Asia Pacific: Forex Reserves May Decline Sharply
Andy Xie (Hong Kong)
Morgan Stanley
Jun 08, 2004
Speculative capital inflows could account for US$700 billion of Asia’s US$2.2 trillion in forex reserves. Financial markets became super bullish towards Asia, mainly on China’s elevated growth paradigm, and bought Asian assets on a massive scale in the past two years. The exceptionally low Fed Funds rate was a major push factor behind the enthusiasm toward Asia. When the Fed raises interest rates, a significant portion of the speculative capital inflow could be withdrawn from the region. Only then will we find out where the sustainable level of demand for Asian assets lies.
As foreign capital is withdrawn from the region, real interest rates would turn positive in Asia within two to three quarters, in my view. Asian central banks will have to increase interest rates with the Fed or face weakening currencies and rising inflation. A number of economies may have to raise interest rates more than the Fed in order to keep money at home.
Asian Forex Reserves Have Peaked
Asian forex reserves have decoupled from trade since the beginning of 2002. Between 1Q02 and 1Q04, the total forex reserves in Asia surged by US$1,029 billion compared to US$406 billion in trade surplus. Japan accounted for 42.7% of the increase, China 26.5%, Taiwan 10.1%, India 6.6%, and Korea 5.9%.
Exhibit 1
Asia: Capital Inflow Has Supercharged Forex Reserves
Trade Forex Reserve
(US$ Billions) Balance Increase
1980-89 400 238
1990-97 571 478
1998 233 58
1999 215 154
2000 186 122
2001 129 116
2002 175 238
2003 193 510
1Q04 38 281
Source: CEIC
Note: Asia includes China, Hong Kong, Taiwan, Korea, Japan, Indonesia, Malaysia, Philippines, Singapore, Thailand and India.
Asian forex reserves probably peaked in 2Q04. Declining values of US treasuries or dollar strength may have contributed to some of the weakness. But the evidence suggests that the surge in Asian forex reserves has stopped. As the Fed raises interest rates in the third quarter, it is quite likely that forex reserves would decline across the region.
Whose Money Is It Anyway?
Asia is a region with capital surplus; its trade surplus was US$1.5 trillion vs. a US$1.6 trillion increase in foreign reserves between 1994 and 2003. The relatively balanced picture hides the reason why the region has trade surpluses. There are two centers for accumulating trade surpluses – the economies of China and Japan. Japan’s surplus is due to its deflation; with interest rates at zero and the fiscal deficit at maximum, Japan could only improve its economy through currency depreciation.
The pressure to de-industrialize is the source of Japan’s deflation, in my view. Because Japan hasn’t been able to create a growth model for a post-industrial economy, its deflation can end only after all the capital surplus from de-industrialization has been exported. It appears that Japan’s capital surplus from de-industrialization has peaked. Japan accounted for 96% of Asia’s trade surplus between 1994 and 1998, but 49% between 1999 and 2003.
Two factors drive the surpluses of Chinese economies. First, political uncertainty could spark a currency crisis in a Chinese society. The central banks of Chinese economies usually demand large forex reserves as a hedge against political uncertainty. Second, because the rule of law tends to be poor in Chinese societies, the demand for a wealth safe haven (i.e., claims on US-based assets) is very high.
This is why Asian forex reserves usually rise less than trade surpluses. Between 1982 and 2001, Asia’s forex reserves rose by US$1.1 trillion compared to US$1.8 trillion in trade surpluses. One would naturally suspect that the recent capital inflow was really Asian money coming home.
To some extent, that was correct. China’s forex reserves increased by $273 billion between 4Q01 to 1Q04. “Chinese Chinese” money probably accounted for half of the increase; Chinese banks decreased their net foreign asset and Chinese households stopped accumulating foreign deposits. The other half mostly came from overseas Chinese who speculated in China’s currency and properties. Many overseas Chinese businesses exaggerated their exports from China to bring in the money for currency speculation.
Just because local money comes back doesn’t mean that it is not speculative and would stick around. The intention behind this capital is to profit from capital appreciation either from stocks, properties, or currencies. This sort of capital isn’t here for the long term and will leave either when expectations for Asian assets reverse or the Fed increases interest rates. At the end of the day, this money left Asia for wealth diversification due to the lack of protection for private wealth. This reason is still valid. The speculative enthusiasm that drove this money back would dissipate as money becomes less cheap.
Asset reallocation by global funds and others and carry trade by hedge funds have been the other sources of capital inflow. The former has probably accounted for one-third of the capital inflow and the later 15-17%, in my estimation. Both are not long-term capital, in my view. Global or international funds massively increased weightings in Asia on China optimism in 2H03. But, the optimism mistook China’s cyclical overshooting for a new secular trend. As China cools its economy, the market would adjust its expectations accordingly, which would cause global funds to decrease their weighting for Asia.
The low US interest rate and the expectation for renminbi appreciation drove the carry trade in Asia. The Japanese yen, in particular, was the most important target. Other Asian currencies were also used as proxies for the renminbi. The carry trade was extended to Asian equities as the Asian central banks refused to budge under the inflow. A significant portion of the carry trade has been unwound. It was probably the main reason for the weak performance in Asian forex reserves. A 70% reduction in the appreciation expectation for the renminbi is another indicator. However, much still remains. In particular, the bullish sentiment towards Japan still ties down quite a lot of money in the long-yen, long-Nikkei and short-JGB trades.
Does It Matter?
Does it matter if a country’s forex reserves decline? It always matters, in my opinion. It implies tightening in financial conditions that would manifest in higher interest rates or a lower exchange rate. The magnitude of the impact depends on how much capital inflow has been sterilized.
When forex reserves rise, it normally implies that money supply accelerates. When the money is lent out, it increases demand and causes inflation. If the money is lent for investment, it causes the economy to reallocate resources to investment from consumption. The resulting inflation is usually a tax on the people, i.e., consumption prices rise faster than wages.
When the forex reserves stagnate or decline, excess credit creation stops or reverses. As many investment projects have already begun under the loose liquidity environment, there wouldn’t be enough money to finish these projects. Hence, balance sheet pressure would intensify and credit accidents proliferate. The economy would decelerate quickly as a result.
If a central bank sterilizes capital inflow by issuing bonds to control money supply, it could prevent an investment bubble but may trigger a price bubble in the stock or property market. The sterilization causes the currency to be undervalued and negative real interest rates, which would cause leverage to rise in the economy anyway, even without rapid investment growth. Hong Kong, for example, was mainly a price bubble before 1997. Thus, sterilization is not a panacea. If asset markets have risen a lot with the forex reserves, they will likely reverse when the forex reserves begin to decline. The resulting wealth effect would have a significant impact on the economy.
Hence, rapidly increasing forex reserves will either cause an investment bubble, if the inflow is not sterilized, or a price bubble, if the inflow is sterilized, in my view. When the reserves decline, the economic impact would be big in either case.
When Does the Adjustment End?
Asia has been experiencing a liquidity bubble due to the Fed keeping interest rates low for three years. The unwinding is just beginning, in my view. Capital outflow will be a necessary byproduct of this adjustment. Asia’s forex reserves could decline by US$350 billion or more for the adjustment to be complete, as the trade surpluses and capital-raising activities could make up for half of the excess forex reserves. The adjustment will take 12-18 months, in my view.
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