The accumulation of foreign exchange reserves

Ettore DorrucciDeputy Head, International Policy Analysis and Emerging Economies Division

European Central Bank

Meeting of the Foreign Exchange Contact Group

ECB, Frankfurt am Main, 31 May 2006

Outline of the presentation

1 - Evidence on the accumulation of cross-border official financial assets:

(a) fx reserves(b) alternative uses

2 - Drivers3 - Impact on U.S. yields4 - Risks and costs5 - Conclusions

Part 1 (a)

Evidence on the accumulation of foreign reserves

The rapid increase in foreign exchange reserves of Asian and oil-exporting countries since 2002

Foreign exchange reserve assets holdings (USD billions)

Oil Exporting Countries

Japan

China

Other emerging Asia (excluding

China and India)

0

100

200

300

400

500

600

700

800

900

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: IMF, World Economic Outlook1Part 1 (a)

8 Asian countries currently rank among the 10 largest reserve holders

Foreign exchange reserves of countries with the largest holdings (2001 - 2005)

(USD bln)

Source: IMF, The Central Bank of China and Bank Negara Malaysia.

0100200300400500600700800900

Japan

China,

P.R. Main

land

Taiwan

Korea

Russia

Euro A

rea India

China,

P.R. Hon

g Kon

gSing

apore

Mexico

Malaysi

aAlge

riaBraz

ilTha

iland

Turkey

Norway

Austral

iaUnit

ed K

ingdo

mPola

nd

Libya

Dec-01 Dec-02 Dec-03 Dec-04 Dec-05

2Part 1 (a)

The degree of concentration in reserve accumulation increased in 2005

0.010.811.192.042.42.953.053.834.735.045.946.6310.2311.5511.7914.92

54.88209.07

0 50 100 150 200 250

Japan

Brazil

Chile

Thailand

Philippines

Hungary

Norway

Singapore

Argentina

Venezuela

Poland

Malaysia

Mexico

Taiwan

Korea

Turkey

Russia

China

reserve accumulation in bn USD

2004

2005 Top-five share in total

reserve accumulation:

• 57% in 1995-2001

• 68% in 2004

• 78% in 2005

54% of total reserve accumulation in 2005

3Part 1 (a)

The emergence of oil exporters in 2005 as the main region with current account surpluses …

United States

Oil exporters

Euro Area

Japan

China

Other AsiaOther industrialized

Central and Eastern Europe

Western Hemisphere

-1000

-800

-600

-400

-200

0

200

400

600

800

1000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

bn U

SD

.

Latin AmericaP

Source: IMF WEO

Current account imbalances: overview 4Part 1 (a)

-100

0

100

200

300

400

500

1998 1999 2000 2001 2002 2003 2004 2005

Other

Portfolio

Reserves

FDI

Financialoutflow

… is not clearly reflected in the statistical evidence on reserve accumulation …

Source: IMF WEO and ECB staff calculations

Oil exporters. Net financial outflows (+) (USD billion) 5Part 1 (a)

Major accumulators are not central banks, but special investment agencies (e.g. Norway’s Petroleum Fund, Abu Dhabi Investment Authority, Kuwait Investment Authority)

… but may be indirectly detected in the evidence on US portfolio inflows

-20

0

20

40

60

80

100

120

140

160

1990Q1 1991Q11992Q1 1993Q1 1994Q1 1995Q11996Q11997Q1 1998Q1 1999Q12000Q12001Q1 2002Q1 2003Q1 2004Q12005Q1 2006Q10

10

20

30

40

50

60

70

80

90

Net purchases UK and Caribbean (lhs) WTI oil price (rhs)bn USD USD/bbl

Net purchases of US long-term securities by UK and Caribbean offshore centres (in USD billion) and oil price (in USD/bbl) 6Part 1 (a)

Part 1 (b)

Alternative uses of accumulated cross-border

official foreign assets

Main alternative uses

•• Oil fundsOil funds: stabilising volatile oil revenues through time (Russia, Norway, Venezuela, Kuwait, Oman, etc.)

•• Heritage fundsHeritage funds: preserving the value of foreign assets for future generations (Singapore, Abu Dhabi, Kuwait)

•• Recapitalising stateRecapitalising state--owned banksowned banks (China)

•• Repaying external debtRepaying external debt (Russia, Argentina, Brazil) or or domestic debtdomestic debt (Saudi Arabia)(Saudi Arabia)

•• Financing major investment projectsFinancing major investment projects (Taiwan)

7Part 1 (b)

The Russian Oil Stabilisation Fund: How does it work now?

USD Oil

8Part 1 (b)

Exporters

Central Bank Ministry of Finance

Fx market

USD 200USD

EUR

GBP

200 RUB

40 RUB (taxes)

USD

EUR

GBP

OIL STABILISATION

FUND (*)

40 RUB

FX RESERVE ASSETS

100 RUB

(base money)100 40

(*) Invested by the central bank on behalf of MoF (45% USD, 45% EUR, 10% GBP)

Part 2

What are the main drivers of reserve accumulation?

The accumulation of foreign reserves: macroeconomic preconditions

… Moreover:

• Exchange rate pressure also from net portfolio and banking inflows in certain countries (China, Korea, India, Taiwan)

S > I

Current account, savings and investmentChina

25

30

35

40

45

50

55

1995 1997 1999 2001 2003 2005

% GDP

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5% GDP

Savings (left) Investment (left) CA (right)

Other Asia

10

15

20

25

30

35

40

1995 1997 1999 2001 2003 2005

% GDP

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5% GDP

Savings (left) Investment (left) CA (right)

Oil exporters

10

15

20

25

30

35

40

1995 1997 1999 2001 2003 2005

% GDP

-5

0

5

10

15

20

25% GDP

Savings (left) Investment (left) CA (right)

9Part 2

Three fundamental drivers of reserve accumulation

Given savings glut/investment drought:savings glut/investment drought:

1. Unilateral selfself--insuranceinsurance against future financial crises

2.2. ExportExport--led growthled growth (post-crisis recoveries) supported by exchange rates anchored to the US dollar

10Part 2

3. The underdeveloped financial structureunderdeveloped financial structure of several emerging countries, including (i) difficulties to channel private S to I, (ii), dollarization of foreign assets, and (iii) costly hedging if one-way bet

The renminbi REER depreciated by 15% between 2002 andthe exchange rate reform of 21 July 2005 …

90

100

110

120

130

140

150

160

Jan-94 Sep-95 May-97 Jan-99 Sep-00 May-02 Jan-04 Sep-05Source: JP Morgan

Index Jan-94=100

Appreciation21/7/06

reform

Real exchange rate of the renminbi11Part 2

-4-2024681012

1995 1997 1999 2001 2003 2005

Investment ConsumptionNet trade InventoriesGDP

per cent

Source: IMF World Economic Outlook.Contribution by expenditure component, annual growth rates.

… but the “export-led growth” argument should not be overemphasised for China

China: Contributions to real GDP growth 12Part 2

Part 3

Measuring the impact on U.S. yields

Impacts on U.S. government bond yieldsof reserve accumulation: Some estimates

Estimates of the effect of reserve accumulation on US Treasury yields(basis points)

Source Estimated reduction of yields

Merrill Lynch 30

JP Morgan 30 — 50

Goldman Sachs 40

Eurosystem 65

Edwin Truman 75

Patrick Arthus 75

Ben Bernanke et al. 50 — 100

Bill Gross 100

Banque de France 125

Stephen Roach 100 — 150

Nouriel Roubini et al. 200

Robert McCauley Significant, but unstable and short–lived relation

Vanguard Group No long–term effectSource: Eurosystem.

13Part 3

Do the “traditional” U.S. TIC data underestimate the relative importance of official portfolio flows to the United States?

0

50

100

150

200

250

300

350

400

Jul 2002 - Jun 2003 Jul 2003 - Jun 2004 Jul 2004 - Jun 2005

Survey data: Foreign official inflowsTICS data: foreign official inflowsUSD bn

Data provided by U.S. custodians

U.S. Treasury International Capital Flow reports

Foreign official purchases of US long-term securities: Total inflows 14Part 3

Part 4

Risks and costs of reserve accumulation

The accumulation of foreign reserves: potential risks and costs (see ECB Occasional Paper No. 43)

Potential risks or costs Underlying factors

Conflict between exchange rate stability and easing of monetary conditions if interventions not fully sterilised inflation and/or asset price bubbles

Underdeveloped financial markets;

shortage of sterilisation instruments;

snowball effects: sterilisation coupled with expected exchange rate appreciation capital inflows more sterilisation and expected appreciation

Segmentation in the public debt market Excessive sterilisation through issuance of central bank liabilities instead of government securities

Potential deterioration of central bank balance sheet

Domestic currency appreciation (currency risk)

Opportunity costs Yields paid on domestic sterilisation instruments exceed those on foreign assets

Concerns about bank profitability Because of controls on bank lending, the banking sector might not have alternatives to buying low-yield sterilisation instruments

Source: Eurosystem.

Costs

Risks

15Part 4

Reserve accumulation and global imbalances:Conclusions

Financing US CA deficit

Low yield environmentShort-term effects

Insufficient fx flexibility in CA surplus countries

Less policy discipline in deficit countries

… but:

Part 5 22

Multi-pronged approach to global imbalances (G7 statements): Exchange rate flexibility alone does not work

There are deep reasons for reserve accumulation which call for some gradualism in its discontinuation

Longer-term effects

Thank you