With the US trade deficit recently widening to an 18-month high, the issue of global imbalances is back at the forefront of the international economic agenda. Yet whereas the impact of exchange rates on trade flows has been much debated, hardly ever discussed are the costs countries bear, particularly in Asia, for the excess foreign exchange reserves they carry as a counterpart to their persistent trade surpluses.
The world's leading holders of foreign exchange reserves are China, with $2.4 trillion worth, and Japan, with $1 trillion worth. About 70% of such funds are held in US dollars, mostly in the form of low-yielding US Treasury securities. Many commentators, top Obama Administration economics adviser Larry Summers most prominent among them, have suggested that such funds are invested over-conservatively, resulting in opportunity costs on the order of 6%.
Such estimates of potential forgone income are generally dismissed by central bankers, who view the funds as a form of insurance. After all, most countries' vital imports are paid for overwhelmingly in US dollars. Particularly in a crisis, as Asia experienced in 1997-1998, having dollars ready in liquid form is essential.
But how much insurance is too much? Between April 2000 and March 2004, the Japanese Ministry of Finance bought nearly $400bn in an effort to boost exporters and combat deflation. But since the MoF ceased its currency market interventions six years ago, Japan's reserves have climbed another $200bn. Japan's reserves now amount to 20% of gross domestic product.
Alan Greenspan suggested back in 1999, in the wake of the Asia crisis, that prudent reserve levels should roughly cover a country's total short-term external debt. In Japan's case, that would be about $493bn. This means that Japan's excess reserves are currently on the order of $530bn, or 10% of GDP, vastly more than even extreme prudence could merit.
When a country holds far more reserves than it could possibly need for insurance purposes, the excess funds are best viewed as investments. By Summers' reckoning of opportunity costs, Japan has done poorly on such investments. But the situation is actually much bleaker than that.
The value of Japan's reserves, as is normal around the world, is measured in US dollars. But the global and local purchasing power of dollars fluctuates considerably through time. So, while Japan's reserves have increased by over $100bn since June 2007, they have actually fallen by over ¥17 trillion when measured in local currency terms. This notional loss is equivalent to more than 3.5% of GDP.
And whereas many economists categorically reject the utility of thinking about the value of reserves in local currency terms, owing to the fact that they are not intended to be repatriated, we would highlight the following contradiction. It is orthodox among economists to focus on Japan's net debt, rather than gross debt, when evaluating the sustainability of the country's debt burden.
However, the net debt numbers offset yen liabilities with government assets, including foreign reserves, to present Japan's level of indebtedness.
If the local value of the reserves drops, net debt will increase, and vice versa. Thus, from this perspective, the local value of reserves clearly matters. In fact, the local losses on Japan's reserves since 2007 contributed more to the increase in net debt than did the government deficits in fiscal year 2007 or 2008.
In the case of China, where reserves are equivalent to 50% of GDP, the financial risks are much larger. With only $150bn in short-term external debt, by Greenspan's measure China's excess reserves are nearly $2.25 trillion – a whopping 45% of GDP. And China, unlike Japan, has been pegging its exchange rate to the dollar (its recent pledge of “flexibility” notwithstanding).
If China were to set the renminbi free while continuing to prevent its citizens from diversifying their savings abroad, China's unrealised foreign exchange losses would dwarf those of Japan.
The dilemma China faces serves to highlight the importance of the observation made by central bank governor Zhou Xiaochuan a year ago, or former French president Charles de Gaulle four decades ago – that the ability of the United States to conjure up the world's international trade and reserve currency creates a permanent fault line in the international monetary system.
The result is periodic crises – when countries have too few dollars, as during the Asian financial crisis, or when they suck in far too many of them, as they appear to be doing now.
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