Chinese authorities should adopt five adjustment mechanisms to mitigate risks accompanied by the continued accumulation of foreign exchange reserves, say Kai Shi and Liu Li-zhen in a recent research paper. Their first suggestion, as outlined in A study on China’s huge foreign exchange reserves security from the perspective of structural optimization’ (), is about currency composition. “According to estimates, the US dollar predominates and accounts about 60-70 per cent; euro is about 20-30 per cent; pound sterling and yen amount other 10 per cent. Besides, the shares of other strong currencies are relatively less,” the paper informs.

The second aspect highlighted in the paper is the scale of forex reserves. Stating that high forex reserves put pressures on domestic currency, and ruin the price comparativeness of exports, the authors caution also about possible trade friction.

Third in the list is investment structure. Advising that the reserves investment should not involve high-risk fields, such as venture capital, stock and subordinated bonds, the authors insist that about 90 per cent should be invested on the fully mobile and relatively secure national bonds. And the remaining two suggestions relate to the ratio of foreign debts to foreign exchange reserves, and term structure.

Appropriate addition to your study list.

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Fear of appreciation

What are the consequences of strong currencies, and reserves accumulation on exports, growth and price? Exploring this is ‘Episodes of Large Exchange Rate Appreciations and Reserves Accumulations in Selected Asian Economies: Is Fear of Appreciations Justified?’ by Victor Pontines and Reza Siregar ().

The authors observe the experiences of six major Asian economies — Indonesia, Malaysia, the Philippines, Thailand, Singapore, and Korea — during the past two decades, and find weak evidences of adverse consequences of large exchange rate appreciation on exports, growth and price variablesAs for growth, the paper speaks of limited undesirable consequences in only three countries — Indonesia, Philippines and Singapore.

‘Fear of appreciation,’ or ‘fear of floating in reverse,’ is explained in the paper as exchange rate intervention by monetary authorities by asymmetrically managing their exchange rates, allowing for some currency depreciation while substantially limiting the extent of currency appreciation (Levy Yeyati and Sturzenegger - 2007).

The authors note that after experiencing a tumultuous period punctuated by sharp and volatile movements in exchange rates, the countries in focus slowed the pace of the depreciations of their currencies vis-à-vis the US dollar, while at the same time, retained their preference to restrain the strengthening of their currencies against the US dollar. In the case of the Korean won, however, which can be depicted as being the most affected amongst the Asian currencies in the group during the outbreak of the global financial crisis (GFC), the authors notice some loosening in the restraint to the appreciation of the currency against the US dollar after the GFC, which is in marked contrast to the outcome found during the pre-GFC period.

Of interest to forex watchers.

Costly hoarding

When faced with a dilemma, the choice generally is between one or the other. In the case of a ‘trilemma’ — such as when pursuing three policy objectives, namely, financial integration, exchange rate stability, and monetary autonomy — you can accomplish only two, reminds ‘The Impossible Trinity (aka The Policy Trilemma)’ by Joshua Aizenman (http://econpapers.repec.org).

Stating that the financial globalisation during 1990s-2000s reduced the weighted average of exchange rate stability and monetary autonomy, the author adds that an unintended consequence of financial globalisation has been the growing exposure of developing countries to costly capital flights. “Emerging markets responded by adding financial stability to the three trilemma policy goals, coupling their growing financial integration with large hoarding of international reserves, as means of self-insuring their growing exposure to financial-turbulences.”

Such hoarding, however, is a costly option, which may not be sufficient unless it is coupled with assertive policies directed at managing and mitigating aggregate exposure to external debt, cautions the author. In his view, alternatives to massive hoarding of international reserves include a deeper use of swap lines and international reserves pooling arrangements as well as channelling reserves into potentially higher yielding but riskier assets, such as those managed by Sovereign Wealth Funds.

While potentially useful, these alternatives are not a panacea, notes Aizenman. Swap lines are typically of short duration, and are limited by potential moral hazard considerations, he explains. “Diversification by means of Sovereign Wealth Funds exposes the economy to the risk that value of the fund may collapse precisely at the time when hard currency is needed to fund deleveraging, as has been the case during the 2008-9 global liquidity crisis.”

Of contemporary interest.

(This article was published on July 7, 2012)
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