Management To Attract Global Asset Management CompaniesCompanies


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Bank of Korea’s Current Reserve Management (I)


Three-Tranche Approach

Purpose Benchmark

Liquidity Tranche Liquidity Demand Deposits and US Treasury Securities (Short-term)

Investment Tranche Higher Returns JP Morgan Government Bond Index Adapted

Trust Tranche Outsourcing Lehman Brothers Global Aggregate Index and US Intermediate Government and Corporate Index

Source: IMF (2003)Source: IMF (2003)

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Bank of Korea’s Current Reserve Management (II)

Investment InstrumentsInvestment Instrumentsa.a. Marketable Securities:Marketable Securities:

sovereign bonds, government agency bonds, MDI-issued sovereign bonds, government agency bonds, MDI-issued bonds with AA-rated or higherbonds with AA-rated or higher

b.b. Deposits: Deposits: Only with financial institutions with credit ratings of A or Only with financial institutions with credit ratings of A or aboveabove

c.c. Outsourced Assets: Outsourced Assets: May include corporate bonds, ABSs, and MBSs with AA May include corporate bonds, ABSs, and MBSs with AA ratings or higherratings or higher

Differences between KIC’s management and Differences between KIC’s management and BOK’s management?BOK’s management?


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Major Operational Policy Issues with KIC (I)1.1. Is KIC’s Operation Part of Foreign Exchange Is KIC’s Operation Part of Foreign Exchange

Reserve Management?Reserve Management?a.a. If yes, then the relation between MOFE and If yes, then the relation between MOFE and

BOK vis-a-vis KIC? BOK vis-a-vis KIC? b.b. If not, the integrity of foreign exchange If not, the integrity of foreign exchange

reserve management may be reserve management may be questioned.questioned.

2.2. Governance System of KIC?Governance System of KIC?a.a. Transparency Transparency

b.b. Accountability and Assurances of KIC’s Accountability and Assurances of KIC’s integrityintegrity


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Major Operational Policy Issues with KIC (II):

c.c. Lack of Transparency and AccountabilityLack of Transparency and Accountability

1.1. Fiscal Investment and Loan Program of JapanFiscal Investment and Loan Program of Japan

Assets:Assets: US$3.67 trillionUS$3.67 trillionLoans:Loans: US$2.88 trillionUS$2.88 trillion Extended to: Extended to: (i) FILP-Dependent Enterprises*; (i) FILP-Dependent Enterprises*;

(ii) Municipal Governments; and (ii) Municipal Governments; and (iii) (iii) Government-Owned BanksGovernment-Owned Banks

* Transportation, Education, Utilities, Housing, Roads, * Transportation, Education, Utilities, Housing, Roads, Bridges, Airports, SMEsBridges, Airports, SMEs

Sources of Funds: Sources of Funds: Postal Savings Deposits Postal Savings Deposits Employees’ Insurance DepositsEmployees’ Insurance Deposits

75% of FILP Loans are Non-Performing & Estimated Losses = 75% of FILP Loans are Non-Performing & Estimated Losses = ¥75 ¥75 trillion ( = US$680 billion) or 15% of GDP trillion ( = US$680 billion) or 15% of GDP [Doi and Hoshi (2002, [Doi and Hoshi (2002,

NBER)]NBER)]


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Major Operational Policy Issues with KIC (III): 2.2. Temasek Holdings Ltd. (Singapore)Temasek Holdings Ltd. (Singapore)

Singapore’s Ministry of Finance-owned investment arm Singapore’s Ministry of Finance-owned investment arm controlling more than 20% in 22 major local companiescontrolling more than 20% in 22 major local companiesTotal investment Total investment > US$130 billion> US$130 billion over 30 years over 30 yearsIts financial statement will be disclosed to the public for the Its financial statement will be disclosed to the public for the first time in its 30 year history first time in its 30 year history

3.3. Government Investment Corporation of SingaporeGovernment Investment Corporation of Singapore Total Fund under Management > US$100 billionTotal Fund under Management > US$100 billion

i.i. Government of Singapore Investment Government of Singapore Investment Corporation Pte Ltd.Corporation Pte Ltd.

ii.ii. GIC Real Estate Pte Ltd.GIC Real Estate Pte Ltd.iii.iii. GIC Special Investments PteGIC Special Investments Pte

Very little is known about its financial status Very little is known about its financial status


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Major Operational Policy Issues with KIC (IV):

4.4. Khazanah Nasional Berhad (Malaysia)Khazanah Nasional Berhad (Malaysia)6 subsidiaries6 subsidiaries18 associates18 associates13 investments13 investments

No information on its performanceNo information on its performance

5.5. The Minister of Finance (MOF) Inc. The Minister of Finance (MOF) Inc. (Malaysia)(Malaysia)No information on its performanceNo information on its performance


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Major Operational Policy Issues with KIC (VI)3.3. Reserve AdequacyReserve Adequacy

a.a. Money Supply-Based Approach Money Supply-Based Approach (Ratio of Reserves to Money Supply):(Ratio of Reserves to Money Supply): Poor measure of capital flight Poor measure of capital flight Poor predictor of currency crisisPoor predictor of currency crisis

b.b. Current Account-Based Approach Current Account-Based Approach (Reserves in Months of Imports):(Reserves in Months of Imports):Relevant for Small Economies?Relevant for Small Economies?Poor predictor of currency crisis for Open Poor predictor of currency crisis for Open

EconomiesEconomiesc.c. Capital Account-Based Approach Capital Account-Based Approach (Ratio of Reserves to Short-term (Ratio of Reserves to Short-term

External Debt)External Debt)Better measure for Economies with significant but Better measure for Economies with significant but

uncertain access to international capital uncertain access to international capital market? market?

d.d. Combination of current and capital account approaches Combination of current and capital account approaches


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Reserve Adequacy: Korea’s Reserves and External Debt (November 2003)


Source: Asian Development BankSource: Asian Development Bank

Thank You!For Further References,

Please visit http://www2.hawaii.edu/~rheesg


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Asian Stock Market Performance(Annual Return)


1995-20001995-2000 20012001 20022002 20032003 2004:1stQ2004:1stQ

ChinaChina 27.61% 27.61% -21.89%-21.89% -17.13%-17.13% 10.57% 10.57% 16.4%16.4%

Hong KongHong Kong 13.01 13.01 -24.50-24.50 -18.21-18.21 34.92 34.92 0.840.84

IndonesiaIndonesia -2.38-2.38 -5.83-5.83 8.398.39 62.82 62.82 6.336.33

Japan Japan -7.05-7.05 -23.52-23.52 -18.63-18.63 24.4524.45 9.739.73

KoreaKorea -13.25-13.25 37.47 37.47 -9.54-9.54 29.19 29.19 8.618.61

MalaysiaMalaysia -6.89-6.89 2.42 2.42 -7.15-7.15 22.84 22.84 13.5913.59

PhilippinesPhilippines -11.71-11.71 -21.84-21.84 -12.81-12.81 41.63 41.63 -1.25-1.25

SingaporeSingapore -2.96-2.96 -15.74-15.74 -17.40-17.40 31.5831.58 5.355.35

TaiwanTaiwan -7.81-7.81 17.02 17.02 -19.79-19.79 32.3032.30 10.7210.72

ThailandThailand -27.67-27.67 12.88 12.88 17.3217.32 116.60 116.60 -16.17-16.17

USA(DJIA)USA(DJIA) 16.0816.08 -7.10-7.10 -16.76-16.76 25.3225.32 -0.92-0.92

challenges and opportunities in managing foreign exchange reserves

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