Brad Setser

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Reserve Diversification

by Brad Setser
February 22, 2005

Three somewhat wonky and technical thoughts:

1) Do not underestimate Korea just because it does not hold as many reserves as China and Japan.

$200 billion is $200 billion. Moreover, the combined reserves of Taiwan, Korea, Russia and India are larger than China’s reserves: $685 billion v. $610 billion at the end of 2004. Taiwan, Korea, Russia and India added $152 billion to their reserves in 04. That is a bit behind China’s $200 billion increase, but it not a small sum. If all those reserves went into dollars (unrealistic, i know, particularly since some of the increase reflects valuation gains), it would have been enough to fund about 1/4 of the United States’ 2004 current account deficit.

News about what any of these four central banks intend to do is hardly marginal news in my book. Three of the four — Russia, India and Korea — have now indicated a desire to either diversify their reserves or to spend their reserves on “infrastructure.” Some say Taiwan has made similar noises as well, though Taiwan’s central bank officially denies any such intent.

Right now, I think it is fair to say that their continued willingness to add to their dollar reserves at the same pace as in 2003 and 2004 is somewhat in doubt — though there ability to accept the consequences of not adding to their reserves and letting their currencies appreciate remains equally open to question.2) Reserve diversification alone cannot protect a central bank’s balance sheet all that much; the overall size of the central banks stock of reserves probably matters more.

Shifting from dollar reserves to euro reserves back in 2002 certainly would have made a lot of sense: the central bank would have seen the value of its assets rise (in dollar terms) as the euro rose against the dollar, and some central banks might now be sitting on fat capital gains. But the past is the past: central banks cannot buy a euro for less than a dollar anymore. Shifting into euros now only protects the central bank against future falls in the dollar against the euro. It won’t necessarily cut the capital losses many Asian central banks face when their currencies are revalued.

Take the following example. Suppose China lets the value of its currency rise by 20%, from 8.28 renminbi to the dollar to 6.62 renminbi to the dollar. (Incidentally, in local currency terms, the value of the renminbi has gone up by 25%, from 12 cents per renminbi to 15 cents per renminbi — be careful with percentages with large exchange rate moves). If the euro/ dollar exchange stays constant, the renminbi will also go up be 20% against the euro, rising from 10.76 to the euro to 8.61 to the euro. If the central bank has sterilized its reserve accumulation by selling renminbi debt, and has renminbi liabilities offsetting its dollar and euro assets, the capital loss on its dollar and euro reserves will be identical. Now suppose the Euro/ dollar is not constant. Rather suppose the euro falls against the dollar by 20% (from say 1.30 to 1.04) when China revalues the renminbi. The renminbi then goes from 10.78 renminbi to the euro to 6.88 renminbi to the euro — the renminbi appreciates v. the dollar and the dollar appreciates v the euro, so the renminbi really appreciates v. the euro. The net result: larger capital losses on euro than on dollar reserves. Now suppose the renminbi appreciates against the dollar and the euro also appreciates against the dollar, so euro rises from 1.3 to 1.56. If I did the math right, one euro is worth 10.78 renminbi before the currency move, and 10.33 renminbi after. The net result: smaller capital losses on euro than on dollar reserves, since the local currency value of the euro stays more or less constant.

So diversification may, or may not, help at this stage: it depends on the future course of the dollar/ euro.

The surest way for Asian central banks to limit their future capital losses is simple. They need to stop adding to their stock of reserves. That at least keeps the central bank’s aggregate currency mismatch (local currency liabilities v. foreign currency assets) from growing. If you are in a hole, stop digging! Of course, ending all intervention means letting your currency appreciate, and taking the capital loss on your existing stock of reserves today, rather than taking a potentially larger loss in the future.

3) Just in case there are any aspiring currency strategists out there, one word of advice: official purchases of Treasuries (as reported in the TIC data) are an increasingly bad proxy for overall central bank purchases of dollar assets. Central banks could be buying Treasuries through intermediaries, or just buying a broader range of dollar-denominated assets.

Life was sort of easy back when Japan was adding to its reserves, since a rise in Japan’s reserves was followed, with a bit of a lag, by a surge in official purchases of Treasuries. However, the central banks of emerging Asia have indicated publicly that they intend to invest in a broader set of securities than just Treasuries. It may be that the rising gap between reported official purchase of Treasuries and the reported increase in central bank reserves indicates some diversification into non-dollar assets. But it also could just indicate that central banks are buying a broader range of dollar-denominated assets, and are doing more of their purchases through harder to trace broker-dealers.

To my knowledge, at this stage, we have no real way of knowing whether Asian central banks are purchasing fewer dollar assets (relative to the increase in their reserves), or just purchasing fewer Treasuries. In one scenario, Asian central banks are buying euros and other currencies. In the other scenario, they are just buying a broader range of (higher-yielding) dollar-denominated assets, and doing their purchases in ways that the US data does not pick up as cleanly.


  • Posted by BSetzer

    What kind of an impact would a large sell-off or dramatically reduced purchasing of Tresuries by Taiwan, Korea, Russia or India have on yields? Why are they so low now and what would push them up? Would increased yields impact the cost for China of a renminbi reevaluation vs. dollar?

    Since China holds much larger reserves in dollars than in euros, how can it encourage the euro to fall against the dollar as well in order to minimize capital losses on its dollar reserves? Wouldn’t the EU CB also favor this?

  • Posted by anne

    What puzzles me is why a central bank would discuss a change in reserve policy before the policy is implemented. Why should the Korean central bank tell us of policy before there has been significant diversification? Currency traders will simply play off the information. Curious.

  • Posted by anne

    What is the connection between materials prices and relative dollar value? Can we make any sensible connection in the case of oil?

  • Posted by anne

    Does OPEC have the intent and market impact to increase the price of oil in line with any decline of the value of the dollar?

  • Posted by Oy Vey

    Can’t you at least try to combine all of your thoughts in a single post, anne? Frequently, it looks like Brad Setser is posting on your blog and not vice versa.

  • Posted by thomas


    how would the Indian government use its reserves for infrastructure ? I’m assumung it would borrow
    an amount from the central bank (thereby increasing the deficit) and convert the US$ to rupees in the forex market. Is that correct ? thanks.

  • Posted by brad

    B.Setzer — estimates of the impact of dramatically reduced purchases on Treasuries range from about 50 bp to 200 bp, with roach and bill gross estimating 100 bp plus. Nouriel and I have a section in our most recent paper on this, and I intend to do a longer post on it later this week.

  • Posted by brad

    Anne — no objections to me to multiple, short posts.

    Korea is a democracy, and in democracies, you sometimes have to explain policy choices to the people … that may be one reason for “announcing” it, but I don’t really know.

    re: OPEC, they certainly have a fair amount of market power, and one theory for the current market price of oil is that they really have a “30 euro a barrel” target … i.e. the oil sheiks want to keep the price of their summer vacations in Europe constant, in terms of oil. That argument probably has an element of truth in it, though a bit of cold weather and evidence the global demand remains robust also seem to explain the recent run up.

  • Posted by steve kyle

    Yes, there is a problem in using reserves for infrastructure in that most infrastructure is heavily biased toward non-traded goods – Building roads, moving dirt, construction of various kinds for the most part use domestic inputs. So you would have to take the reserves and buy domestic currency to do it, with consequent exchange rate (real and nominal) effects which you might or might not like. I didnt think India was trying to appreciate its currency but I dont really know their current situation.

  • Posted by anne

    Thomas and Steve

    India is poor in infrastructure and somewhat limited in the heavy industry base needed to develop infrastructure, but India has ample foreign currency reserves in dollars. Why not use dollar reserves to “bond” development projects? Even if the dollar loses value against the Euro, there is low relative inflation in America and dollars will buy many heavy manufactured products from America. A dollar reserve or bond on infrastructure projects is an assurance the projects are properly funded, and India has dollars.

  • Posted by anne

    There is a remarkable interview of Amartya Sen on India’s poor and health needs:

    January 9, 2005

    India’s poor need a radical package: Amartya Sen
    The Hindu

    IF THE Manmohan Singh Government is serious about ending the chronic under-nutrition that so many poor Indians suffer from, it needs to think seriously about the public provision of basic healthcare, nutritional support for children and income sup port for the unemployed poor, says Nobel Prize-winning economist Amartya Sen in an exclusive interview to Siddharth Varadarajan of The Hindu.

    Siddharth Varadarajan: If one looks at the social policy commitments of the UPA Government — for example on education and employment — health seems to have something of a low priority. You have been involved in a recent study on the state of healthcare in rural areas. Based on those findings, what do you feel the Government’s approach to health services should be?

    Amartya Sen: We need a radical change in the way health delivery in the public sector occurs. India spends a lower percentage of GDP on public health than almost any other country, including those of similar income levels. The neglect here is massive, particularly because this has led to both the substandard delivery of public health and the development of an immensely exploitative private enterprise in healthcare that survives on the deficiencies — and sometimes absence — of public health attention.

    What we found in the Pratichi Trust survey in West Bengal but also much more sharply in Jharkhand — and based on other information we have, the picture seems fairly widespread — is that when patients go to many of the primary health centres, they find no one there. Sometimes, when they find someone, they will be referred to private doctors. Also, the medical system in the public sector offers no diagnostics, even of basic illnesses like malaria or TB. Patients are usually told to go to private practitioners for testing. Sometimes the testing isn’t very good and, in any case, the economic cost could be ruinous.

    On top of that, the care that is often provided by the private sector comes from quacks. We found an incredible proportion of quacks in Jharkhand, particularly, but a significant proportion even in West Bengal, who provide almost no serious medical attention and instead give saline injections for malaria, which is not really known anywhere in the world as a cure….

  • Posted by anne

    In a Corner of India, They Have the Vote, but Little Else

    PATNA, India – On the next-to-last day of the toughest election race of his career, Laloo Prasad Yadav, one of India’s canniest and most caricatured politicians, is wrapped up in a rambunctious campaign caravan known here as a “road show.”

    Laloo-ji, as he is universally called, sits in the cab of his forest-green campaign bus, eats sugar-cane candy out of a plastic bag and promises factories and bridges to the roaring crowds outside. Marigold garlands are tossed at him in adoration; campaign fliers are tossed out to the crowds; his fans practically stampede for a chance to touch his outstretched hand.

    Mr. Yadav, scion of lower-caste farmers, self-fashioned champion of the downtrodden, now a federal cabinet minister who rules India’s third most populous state, Bihar, worships them in return. “I salute you, I pay my respect to you,” he bellows. “The government of India is yours.”

    As dusk turns to dark, on the edges of the road, Laloo loyalists display his party symbol in a show of support: they hold up lanterns to light up the road.

    Actually, they do not have much of a choice….

  • Posted by P O'Neill

    minor — I think you’re missing a ‘not’ in point (1) of the post.

  • Posted by fatbear

    India’s use of reserves – see this morning’s FT – the Indian Oil Corp bidding to buy medium-sized French oil exploration co with eye (and gov’t eye) on ~300MM barrels in and around Congo, Senegal, Tanzania, etc. That’s a good use of reserves.

    Also, and 2 thoughts slightly cross-posted from comments at the gen’l’s site, I don’t get this sudden notice of the Won. It rose from ~1160 to ~1000 in Q4, and no one said anything – then it settled back to ~1040, and still nada. So the Koreans (who by then had suffered lots of pain very quickly) send out “The Memo” – which by then may have been old news, as they may have decided on diversifying in response to Q4 and already been doing it in early 2005. 2-4% gain/pain now is nothing like the toothache they had at the turn of the year.

    Other point is 71.5% iron ore price increase accepted by the Japanese steel industry – first from CVRD (Brazil) and backed by Rio Tinto. This apparently is in US$ terms, so I guess the Chinese will feel it more than the Koreans, and the Aussies will get less of the benefit than if priced in non-US terms.

  • Posted by Lorenzo


    OPEC, they certainly have a fair amount of market power, and one theory for the current market price of oil is that they really have a “30 euro a barrel” target … i.e. the oil sheiks want to keep the price of their summer vacations in Europe constant, in terms of oil. That argument probably has an element of truth in it, though a bit of cold weather and evidence the global demand remains robust also seem to explain the recent run up.

    I’d disagree pretty strongly here. I see little evidence to support the notion that OPEC has had any consistent ability to influence oil prices over anything but the extremely short run. Especially considering that looking at the data sinse 1960 the case could very strongly be made that the world market price of oil is a predictor of the actions OPEC takes rather than OPEC’s actions having predictive power over the price. This is clearly observable in that OPEC’s production movements consistently temporally trail, rather than precede, medium and long term tends in oil prices.

  • Posted by Lorenzo

    Oops, sorry about the lack of formatting distinguishing quoted text from my response, I forgot the quotation marks.

  • Posted by gillies

    anne –
    there is a 5 year table of oil price in dollars and in euros at this u r l.

  • Posted by brad

    PON – thx for the heads up, fixed.

    Fatbear — Korea may be old news … still, there is an important difference between now and q4. at least until the end of November, Korea was intervening like mad in the fx market to try to stem the won’s rise — so its reserves grew quite substantially in q4 even in the face of won appreciation. The net result: dollar reserve growth, and financing for the US. With the BOK largely out of the market, to my knowledge, reserve growth has slowed at least for now (this was certainly true in january). So any reserve diversification by korea would mean a net reduction in CB financing for the US in q1 05.

    lorenzo, fair point. you can certainly argue that the current run up in oil prices has nothing to do with OPEC. it just reflects a generally tight market — strong demand growth, limited supply, almost everyone producing all out. on the other hand, strong demand and tight non-OPEC supply creates precisely the set of conditions when a cartel — or even one large producer (Saudis) could have an impact on the market. I certainly suspect that fears that OPEC might take some of its production off the market (or Saudis might do so on their own) if prices fell are at least contributing to the current market price. More generally, most oil producers resemble Nigeria more than Norway, so some unforeseen interruption in oil supply cannot be entirely ruled out.

  • Posted by anne


    Thank you for the helpful reference.


    Thank you letting me think in spurts as I am figuring out, or not, what puzzles me.

  • Posted by fatbear

    brad –

    If BOK did support in Q4, then (it looks like) they didn’t in Q1 (as Won dropped through Jan early Feb) – so no need to increase $ reserves early Q1. Then “The Memo” – did that mean BOK going elsewhere, and, if so, did Japan/Taiwan reaction force them to reverse?

    I know I’m in minority, but I think BOK will still acquire other currencies beyond $ – they got badly banged up in the previous market escapade (1998), and it’s my bet that their (longer than our bankers’) memories will make them want to be hedged (no pun) with other currencies in the coming crisis (whenever it comes, now or any date you care to speculate).

  • Posted by brad

    Fatbear — look at the wsj online article glory mentioned in the “korea, enough said” thread. one way to diversify is to farm out your reserves to outside managers, who then invest the funds in a broader range of securities/ broader range of currencies … the WSJ article indicates the basic direction Korea intends to move in, but does not spell out the pace of change.

    It also puts a number on Russia’s euro reserves –about 33% now. i suspect that sets a useful benchmark for thinking about the share of euros (or anything other than dollars) in Asian reserve portfolios.

  • Posted by fatbear

    brad –

    I think I’m with you, and I think we’re actually saying the same thing, except your language is clearer than mine – a simple question:

    Will the BOK diversify no matter what other countries’ reaction was to “The Memo”? (whether BOK direct dealing or through agents)

    1. Yes (my answer)

    2. No, because the pain will be too great if Won rises. (not my answer)

  • Posted by brad

    my gut says that they will do 1, but slowly, and deliberately (in part b/c governments do things cautiously in general). I suspect that to a degree they will end up both diversifying their reserves and still adding to their reserves, which is a mix of 1 and 2, so the net effect will be that there dollar exposure grows, but more slowly than if they were not diversifying …

    That answer should at least eliminate any illusion of clarity on my end.

    I do think we are saying the same thing, namely that they intend, over time, to diversify their reserves in various ways, but that they will want to do so without disrupting the market and will move at a deliberate pace —

  • Posted by ann o'non

    “That answer should at least eliminate any illusion of clarity on my end.”

    I think we may have found Greenspans replacement

  • Posted by CalculatedRisk

    Morgan Stanley, ABN Amro Say Asia to Coordinate Currency Policy
    Feb. 24 (Bloomberg) — Asian policy makers will work together to try to stem the advance in their currencies against the U.S. dollar, said Morgan Stanley and ABN Amro Holding NV.