09/02: When larger reserves may not really be good
Posted by: Raja Petra
New Straits Times
The argument that a nation’s foreign exchange reserves is a key indicator of its macroeconomic strength is a notion that is pitifully assailable, writes MOHAMED ARIFF.
THE size of foreign exchange reserves held by central banks the world over is often viewed by analysts, investors and policy-makers as a key indicator of macroeconomic strength. This notion is pitifully assailable, not only because inter-country comparisons are fraught with pitfalls, but also because the bigger-the-better argument does not hold water.
It does not necessarily mean that a country that has reserves double that of another is twice as secure. It will be meaningless to compare, for instance, Malaysia’s reserves with that of China’s. Malaysia’s reserves, which now stand at about US$82 billion (RM287 billion), pale in comparison with China’s which exceeds US$1 trillion.
However, Malaysia’s reserves are very sizeable by any standard. Its external reserves are equivalent to eight months of retained imports, which is substantial considering the fact that only a few countries in the world could have reserves equivalent to more than four months of retained imports.What is more, the value of Malaysia’s reserves is equal to six times that of its short-term external debt. In other words, Malaysia has much more reserves than it needs to cope with any exodus of short-term foreign capital of the magnitude seen in times of financial crisis.
Continuous reserve accumulation suggests that a country has a strong external sector with sizeable trade surpluses (exports exceeding imports) and more than comfortable current account surpluses, thanks to the recurrent trade surplus and/or sustained foreign capital inflows.Malaysia has been registering trade and current account surpluses continuously month after month since 1998, although foreign capital inflows have slowed considerably.
The persistent trade surplus can be interpreted differently. It can be taken as a sign of growing competitiveness of the economy in the international market place, an assertion that does not find support in the world competitiveness index. Even so, it is possible that Malaysia’s exports have remained competitive, but this competitiveness may be due not to rising productivity or falling costs but to undervalued exchange rates.
The sharp drop in the value of the ringgit from the July 1997 pre-crisis level to the pegged level of September 1998 until the de-pegging in 2005 must have made a huge difference to Malaysia’s exports.
The subsequent appreciation of the ringgit has been quite slow and somewhat marginal until recently in the wake of the marked depreciation of the greenback.There is consensus among analysts that the ringgit is still undervalued. It appears that the ringgit is on a tight leash. Understandably, the central bank is anxious to ensure that the currency appreciation is gentle and orderly, as any sharp appreciation of the ringgit would hurt Malaysia’s export prospects.
The argument that the competitiveness of Malaysian exports is heavily dependent on undervalued exchange rates rather than on productivity gains sounds very plausible and persuasive. It is, of course, dangerous to rely for long on a cheap currency for one’s export competitiveness. The question is, how long can this go on?
The answer would depend, at least in part, on foreign exchange reserves that Malaysia has been accumulating. Economic theory suggests that no country can go on amassing reserves and that there are limits that will force excess reserves to evaporate.According to the quantity theory of money, current account surpluses would enable traders and businessmen to convert their foreign exchange earnings into local currency, resulting in increased money supply and rising domestic prices. This, in turn, would cause exports to fall and imports to rise with growing current account deficits that would eat into the country’s external reserves.
Another theoretical construct suggests that increased money supply resulting from current account surpluses would cause interest rates to fall, thereby stimulating the economy through rising incomes and increased expenditures. Here again the upshot, according to this reasoning, would force the country’s reserves to deplete through increased demand for imports.
Economic theory also postulates that, under flexible exchange rates, large reserves would exert pressures on the domestic currency to appreciate to an extent that would reverse the current account surplus situation into a deficit state, again forcing the reserves to be downsized.Admittedly, the real world is far more complex than the simple textbook models. Yet, it would be foolish to treat all this simply as abstract stuff based on questionable assumptions that do not correspond to present-day realities.
Already, there are signs of excess liquidity, low interest rates and inflationary pressures that seem to conform to the above theoretical outcomes of the surge in the country’s external reserves, although these have not assumed alarming proportions.
It is comforting to note that all these are still within manageable limits so that Malaysia can continue on the current trajectory. It is hard to predict when the breaking point will come or to determine the optimum level for the external reserves, as this will vary not only from country to country but also from time to time. Much would also depend on the composition of the reserves.
Now that Bank Negara has diversified its reserves, significantly reducing its dollar holdings, as reported by Prime Minister Datuk Seri Abdullah Ahmad Badawi at the World Economic Forum in Davos recently, Malaysia’s reserves have become less vulnerable to further depreciation of the US dollar.
In other words, the ringgit is backed by quality reserves, a perception that would fuel expectations of further appreciation of the currency in the near term. One can therefore expect large speculative capital inflows into the country, which would raise the reserves further, in addition to lifting asset prices in the stock market.
This trend is likely to be reinforced by the reversals of fortune next door in Thailand, which has been shooting itself in the foot, inadvertently diverting capital flows into neighbouring countries. While all this may sound exciting for many Malaysians, care needs to be taken to avoid a deja vu.
The prognosis however looks somewhat frightening, with massive capital inflows, soaring reserves, strengthening currency and booming stocks, finally culminating in speculators cashing in on the strong ringgit and flying away to another destination.
To be sure, Malaysia is now better equipped to handle another crisis the next time around. In this regard, while large reserves provide much comfort in terms of solvency, the flip side is that these reserves themselves can become the target for speculative capital movements.Experience has shown that speculators tend to show interest in countries with big reserves.
Herein lies the danger of amassing reserves for the sake of it. In other words, it does not make economic sense to pursue huge reserves as a policy objective. It will be an exercise in futility, as excess reserves tend to be drained out one way or another, sooner or later.
A policy option would be to use the reserves to pay off external debts, encourage reverse investments and finance development projects, so as not to invite speculative attacks.
A robust domestic economy would also shift the focus from preoccupation with exports, current account surpluses and large reserves to internal dynamics that would drive imports closer to exports and the balance of payments closer to equilibrium with current account balance and stable external reserves.
Professor Emeritus Mohamed Ariff is executive director of the Malaysian Institute of Economic Research (MIER).
Sunday, February 11, 2007
09/02: When larger reserves may not really be good