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February 23, 2005

Brad Setser Thinks About Foreign Central Bank Reserve Diversification

He writes:

Brad Setser's Web Log: Reserve Diversification: 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.... News about what any of these four central banks intend to do is hardly marginal news in my book.... 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.... But the past is the past.... 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 [renminbi price] of [the dollar fall] by 20%, from 8.28 renminbi to the dollar to 6.62.... If the euro/ dollar exchange stays constant... the capital loss on its dollar and euro reserves will be identical... diversification may, or may not, help at this stage....

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....

Posted by DeLong at February 23, 2005 12:04 PM