With a surplus current account, albeit a tad narrow, Malaysia’s reserves are adequate

LATELY, Bank Negara Malaysia’s foreign-reserves position has assumed renewed prominence. Hovering around US$96 billion, the reserves have dipped below the psychological mark of sufficiency of US$100 billion — the first time since September 2010. This dip has raised concerns that any further erosion of the reserves may cause more capital flight, impair the country’s credit rating and, thereby, spark a downward spiral of the economy as in those dark days of the 1997/1998 Asian financial crisis. Such concerns suggest that foreign reserves are relevant after all. But are these worries justified? 

With a surplus current account, albeit a tad narrow, Malaysia’s reserves are adequate

Malaysia is an open economy. Our exports and imports constitute 82 per cent and 70 per cent of our gross domestic product (GDP) respectively. Foreign reserves are necessary for three main reasons: 

FIRST, foreign reserves avoid trade disruption. Reserves are required to pay foreign exporters largely, in US dollars — the currency of choice in trading contracts; 

SECOND, foreign reserves allow the country to withstand prolonged outflows when foreign investors lose their appetite for risk in Malaysia and pull out their investments in bonds and stocks. As much as RM12 billion of foreign funds has exited our equity market this year as against RM7 billion last year. In July alone, global investors disposed 2.4 per cent of their holding of government securities and corporate bonds. As such, foreign-denominated debt has fallen to RM207 billion — the lowest level in three years. All this has scalded the KL Composite Index of Bursa Malaysia, causing it to tumble 13 per cent from the year’s high in April; and, 

THIRD, foreign reserves also serve to back liabilities that a central bank carries in its books. These liabilities include the local currency it issues as well as the statutory deposits banks are required to keep with the central bank. 

Apart from trade, a definitive answer to the question of the relevance of reserves rests on the currency regime of a country. Excepting the many variations, there are essentially three types of exchange rate regimes: 

FIRST, in the fixed exchange rate system, the local currency is pegged to the US dollar, or a basket of currencies, primarily to ensure certainty in the exchange rate and, accordingly, in trade and investment. 

Using its foreign reserves, the central bank defends this peg by intervening in the foreign exchange market by selling foreign currencies (when the demand for the local currency is falling and, thereby, creating additional demand to restore the peg) or buying foreign currencies (when the demand for the local currency is rising and, thereby, increasing the supply of the local currency). During the 1997/1998 financial crisis, Thailand, Indonesia and Malaysia had to unpeg their weakening currencies against the US dollar as their central banks had depleted their reserves in defending their currency pegs against the onslaught of unscrupulous speculation; 

SECOND is the freely floating exchange rate regime. This idealistic free-market system determines the value of a currency against that of a foreign currency solely by the free play of the forces of supply and demand for that local currency. As the central bank has no role to play, foreign reserves are of no relevance to determining a currency’s value; and, 

THIRD is the “dirty” or managed-float exchange rate system such as the arrangement in Malaysia. Here, Bank Negara is not so much interested in maintaining a particular exchange rate as in smoothening any sharp downswing or upswing of the ringgit’s value, especially to the US dollar, so that such swings are not disruptive of short-term investments and consumption. 

It is such recent interventions by Bank Negara that best explain the gradual erosion of our foreign reserves which the bank has so assiduously accumulated from the US$20 billion in 1998 to the current level. Capital flows into the country from the early 2000s assisted this accumulation as Bank Negara dipped into the market to decelerate the consequent ringgit appreciation. 

If foreign reserves are necessary for a well-functioning trading economy as Malaysia’s, what then should be their optimal size? Although questions have been raised as to their usefulness, there are two commonly used yardsticks: 

FIRST, reserves should support the purchase of three months of retained imports (imports minus re-exports); and, 

SECOND, reserves are able to finance fully a nation’s short-term (less than a year) foreign debts. Below these levels, the markets will start to panic and the economy vulnerable to collapse. 

On both these fronts, Malaysia is in a comfortable position. Our reserves can finance roughly eight months of retained imports — unlike Nigeria or Russia (and our position in 1998), with reserves just covering three months. Our reserves can more than cover (1.05 times) all short-term foreign debt. Indeed, as the International Monetary Fund suggests, countries with good institutions and policies, such as Malaysia, can afford lower levels of reserves. 

Large reserves are especially required by countries that only produce a few goods; and that, too, commodities. Given the wild commodity-price swings, such countries would require large reserves to pay for imports should commodity-export prices collapse. As China, Japan and India, Malaysia’s exports are well diversified. With a surplus current account to boot, albeit a tad narrow, Malaysia’s reserves are adequate. 

Ultimately, it is not foreign reserves per se that are critical to protecting a country’s economy from potential crisis. Rather, it is the overall quality of its macroeconomic policies. Prudent economic management will engender confidence among foreign investors to stay invested in the country. On that score, too, Malaysia fares well.

Source : NST