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Challenges and Opportunities in Managing Foreign Exchange Reserves

Challenges and Opportunities in Managing Foreign Exchange Reserves. S. Ghon Rhee, Ph.D. K. J. Luke Distinguished Professor of Finance Executive Director Asia-Pacific Financial Markets Research Center University of Hawai ‘ i The 5 th Seoul International Financial Forum

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Challenges and Opportunities in Managing Foreign Exchange Reserves

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  1. Challenges and Opportunities in Managing Foreign Exchange Reserves S. Ghon Rhee, Ph.D. K. J. Luke Distinguished Professor of Finance Executive Director Asia-Pacific Financial Markets Research Center University of Hawai‘i The 5th Seoul International Financial Forum April 27-28, 2004, Seoul, Korea Asia-Pacific Financial Markets Research Center, University of Hawaii

  2. Capital Flows to Asia+ US$ Billion 200120022003*2004** Current Account Balance48.2 71.9 73.4 56.9 Direct Foreign Investment51.7 55.9 55.7 59.8 Portfolio Investment12.4 2.6 27.7 25.2 Private Credits-13.1 6.3 27.9 11.7 Official Capital Flows-8.1 -15.5 -12.6 -5.4 Resident Lending/Errors & Omissions-20.9 -9.5 15.0 -5.6 Total Inflows70.3 111.9 187.1 142.5 * Estimate ** Forecast + China, India, Indonesia, Korea, Malaysia, Philippines, Thailand Source: Institute of International Finance (2004) Asia-Pacific Financial Markets Research Center, University of Hawaii

  3. Increasing Capital Inflowsto the Region Not Necessarily Good News a. Appreciate the local currency b. Undermine the competitiveness of export industries c. Cause inflation to rise d. Too much liquidity encourages over-investment and overheating of the economy Asia-Pacific Financial Markets Research Center, University of Hawaii

  4. Case In Point: Challenges Facing People’s Bank of China • Foreign Exchange Reserves: Increased by $120 billion in 2003 • Speculative Hot Money ($25 - $40 billion): Happy Depositors in RMB Accounts • Reckless Lending: Major Concern Given Too Much Liquidity in the Banking Sector • Issuance US$-Denominated domestic bonds: Under Plan • 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 2003; Increase Discount Rate (2% to 2.5%); Increase Reserve requirements (6% to 7% in Sept 2003 and to 7.5% for weak banks in March 2004) • Open Market Operations: Now twice a week since Feb. 25, 2003 Asia-Pacific Financial Markets Research Center, University of Hawaii

  5. Dilemma for Central Banks Tight Monetary Policy a. Drives up short-term interest rates b. Encourages further capital inflows c. More Pressure on Currency Appreciation d. Heavy burden on government debt servicing cost Deepening conflicts between monetary policy and fiscal policy implementation Asia-Pacific Financial Markets Research Center, University of Hawaii

  6. Government Debt Mgmt Optimal Cost/Risk Trade-off Fiscal Policy Monetary Policy Aggregate Debt Price Stabilization Separation of Government Debt Management from Monetary and Fiscal Policies Asia-Pacific Financial Markets Research Center, University of Hawaii

  7. Open Market Operations with Fully-Developed Government Bond Market 1. The central bank can expand or contract bank reserves and money supply and transmit its policy signaling through open market operations 2. Two Alternatives in Setting: a. Target Amount of Bank Reserves with Short-Term Interest Rate Fluctuating b. Target Short-Term Interest Rate with Bank Reserves Fluctuating With well-functioning government bond markets, second alternative becomes the norm among industrialized countries 3. Open Market Operations: Secondary Market Government Debt Management:Primary Market Asia-Pacific Financial Markets Research Center, University of Hawaii

  8. Open Market Operations with Under-Developed Government Bond Market 1. Capital Inflows are Sterilized as part of Open Market Operations 2. Central Banks prefer short-term or floating-rate domestic debt; inflation-indexed bonds; and foreign currency debt 3. Government Debt Management Officesdo not prefer these instruments due to rollover risk triggered by external shocks 4. Rollover Risk Emerges as the Main Concern while Market Risk Remains Important and Conflicts Deepen between monetary policy and government debt management Asia-Pacific Financial Markets Research Center, University of Hawaii

  9. Alternative Policies to Sterilization 1. Fiscal Adjustment 2. Switch Government Deposits from Commercial Banks to Central Banks 3. Ease Restrictions on Capital Outflows 4. Flexible Exchange Rate Regime 5. Accelerate Trade Liberalization 6. Variable Reserve Requirements on Certain Categories of Foreign Borrowing 7. Develop Long-Term Government Bond Markets But All of Them Represent Slow Processes Except Alternative No. 2 Asia-Pacific Financial Markets Research Center, University of Hawaii

  10. Foreign Exchange Reserves(As of March 2004) Japan US$826.6 billion China 439.8 Taiwan 226.5 Korea 163.6 Hong Kong 123.8 India 110.3 Singapore 102.8(Preliminary) Germany 94.5 (as of February) United States 84.7 Russia 83.7 ------------------------------------------------------------------------------------- Malaysia 51.3 Thailand 42.9 Philippines 15.7 ------------------------------------------------------------------------------------- Total ( 10 Asian Economies) $2,103.3 Asia-Pacific Financial Markets Research Center, University of Hawaii

  11. Foreign Holdings of US Securities by Selected Asian Economies (June 2002) US$ Billion Source: US Department of Treasury • Asia-Pacific Financial Markets Research Center, University of Hawaii

  12. Foreign Holdings of US Treasury Securities *Rankings are of the year of 2004. Source: US Department of Treasury www.treas.gov/tic/mfh.txt • Asia-Pacific Financial Markets Research Center, University of Hawaii

  13. Utilization of Reserves for Various Purposes a. Korea $20 billion investment in Korea Investment Corporation b. China $45 billion diverted for Restructuring of State Banks Additional $40 billion for the same purpose? c. Thailand Unspecified amount diverted to buy machinery or license intellectual property for local corporations d. Taiwan $10 billion allocated to banks to participate in major investment projects relating to overall domestic economic development Asia-Pacific Financial Markets Research Center, University of Hawaii

  14. Korea Investment Corporation a. Capital: $20 billion from the BOK’s FX reserves; Additional capital may be drawn if reserves reach $200 billion b. “Cashing Contract”: KIC’s assets be cashed when necessary upon request from BOK c. Initial Investment: Financial Assets d. Critical Vehicle: To Attract Global Asset Management Companies Asia-Pacific Financial Markets Research Center, University of Hawaii

  15. Bank of Korea’s Current Reserve Management (I) Source: IMF (2003) Asia-Pacific Financial Markets Research Center, University of Hawaii

  16. Bank of Korea’s Current Reserve Management (II) Investment Instruments a. Marketable Securities: sovereign bonds, government agency bonds, MDI-issued bonds with AA-rated or higher b. Deposits: Only with financial institutions with credit ratings of A or above c. Outsourced Assets: May include corporate bonds, ABSs, and MBSs with AA ratings or higher Differences between KIC’s management and BOK’s management? Asia-Pacific Financial Markets Research Center, University of Hawaii

  17. Major Operational Policy Issues with KIC (I) 1. Is KIC’s Operation Part of Foreign Exchange Reserve Management? a. If yes, then the relation between MOFE and BOK vis-a-vis KIC? b. If not, the integrity of foreign exchange reserve management may be questioned. 2. Governance System of KIC? a. Transparency b. Accountability and Assurances of KIC’s integrity Asia-Pacific Financial Markets Research Center, University of Hawaii

  18. Major Operational Policy Issues with KIC (II): c. Lack of Transparency and Accountability 1. Fiscal Investment and Loan Program of Japan Assets: US$3.67 trillion Loans: US$2.88 trillion Extended to: (i) FILP-Dependent Enterprises*; (ii) Municipal Governments; and (iii) Government-Owned Banks * Transportation, Education, Utilities, Housing, Roads, Bridges, Airports, SMEs Sources of Funds: Postal Savings Deposits Employees’ Insurance Deposits 75% of FILP Loans are Non-Performing & Estimated Losses = ¥75 trillion ( = US$680 billion) or 15% of GDP [Doi and Hoshi (2002, NBER)] Asia-Pacific Financial Markets Research Center, University of Hawaii

  19. Major Operational Policy Issues with KIC (III): 2. Temasek Holdings Ltd. (Singapore) Singapore’s Ministry of Finance-owned investment arm controlling more than 20% in 22 major local companies Total investment > US$130 billion over 30 years Its financial statement will be disclosed to the public for the first time in its 30 year history 3. Government Investment Corporation of Singapore Total Fund under Management > US$100 billion i. Government of Singapore Investment Corporation Pte Ltd. ii. GIC Real Estate Pte Ltd. iii. GIC Special Investments Pte Very little is known about its financial status Asia-Pacific Financial Markets Research Center, University of Hawaii

  20. Major Operational Policy Issues with KIC (IV): 4. Khazanah Nasional Berhad (Malaysia) 6 subsidiaries 18 associates 13 investments No information on its performance 5. The Minister of Finance (MOF) Inc. (Malaysia) No information on its performance Asia-Pacific Financial Markets Research Center, University of Hawaii

  21. Major Operational Policy Issues with KIC (VI) 3. Reserve Adequacy a. Money Supply-Based Approach (Ratio of Reserves to Money Supply): Poor measure of capital flight Poor predictor of currency crisis b. Current Account-Based Approach (Reserves in Months of Imports): Relevant for Small Economies? Poor predictor of currency crisis for Open Economies c. Capital Account-Based Approach (Ratio of Reserves to Short-term External Debt) Better measure for Economies with significant but uncertain access to international capital market? d. Combination of current and capital account approaches Asia-Pacific Financial Markets Research Center, University of Hawaii

  22. Reserve Adequacy: Korea’s Reserves and External Debt (November 2003) Source: Asian Development Bank Asia-Pacific Financial Markets Research Center, University of Hawaii

  23. Thank You!For Further References,Please visit http://www2.hawaii.edu/~rheesg • Asia-Pacific Financial Markets Research Center, University of Hawaii

  24. Asian Stock Market Performance(Annual Return) Asia-Pacific Financial Markets Research Center, University of Hawaii

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