Emerging Markets: Asian central bankers prepare to change tack

Emerging Markets, May 4 2011

Asian central banks are on the cusp of a major shift in their approach to investment, according to bankers and fund managers who work with them. There is a growing sense that their soaring levels of reserves are so far in excess of requirements that they ought to be invested more widely than they are today.

The view is amplified by comments on April 19 from Zhou Xiaochuan, governor of the People’s Bank of China, that “foreign reserves have exceeded our country’s rational demand, and too much accumulation has caused excessive liquidity in our markets.” He said China’s State Council had required a cut in excessive accumulation “and good management of the funds accumulated, including diversification of investments.”

The remark has been widely noted by bankers. “It’s not something you ever hear central bankers say,” said Michel Paulus, head of public sector coverage for Asia at Citi. But it reflects a growing sense that a surplus exists not just in China but at central banks across the region. “Generally most of them have enough now to weather any storm,” Paulus said.  “And if they have a surplus, how do they manage it? Perhaps they will have 10% they want to put into alternatives, or to invest to better understand the market, or use an external manager.”

Thirachai Phuvanatnaranubala, Secretary-General of the Thai Securities and Exchange Commission, said reserve use “will become a more hot topic. There have been suggestions for Thailand to set up a sovereign wealth fund, taking some of our reserves,” but the central bank has not supported it, he said. He argued, though, that something had to be done to make better use of reserves. “There is no way the central bank can get enough yield from its investments to cover the opportunity cost” of holding the reserves, he said.

Oliver Bolitho, head of Goldman Sachs Asset Management in Asia, said this process of surplus investment was already in evidence with the establishment of sovereign wealth funds to invest state assets in China and Korea in recent years. “But increasingly, the original mother organization [the central bank] is talking about diversifying its underlying asset base,” he said. “That is a reflection that the book of reserves has outgrown its original purpose, and also that increasingly there is a risk in being constrained to a single asset exposure in those reserves.”

Gerard Lyons, chief economist at Standard Chartered, said he expected a continuing increase in reserves, but “the question is which currency you put the money in. I call it passive diversification: reserve managers don’t actively want to sell their dollars lest it triggers the crisis they fear. But… less net new reserves will go into dollars.” Lyons called for a deepening of local currency bond markets to deploy assets, and said: “There is a desire to use reserves more proactively, maybe as a social investment. What the Chinese are going to do with their money is going to be key to this whole story.”

That said, expectations of sufficient reserves have changed, Mr Paulus said, citing the example of Korea, whose foreign reserves fell from $240 billion to $190 billion during the financial crisis and which was consequently badly hit in the markets. “Other central banks in the region watched in amazement,” he said. “How could that not be enough? One lesson they took from that was you think you have enough reserves but you can never be sure you really do.” This suggests central banks will continue to accumulate foreign exchange reserves, even if they then deploy them in a more active and diversified way than they used to.