from Follow the Money

Sit back and watch Asia’s reserves grow.

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Not because Taiwan is reportedly intervening once again last week.   But because Asia holds lots of euros and yen.    The euro rose 2.4% against the dollar last week, the yen by 2.8%.  And Asia holds lots of reserves, period.  And even low yielding reserve assets pay some interest.

A bit of ball park math.  Suppose Asia has $3 trillion in reserves.   That is a bit too high. China's end September reserves and the rest of Asia's end November reserves summed up to $2.64 trillion.   It is a safe to say Asia ended the year with $2.7 trillion ($2,700 billion) in reserves.

But the math is super-easy if we assume $3 trillion in reserves, and 1/3 of those reserves are in euros and yen and other currencies other than the dollar.  That works out to $1 trillion in euro and yen reserves.  Hell, all those reserves - plus lots of petrdollars and petroeuros - are presumably one reason why long-term rates in all reserve currency countries are low.

If all those reserve were in euro, a 1% rise in the euro's value would generate a $10 billion rise in Asia's reserves.   So ball park, Asia's reserves increased by $25 billion last week.  A 10% rise over the course of 2006 would increase Asia's reserves by $100 billion.  Add at least $100 billion in interest on those $3 trillion in reserves (ok, $2.7 trillion - no need to keep the math easy), assuming that interest payments are not converted into local currency.  So Asia's reserves could easily increase by $200 billion even if Asian central banks did not buy any dollars in the local fx market. 

I mention this for a reason - several actually. 

We already are seeing the impact of small valuation gains (and interest payments) in the December Asian reserve totals.  Korea, for example, reported that tis foreign exchange reserves increased in December. That is a bit different than earlier in the year.  When the dollar was falling, Korea's reserves fell.   Korea clearly holds some of its reserves in euros and yen.  But not as much as Malaysia's central bank.  Bank Negara reported valuation losses in 2005 of over $4 billion, on reserves of $70.5 billion.  Malaysia sold reserves in the last bit of the year; it held more reserves back they when the dollar really fell v. the euro in the first half of the year.

Valuation gains are not entirely hypothetical.

A former member of China's monetary policy committee noted in an interview with Market News International that China made a big bet on the euro back in the late 1990s, and then took big losses.  And since China reports its reserves in dollars, his valuation losses were quite apparent to China's State Council.   China's reserve manager ended up taking his life.   The point: holding your reserves in dollars is safe if your reserves are reported to the world -- and to your boss -- in dollars.   You never take valuation losses  ... you just miss out on valuation gains.

China though clearly holds some non-dollar currencies in its reserves, and took valuation losses during the course of 2005.    Consequently,  valuation effects are - obviously - relevant for the debate over why China's reserve growth slowed, and what is happening to liquidity in East Asia more generally.

Morgan Stanley's Xie argues Asian liquidity growth is slowing dramatically, based largely on the reserves data.   He may be right - but the fall in the euro and yen in the fourth quarter probably knocked $15 billion off Asia's total reserves.   India's reserve growth was slowed by a $6 billion payment on its Millennium Deposits in December.  China's by a $6 billion currency swap (though the accounting of this in China's reserves is 100% clear yet).  And so on. 

Still, a couple of data points do suggest that there was a fall off in Asian reserve accumulation in the fourth quarter. 

There is no doubt that hot money flows into Malaysia reversed themselves, and some hot money betting on the ringgit fled Malaysia in q4.    And the troubles in Shanghai's property market may have reduced hot money flows to China (hot money flows were certainly small in October). Could Shanghai be the Bangkok of this Asian boom?  1 million new apartments are under construction, and 76% of all bank loans in Shanghai last year were for real estate.  Sounds familiar ...  (data from the LA Times; hat tip Mark Thoma

However, a slowdown in reserve growth, particularly in China, need not mean a fall in overall liquidity though.   Slower reserve growth from less weaker hot money inflows might just mean less sterilization.  Monetizing China's ongoing current account surplus and FDI inflows alone would generate substantial base money growth.  And there are ways of injecting liquidity into the domestic economy (buying dud loans for cash, for example) that don't require an increase in reserves. China's domestic data - which shows accelerating broad money growth - doesn't support Xie's argument that domestic Chinese liquidity is slowing significantly. 

Moreover, the fall off in pressure on China seems to have been correlated with general weakness in many Asian currencies (led by the yen) against the dollar in the fourth quarter, and that trend reversed itself, big time, last week.  Asian currencies -- and the euro -- all gained against the dollar last week.

Rajat Bhattacharya of Reuters

....  economies from Taiwan to India are set to accelerate thanks to an upturn in domestic demand while China remains the engine of growth in the region. The improving outlook, which contrasts with an expected slowdown in the United States, has led to a rush of foreign equity investors into India, Taiwan, Thailand and other Asian countries in the past month.

Stock indices in South Korea, India and Indonesia hit record highs this week while those in Singapore, Thailand and the Philippines reached or approached multi-year peaks.

"Hence the underlying flows remain solidly in favour of regional Asian currencies," Shahab Jalinoos, Asian currency strategist at ABN AMRO Bank, said in a note. In fact, Asian currencies have been rising against the US dollar since December. The foreign equity inflows in the new year merely accelerated the process, with the won hitting an eight-year high of 985.1 per dollar on Thursday.

Broad-based move: Claudio Piron, Asian currency strategist at JPMorganChase Bank, noted that this year's Asian rally differed from rallies in 2004 and the early part of 2005, which were driven by speculation about a sharp appreciation in the Chinese yuan.

This time the Asian currencies are moving more in line with the yen, an indication that their gains are more broad-based and can be sustained, Piron said.

Xie's analysis , which is based on stagnant Asian fx reserves, may lag current developments a bit.   Battacharya notes that market participants do not expect Korea to resist won appreciation.

"The market is not afraid of intervention," said Roh Sang Chil, a currency trader at Kookmin Bank in Seoul ... The fundamentals of the Korean economy are getting better. There's not much reason for the Korean won to depreciate. The intervention is going to be just a smoothing operation."

But China still doesn't let the RMB rise in the face of similar pressures.  

In current patterns hold, China's January reserve accumulation likely will surge then (adjusting for any seasonal fall in its trade surplus), for two reasons.  Valuation gains will push up the dollar value of China's euros and yen.  And China may need to intervene more as folks resume betting on RMB appreciation. 

Some of the same tensions that showed up during previous periods of dollar weakness are starting to show up again.  

Korea's finance ministry is complaining about a strong won; Korea central bank is complaining about the cost of sterilization.   General Glut take note, the central bank is resisting rejoining the Asian dollar support coalition.   Rajat Bhattacharya of Reuters, again: 

"There is increased concern about the rising cost to the Bank of Korea from holding large amounts of FX reserves," Merrill Lynch said, adding that the won's appreciation had not had a significantly detrimental impact on the South Korean economy. Asian central banks, including the Bank of Korea, have been raising interest rates to quell inflation pressures and Japan is set to end its ultra-loose monetary policy. Efforts to reverse currency appreciation — which typically loosens monetary conditions — would run counter to those policies.

I suspect a similar debate is going in Beijing.  The PBoC worries about future losses on its reserves; other parts of the Chinese government don't, but do care about sustaining export growth. 

It may be an interesting year.  Even Stephen Jen is changing his tune, at least a bit.

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