Asian central bank reserves surpass optimal levels, says IMF’s Zavadjil

Central banks in emerging Asia – stripping out China – now hold an average of 7.2 months of import cover as reserves. As a result, central banks in the region are starting to hold foreign exchange in excess of optimal levels, according to the latest research by Milan Zavadjil, senior resident representative for Indonesia at the International Monetary Fund (IMF).

Zavadjil has supported the rise in reserves at central banks in Asia following the Asian Financial Crisis 1997–98 and developed a model to estimate optimal reserve levels that includes risk factors such as the probability of a crisis, the opportunity cost of holding reserves and the estimated output loss in the case of a crisis. This model, first published in 2008, found that contrary to popular opinion Asian central banks were not holding excessive amounts of foreign exchange.

Notably, his research from four years ago indicated that both Indonesia and South Korea were not holding sufficient amounts of foreign exchange to fend off sharp adverse moves in financial fund flows currency volatility – a situation that materialised in 2008 and 2009 as both countries struggled to maintain price and currency stability during the global financial crisis.

The IMF official believes central bank reserves need to cover portfolio fund flows in addition to trade and debt financing. "That's because these long-term liabilities can be just as volatile and the capital can depart just as quickly as in the case of short-term debt and especially through hedging you can have the same pressures in the exchange market," he told delegates attending National Asset-Liability Management Asia 2012 in Singapore on July 18. "I remain convinced that high reserves helped emerging Asia through the global financial crisis of 2008 and 2009," Zavadjil added.

Zavadjil's research also indicates that higher levels of reserves can also help countries to raise debt at lower rates of interest, which in turn can help private companies to secure funding at cheaper levels than in the past.

But if reserves exceed optimal levels, as Zavadjil's latest research finds they are now doing, foreign exchange holdings can represent a wasteful use of resources that could be used in other segments of the economy, potentially undervalue exchange rates and contribute to global imbalances.

Despite his latest findings, however, Zavadjil still advised central banks to continue building forex positions as the downside risk of having too few reserves remains far greater than the costs of holding excessive reserves. For example Zavadjil estimated the average output loss for Asian economies during the Asian financial crisis was around 19% of GDP.

Earlier in the day, panel moderator Gary Smith, head of central banks, supranational institutions and sovereign wealth funds at BNP Paribas, said in his conversations with dozens of central banks during the past year, every official he had spoken with believed central bank reserves in aggregate were too high. Despite this, however, not one of these central bank officials said their own reserves were too high, suggesting a reserves 'arms race' is taking place.

Meanwhile, panellist Poomjai Nacaskul, a senior head of research for the economy research department in the Bank of Thailand's monetary policy group, emphasised the importance of the numerator currencies used when determining the optimal allocation of reserves. He highlighted that reliance on US dollar figures when offering portfolio performance updates is not necessarily appropriate and offers the risk that a customised currency allocation may look like a poor investment decision in the eyes of the general public and lawmakers due to the currency in which it is reported. This can result in political pressure to make unnecessary changes in reserves policy.