[R-G] Illusions over Central Banks' Reserves Could Be Shattered

[Yoshie Furuhashi]

<http://www.ft.com/cms/s/0/e9685bc4-9fd2-11dd-a3fa-000077b07658.html>
Illusions over central banks' reserves could be shattered
By Satyajit Das
Published: October 22 2008 03:00 | Last updated: October 22 2008 03:00

The substantial reserves of central banks and their acolytes,
sovereign wealth funds, are frequently cited in support of the case
for a large pool of "unleveraged" liquidity, that is "real" money.

These funds, some reckon, sit ready to support asset values across the
globe. In reality, the available pool of money may be more modest than
assumed. For example, China has close to $2,000bn in foreign exchange
reserves. The reserves arise from dollars received from exports and
foreign investment into China that are exchanged into renminbi. The
central bank generates renminbi by printing money or borrowing through
issuing bonds in the domestic market. The reserves are essentially
"leveraged" using domestic "liabilities".

The dollars acquired are invested in foreign currency assets, 60 per
cent in dollar denominated US Treasury bonds, GSE paper (such as
Freddie Mac and Fannie Mae debt) and other high-quality securities.
China is exposed to price changes in these investments and currency
risk through the mismatch between foreign currency assets funded with
local currency debt. Deterioration in the credit quality of the US
results in losses on investment through falls in the market value of
the debt and a weaker dollar.

Also, it is not easy to tap this liquidity pool. Given the size of the
portfolios, it is difficult for large investors such as China to
mobilise rapidly a large portion of these funds by liquidating their
investments and converting them into the home currency without
substantial losses.

If the dollar assets lose value or access to them cannot be gained,
China must still service its liabilities. It can print money but will
suffer the economic consequences including inflation and higher
funding costs. The position of emerging market sovereign investors
with large portfolios of dollar assets is similar to that of a bank or
leveraged hedge fund with poor quality assets. Wen Jiabao, China's
premier, recently observed: "If anything goes wrong in the US
financial sector, we are anxious about the safety and security of
Chinese capital."

The substantial build-up of foreign reserves in central banks of
emerging markets and developing countries has puzzled economists. As
identified by David Roche, of research boutique Independent Strategy,
the build-up of central bank reserves is really a liquidity creation
scheme that relies on the dollar's favoured position in trade and as a
reserve currency.

Deterioration in the US economy and the issue of more government debt
to support the financial sector could increase pressure on the US
sovereign rating and the dollar. US government support for financial
institutions is approaching 6 per cent of GDP compared with less than
4 per cent at the time of the Savings and Loans crisis. This may set
off a further phase in the global deleveraging as large losses on
dollar investments slow down the international credit creation system.

Gillian Tett of the FT coined the phrase "candy floss money".
Financial technology spun available "real" money into an exaggerated
bubble that ultimately, like its fairground equivalent, collapses. The
emerging market reserves system is another dimension of this candy
floss money.

The perceived abundance of liquidity was, in reality, merely an
illusion created by high levels of debt and leverage as well as the
structure of global capital flows. As the financial system
deleverages, it is becoming clear, unsurprisingly, that available
capital is more limited than previously estimated.

In recent years, money was cheap and other assets were expensive. As
each of the global economy's credit creation engines breaks down and
systemic leverage reduces, money becomes scarce and expensive
triggering adjustments in asset prices in a reversal of the process.

Mark Twain once advised: "Don't part with your illusions. When they
are gone, you may still exist but you have ceased to live". In the
current financial crisis, many illusions have been shattered. The
quantum of available capital and the munificent resources of central
banks and sovereign wealth funds may be another of the accepted
"facts" that may be revealed to be an illusion.

The writer is a risk consultant and author of Traders, Guns & Money:
Knowns and Unknowns in the Dazzling World of Derivatives.