Foreign Exchange Reserves, Exchange Rate Regimes, and Monetary Policy: Issues in Asia
Terada-Hagiwara, Akiko, Asian Development Review
This paper seeks to outline issues arising from rapid foreign exchange reserve accumulations in Asia. Attention is paid to People's Republic of China and India for the significance of the accumulation fed by surges in capital inflows. The paper finds that sterilization interventions by the two economies appear to be effective in curbing credit growth, but the impacts appear limited and short-lived. In this regard, adjustments of exchange rate policies are called for to have more freedom in policy options, though incentives to live with exchange rate fluctuations are still limited, and in fact the currencies have been managed more tightly than before. Therefore, the paper argues that, while maintaining the current exchange rate practices with capital controls in place, domestic reforms should be pushed further to be ready for capital account convertibility and more exchange rate flexibility in the long term.
In Asia, many countries have gradually narrowed their exchange rate fluctuations by actively managing foreign exchange after the crises of 1997-1998.1,2 Authorities are accumulating dollar assets as a by-product of a strategy of export-led growth. The stock exceeded $1,800 billion (or $1,200 billion excluding Japan) at end-2003-half the global total reserves and more than 10 times the $140 billion of its counterpart in Latin America. In 2003, Asian central banks used the reserves to finance well over half of the current account deficit and budget deficit of the United States (US).3 This would allow the US to continue borrowing without the usual warning sign of rising bond yields.4
McKinnon (2003) argues that American overspending has trapped East Asia into running current account surpluses: the region is forced to acquire dollar assets in order to avoid exchange rate appreciation and deflation. Conventionally it is understandable that governments like to have bigger reserves to defend their currencies against future attack. Asia is seen to forego better returns to keep its exchange rates down and export demand up. This regime allows the region's industries to compete on world markets and attract foreign investment (see Dooley et al. 2003).
However, the amount of reserves appears to be more than what would be warranted by conventional fundamentals (IMF 2003). The accumulation has been particularly significant in People's Republic of China (PRC); India; Japan; Republic of Korea (Korea); Pakistan; and Taipei,China where the growth rate of reserves has exceeded 20 percent during the last 2 years. Worth noting are the PRC and India, which recorded average growth rates of above 30 percent in 2001-2003 (Table I).5 The PRC's reserve accumulation reached above $400 billion accounting for 22 percent of the total Asian reserve after Japan (35 percent) in 2003. Bird and Raj an (2003) estimate an opportunity cost of holding foreign exchange reserves of around 0.3-1 percent of gross domestic product (GDP) for six Asian countries (PRC, Indonesia, Korea, Malaysia, Philippines, and Thailand).6
Against this background, several questions arise:
(i) What are the reasons and sources for the reserve accumulation?
(ii) What are the exchange rate policies and practices that have led to the accumulation?
(iii) What has been the liquidity management policy in capital importers in Asia?
(iv) What are the policy considerations for the current policy mix and are they sustainable in the medium to long term?
(v) Are there any incentives to move out of the current monetary practices?
While other questions such as "what are the costs and benefits of accumulating large reserves?" definitely warrant an in-depth study, this paper focuses on issues that are directly linked to sustainability of the exchange rate regimes in Asia, namely international liquidity positions, exchange rate policies, and monetary policies. The aim is to pave the way for a better understanding of the issue. …