A V Rajwade: East Asian reserves and currencies

WORLD MONEY

The dollar's exchange and interest rates will be decided by what half a dozen Asian central banks do.

In my last column, ("Compassion for the poor" March 21), I had speculated that some day Asian central banks may tire of holding huge amounts of reserves in a currency that is no longer a reliable store for value, and may start diversifying their reserves more aggressively. This would have two major impacts "" a sharp fall of the dollar and a rise in dollar interest rates.

In today's world, it seems that even a central bank benignly neglectful of the exchange rate does not have full control over domestic money supply and interest rates. The dollar's exchange and interest rates may well be determined by what half a dozen Asian central banks do rather than by Alan Greenspan.

Broadly speaking, all east Asian central banks, including the Bank of Japan, have tried to manage their exchange rates, eschewing the policy of allowing the external value of the currency to be determined totally by the market.

If one is to go by the results, one cannot really question the wisdom of the Asian policies. Most market fundamentalists belong to countries that have rarely grown faster than 3 per cent on any consistent basis; the east Asian economies have grown, on an average, perhaps three times faster.

In the process, they have also contravened many of the hallowed tenets of the so-called Washington Consensus: protected domestic industry; encouraged some industries through directed, cheap credit; managed the exchange rate; and so on.

Clearly, the Asian model has been far more successful than the Washington model in generating growth. Even the Latin Americans, some of whom were amongst the more faithful adherents of the Chicago/ Washington model, are now increasingly turning against it.

But coming back to Asian central bank reserves and their impact on the dollar's exchange rate, one recent incident is worth recalling: a rather innocuous announcement by the Korean Central Bank that it would look at higher yielding instruments for investing future additions to its reserves, created tremors on the world's foreign exchange market and the dollar fell sharply.

Mind you, the central bank was talking about further inflows and not the existing stock. It can only be imagined what would happen should the big two holders of reserves "" namely Japan and China "" decide to diversify their stock (see table).

But reserves composition apart, are the exchange rate policies of the east Asian central banks likely to change? To my mind, the answer is yes and that too perhaps in unison. As it is, the Asian central banks are committed to support each other's currencies through a swap arrangement. Trade is to become totally free by 2010 "" and is growing at a faster pace than in the European Union or Nafta.

Indeed, the whole of east Asia (excluding Japan) sometimes looks like a giant China-centric supply chain. The interdependence is growing fast "" and hence my expectation that any change in exchange rate policy would happen in concert.

Currently, while the Chinese yuan, the Hong Kong dollar and the Malaysian ringgit are tied to the dollar, other currencies have appreciated against the US currency. Overall, the case for an Asian currency block seems stronger than that for an African single currency, scheduled for introduction in 2021.

Monetary cooperation in east Asia is being seen in other areas as well. The central banks have set up a $1 billion Asian Bond Fund (ABF) managed by the Bank for International Settlements (BIS), for investing in dollar bond issues from the region. (India had also agreed to contribute to the fund, but nothing much has been heard about the proposal for some time now.) An ABF II has also been mooted "" for investments in local currency bonds, but has been slow to take off.

Martin Wolf (of Financial Times) and some other analysts ascribe the Asian central banks' tendency to accumulate reserves as a hangover of the 1997-98 balance of payment crises which hit the region.

They also believe that the spectre of another crisis would be mitigated if an Asian Monetary Fund (AMF) is created to support the economies if needed. Japan had mooted such a proposal back in 1997, but it got nowhere given Washington's opposition: Washington clearly worries that it would not have as much influence over an AMF as it has on the IMF.

Tailpiece: The Korean Central Bank has created a $20 billion fund out of its foreign exchange reserves, for investments in diverse assets like foreign equities, property, bonds and so on. The fund will be managed by independent investment managers.

There are parallels in Singapore's Temasek, and in Switzerland, Austria, Norway and a few other countries as well. Critics of such returns-oriented ventures believe that a central bank should stick to traditional investments. Should the Reserve Bank be doing something on the Korean lines?

Email: avrco@vsnl.com