News and Events

$60B in PH foreign reserves: An embarrassment of riches?

Posted: 2011-04-04
Category: Opinion
By Ronald U. Mendoza

April 04, 2011 – MOST developing country finance ministers brandish a number of macroeconomic indicators to signal the strong “fundamentals” of their country to the international and domestic investor community.
These include robust economic output, rising investments, manageable public debt-to-GDP ratios, and low public sector deficits. In addition, and especially after the Asian financial crisis of 1997-1998, they are now boasting of growing foreign reserve holdings as an indicator of strong macroeconomic health.
Before the Asian crisis, policymakers were content to hold reserves covering three months of imports as a rule of thumb. The crisis soon changed that to holding reserves at least as much as the short-term debt (the so-called Greenspan-Guidotti rule named after the US and Argentine monetary officials who promoted these rules). Many Asian countries burned by this crisis and developing countries outside Asia that appreciated its lessons sought to increase their liquidity as a form of self-protection against abrupt reversals in capital flows and sudden massive adjustments in the balance of payments.

It is partly because of this that most countries were in a relatively better position to weather the initial phase of the food, fuel and financial shocks in 2008-2009 than they otherwise would have. Better macroeconomic policies and more robust reserve holdings compared with past decades provided ample policy space to undertake, at least initially, robust counter-cyclical policies.

Yet self-insurance is not the only motivation behind holding higher reserves. A growing number of countries—many in Asia, including the Philippines—have turned to reserve accumulation as part of their strategy to curb the volatility introduced by “hot money,” or capital flows that are of a more speculative and short-term nature. Curbing the impact of these flows has been critical because these could create instability in foreign exchange rates and the financial system because of abrupt entry and exit.

Recent analyses in the financial industry revealed that in the last decade alone, foreign reserves held worldwide quadrupled from $2 trillion in 2000 to more than $8 trillion by 2010.

Top foreign reserve hoarders today include China, Japan, Russia, Saudi Arabia, Taiwan, India, South Korea, Hong Kong, Brazil, Singapore and Germany—these 11 countries and territories account for about 60 percent of the world total, or about $4.8 trillion.

In 2000, industrial countries held twice as much reserves as developing countries. By 2010, this had been reversed—emerging and developing countries held almost twice as much reserves as industrial countries. Since 2000, the Philippines’ official reserve holdings have also quadrupled, rising from about $15 billion in 2000 to more than $62 billion by the end of 2010, based on IMF data.
The global food, fuel and financial shocks and the worldwide slowdown in 2008-2010 saw global reserves drop from $7.5 to $7 trillion in the mid-2008 to early 2009 period. However, reserve accumulation picked up again in 2009 and 2010.

Much of these reserves are held in US Treasury securities, which offer countries a degree of flexibility and liquidity. Hence, the mirror image of reserves held by developing countries is the debt and current deficit of the United States. The US current account deficit is now primarily financed by the savings of numerous developing countries, such as China (and a few industrial countries with trade surpluses vis-à-vis the US). These countries are losing money in the process, due to such factors as exchange rate movements (a weaker dollar reduces the returns on dollar denominated assets), as well as the low rates on US treasuries (due to recent quantitative easing by the US Fed).

Central banks will typically accumulate reserves in highly liquid assets like US treasuries. To minimize the monetary impact of this operation, they then sterilize the impact on the domestic economy by issuing domestic debt (i.e. borrowing back the money it injected into the economy). The result—as is the case for most reserve holding countries—is a net fiscal cost, which could run higher than 6-7 percentage points. (Let us use this as a rough “guesstimate,” even as trends like a weaker dollar, cheaper US credit and increasing emerging market interest rates will surely increase this spread and concurrent implied cost of reserve holding.)
The headline cost implies a hefty price tag for self-insurance and a stable (and competitive) exchange rate. Brazil’s and India’s almost $300 billion (each) in official reserve assets implies a net fiscal cost of about $18 billion per year for each.

The official reserve assets of the Philippines hit $62 billion by the end of 2010, according to the IMF. One “guesstimate” places the net fiscal cost at about $3.72 billion for the year. At current exchange rate, this amounts to almost eight years of funding (assuming the present allocation) for the government’s flagship poverty reduction and human capital investment program, Pamilyang Pantawid. If the allocations to the program were to be increased to the full amount needed to reach all poor families in the government’s databank (at present the program reaches only half), then up to four years of full funding could be achieved.
And that is just the possible savings of the fiscal cost of reserve hoarding for one year. The reserve level itself could also be reallocated, such as what China did recently, by using part of it to boost social investments to help protect its population against the recent crises.

Counter arguments could of course be raised to help justify this reserve holding strategy. Crises are also disruptive and imply large social and economic costs if the government does not have the flexibility for policy maneuver, such as through the use of reserves. Exporters and investors will find it more difficult to plan and remain competitive, and OFWs will find their purchasing power fluctuating wildly, if not for the active reserve management strategy of the Bangko Sentral.

Suffice to say that economic openness and export competitiveness have a high price tag. This is why the returns from these strategies need to be weighed against their implied cost to the country. Distributional implications of alternate strategies should also be analyzed, to the extent that some strategies could be more egalitarian in their benefits.

Within the wider policy debate on global economic rebalancing, the country’s trade and investments pattern, including its reserve holding strategies, needs to be carefully analyzed. To promote more inclusive growth, the returns from public policies and investments need to be robust and inclusive in their benefits to Philippine society. Every single peso and dollar counts. The question is whether the Philippines is investing its $60 billion wisely.

(The author is associate professor of economics and executive director of the AIM Policy Center.)

This was published in Philippine Daily Inquirer.

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