The Malaysian banking system continues to be sound, liquid and has maintained a healthy positive net asset position in foreign exchange since 2010.
Bank Negara Malaysia’s recent intervention to prop up the Malaysian Ringgit, now at its 17-year low, is reportedly eating into our country’s reserves. Should we be concerned about its impact on the nation’s external finance?
Business Circle speaks to an economist, who declined to be named, about the role the reserves play and whether we have cause to worry.
Q: What are Bank Negara reserves? What is the purpose of the reserves?
Bank Negara’s international reserves are the central bank’s holdings of gold and foreign currencies. The best way to think of reserves is as the nation’s official foreign currency savings (distinct from the savings of Malaysian individuals or companies).
The purpose of holding reserves is to meet Malaysia’s external obligations – paying for imports, paying off foreign currency debt, meeting outflows of capital – in case there are insufficient foreign exchange resources within the broader banking system. For example, if someone went to his or her bank needing Japanese Yen, and that bank doesn’t have sufficient Yen on its books, it will try to buy Yen on the interbank market. If that option isn’t available, the bank can apply at BNM. More generally, if BNM saw insufficient foreign exchange assets in the banking system, it could offer its reserves in exchange for Ringgit, thus replenishing resources within the banking system.
In the economics profession, it is common to think of international reserves as a form of insurance, savings intended for a rainy day. Back in the 1950s and 1960s, when all currencies were fixed against each other, having international reserves was absolutely necessary as reserves would automatically rise and fall with inflows and outflows of trade and capital. The change in reserves served to maintain exchange rates at the required parity. These days, with most currencies following floating exchange rate regimes, international reserves are much less necessary, and quite a few central banks have little or no international reserves at all.
Q: What are the components of the reserves? Do the ratios of the components make any difference?
Central banks that hold reserves typically diversify their holdings. Although a big chunk of those reserves would be held in US Dollars, which is the main currency used in international trade and finance, other currencies are held as well. These include the Euro, the British Pound, and the Japanese Yen, as these currencies feature high liquidity (it’s easy to move in and out of those currencies) as well as deep and large capital markets in which to invest holdings of those currencies. It is highly unusual for more than a tiny fraction of international reserves to be kept as cash. Other currencies are also used, such as the Swiss Franc, and it is becoming more common to hold major developing country currencies, such as China’s Renminbi.
As a rule, central banks do not disclose the exact breakdown of what currencies comprise their international reserves. Data from the Bank of International Settlements (the international central bank to all the other central banks), however, suggests that about 60% of reserves held by central banks globally are in US Dollars, with most of the rest either in the other major reserve currencies, the International Monetary Fund’s (IMF) synthetic SDR (Special Drawing Right) currency, or gold.
Changes in the composition of reserves are generally driven by the investment outlook for the underlying economies, and the need to manage portfolio risk by diversifying holdings. In that sense, central banks act just like any other typical foreign portfolio investor. There are exceptions to this approach; for example in China and Singapore, the management of foreign exchange reserves is outsourced to another agency (SAFE in China, GIC in Singapore) and not under the central bank directly.
Q: What is a healthy level of reserves? How are Bank Negara’s reserves compared with other central banks?
The international benchmark for international reserves is the equivalent of 3 months of retained imports (imports for domestic consumption and not re-exported) and 100% of short-term foreign currency debt (debts falling due in less than one year). These are traditionally used rules of thumb, rather than hard and fast rules on reserve adequacy. Recent changes in what is considered to be foreign exchange “debt” as well as the growth and prevalence of cross-border capital flows, have challenged whether these rules of thumb adequately capture the “insurance” value of international reserves.
Nevertheless, by the old standards, BNM’s reserves are more than sufficient at 7.9 months of retained imports and 1.1 times short-term debt (as of July 2015). By contrast, many developed economies hold minimal reserves. For example, in Australia and France, reserve holdings are sufficient to cover just 2 months of retained imports, while the US, Germany and Canada hold just 1 month (source: World Bank). Japan by contrast holds 14 months of retained imports, and 5-7 months is common in East Asia while the global champion is Saudi Arabia at over 30 months!
In fact, many East Asian central banks (including BNM), have been criticised by the IMF and other developed countries over the past decade for holding an excessive amount of international reserves. One aspect of this criticism is that the act of building up international reserves puts downward pressure on the domestic exchange rate, bringing with it accusations of “currency manipulation” and deliberate “undervaluation” of the exchange rate.
But given the experience of the Asian Financial Crisis, the recent Global Financial Crisis, as well as the outflow of capital that has affected most emerging markets over the past two years, BNM’s strategy of building up international reserves during good times appears to be paying off.
Q: What happens if the reserves fall too low?
With low reserves, a central bank loses the ability to influence foreign exchange liquidity and volatility in the interbank market. Under those circumstances, the banking system will need to manage on its own, and the full impact of capital flows would be reflected in the ups and downs of the exchange rate. For countries with highly developed financial markets, this is obviously less of an issue, which is why the central banks of developed countries tend to hold minimal foreign exchange reserves. For developing countries like Malaysia, especially given our small size relative to global capital flows, reserve adequacy is more of a concern. Nevertheless, Malaysia’s banking and financial system are considerably more advanced than our peers at similar stages of development.
Q: Intervention by Bank Negara to support the still plummeting Ringgit is eating into its reserves at a rapid pace. Many are starting to worry over the nation’s external finance. Is there cause for concern?
BNM’s stated policy since 2005 is to allow the Ringgit to float freely, except during times of high volatility. During those times, BNM will step in to limit market movements of the Ringgit by intervening in the market through buying or selling of international reserves. In other words, BNM will not act to prevent the Ringgit from appreciating or depreciating (there is no “line in the sand”), but will try to limit the rate at which the Ringgit appreciates or depreciates. Thus, foreign exchange intervention and loss of reserves will not occur continuously, but in spots when the interbank system is running short.
Looking at the reserve data makes this clear – the biggest intervention efforts BNM has put in so far has been in January 2015 and June-July 2015. Outside those months, reserves have either declined very slowly, or actually risen.
Another issue is that the habit of quoting reserves in US Dollar terms grossly overstates movements in international reserves when the USD itself is changing value, due to revaluation effects on other reserve currencies. Since not all reserves are in USD, and since is it the USD that is currently appreciating rather than other currencies weakening, the effect is to exaggerate the decline in BNM’s international reserves. To quote an extreme example, the Monetary Authority of Singapore (MAS) earlier this year had to issue a statement saying it had not intervened in the FX market in the latter half of 2014, despite a very large drop in its official reserves in USD terms. Viewed from a Singapore Dollar perspective, MAS reserves had not dropped at all, and the “change” in reserves was entirely due to changes in the USD exchange rate. Similarly, although BNM’s reserves have appeared to drop sharply in USD terms (23.8% since July 2014), the decline is much less acute in Ringgit terms (10.5%).
Lastly, it should be emphasised again that international reserves are really held as insurance. The first “line of defence” is the banking system, which in Malaysia continues to be sound, liquid and has maintained a healthy positive net asset position in foreign exchange since 2010. Net foreign assets of the banking system stood at RM46 billion in May (the latest data available), down from RM62 billion in March, but well up from the RM20 billion after the “taper tantrum” episode in March-June 2013.
Looking ahead, the pending tightening of US monetary policy by the Federal Reserve should provide a turning point, and some relief from the pressure of an appreciating US Dollar. Historically, Dollar reversals tend to occur a few months after changes in Federal Reserve interest rate policy. As such, we should not expect the pressure on the Ringgit, and on Bank Negara’s international reserves, to last forever.
What is the point of buying an umbrella for a rainy day if you don’t use it when it rains? And after the rain, the sun always shines again.