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INTERVIEW: Excess foreign reserves do not help economy: Wu

By Joyce Huang
STAFF REPORTER
Monday, Mar 03, 2008, Page 11

Wu Hui-lin, a research fellow at Chung-hwa Institution for Economic Research in Taipei, speaks at a press conference on Sept. 19, 2005. PHOTO: LO PEI-DER, TAIPEI TIMES

Taipei Times (TT): Taiwan's foreign currency reserves, which were equivalent to the value of 15 months of imports or nearly 70 percent of GDP, leaped to another record high in January ranking as the world's fifth-largest after China, Japan, Russia and India. You've warned that having too much in foreign reserves can lead to disaster since theoretically a country only needs foreign reserves equivalent to three months to six months worth of imports, or 10 percent of GDP. Why?

Wu Hui-lin (吳惠林): Both inflation and market speculation are a result of excess foreign reserves. Once there's too much idle capital, financial floods -- and sometimes tsunamis -- are created wherever it flows. Most countries that have high foreign reserves are facing these two problems: excess capital-triggered inflation and market speculation. These may start as a domestic issue, but will eventually turn into a global problem. These were the reason behind the 1997 financial crisis in Asia and other similar financial downturns around the world, such as Japan's economic recession since 1990.

Currencies should be viewed as a trading tool, but now they are utilized to speculate for gains. Too much money (liquidity) drives up prices, which is a typical inflation story. If the money is used to buy stocks instead of commodities, share prices go up whenever there are capital inflows. Once there's capital outflow, share prices immediately tumble or fluctuate frequently.

An example of this is the local property market bubble. When the money was put into property assets, other than equities, the local property market prices skyrocketed and plummeted between 1985 and 1990.

No country should keep [too much in] foreign reserves. It should be spent on commodities in the places where the foreign reserves were earned from -- trade by barter in the international trade sense. But too many countries are now stashing foreign reserves and their value declines when the foreign currency weakens [as in the recent case of the US dollar].

TT: It creates confusion. Take the New Taiwan dollar's recent appreciation [NT$30.950 against the greenback on Friday] as an example. Foreign capital inflows drove up the NT dollar, but, at the same time, created more foreign reserves in Taiwan, which could worsen the nation's inflation. But somehow, others argue that allowing the NT dollar to rise can help contain inflation since the price of imported commodities will drop. So, what exactly is the story behind it?

Wu: It's a question of cause and consequence. In a country with high foreign reserves, the general expectation is that its currency will gain. If speculative players, who bet on the exchange gains, further decide to pump in capital, the currency will certainly rise more that it would otherwise. If [Taiwan] truly allows the market to decide its own exchange rates, speculative players may not benefit so much, so there wouldn't be this double damage.

TT: Are you saying that the central bank shouldn't have stepped in to intervene in the NT dollar's exchange rate?

Wu: Compared to its Asian counterparts, [Taiwan's] central bank should be given more credit because it has loosened its grip on the foreign exchange market since 1990. [Taiwan's] Foreign reserves have continued to grow for a long time, but few recent gains are from [international] trades, which the central bank ought to keep monitoring along with its interest rate policy and speculative capital inflows. The central bank doesn't step in as often as it once did. Only when irregularities occur does the central bank step in before the market closes.

TT: Earlier you said that the market should decide what the foreign exchange rates are. But you also praised the central bank's decision to buy US dollars recently to slow down the NT dollar's appreciation. Isn't that a bit contradictory?

Wu: Theoretically, if countries in the world allow the market mechanism to prevail, the foreign exchange rates among countries will be decided by the market. However, the reality is that central banks in some other countries are still controlling their rates. If [Taiwan] doesn't join them, we may be victimized because the currency we earned may soon become a worthless pieces of paper [sigh]. Too much money can be troublesome -- a miserable money game human beings trap themselves in.

TT: But, I mean, why won't the central bank join the bandwagon and dump US-denominated foreign reserves while allowing the NT dollar to strengthen against a weakening greenback? Can the central bank allow that to happen although a stronger NT dollar could harm the nation's exporters?

Wu: It's not the central bank's job to be involved in such open-market trades, which should only be restricted to people other than speculative players. Also, it shouldn't be the central bank's responsibility to manage the currency's fluctuation, which puts it in the awkward position of balancing between exports and imports. Being a central banker isn't an easy job at all, especially when a country's policy both encourages exporters and protects importers.

TT: As [former US Federal Reserve chairman] Alan Greenspan said in his biography, inflation should be the main target the central bankers fight. Isn't it so here in Taiwan?

Wu: Yes, by managing money supplies, which are, nevertheless, highly difficult to bring under control. That's why [US economist] Milton Friedman, who passed away two years ago, couldn't help but come up with a constant rule that suggests that a country's growth of foreign reserves should be in line with its GDP and inflation rate. Hypothetically, if a nation has a 3 percent GDP and 2 percent inflation, its foreign reserves should have an estimated 5 percent growth.

Empirical evidence also shows that a country's foreign reserves should be equal to one-tenth of its GDP or three months to six months of imports. Taiwan's foreign reserves, which accounted for 70 percent of its GDP or 15 months of imports, are far more than needed. No wonder the country's inflation is set to rise. But regretfully, these rules haven't been closely followed by central banks around the world, which is why we are living in a chaotic financial world [sigh].

The most ideal way would be for the world to use the same currency, which would eliminate the hassle of exchange rates among countries. This is also why the euro was created -- to cut down exchange hassles.

The greatest financial instability lies in China with its US$1.5 trillion in foreign reserves, which can spell a lot of financial volatility in the future. Still, a lot of businesses fearlessly flood into [China] without knowing the looming crisis.

TT: When it comes to China, there's always debate as to whether it is full of new business opportunities or will soon collapse. It seems that you side with the latter?

Wu: Yes and I believe [August's] Olympic Games will be a good reference to determine whether it will collapse. Before the game, China is doing all it can to maintain prosperity and stability. It has also tightened control over the media, which now only reports positive news about the country. But the truth is that China's "macro control" measures to cool the economy are mostly ineffective and will end up creating more chaos. This is what we call the market's fight-back force because no government can really control anything. China is speeding up its massive infrastructure push before the Games all around the country, which will largely sit idle after the Games.

TT: But some argue that the domestic demand in China is picking up with people getting richer and richer.

Wu: That is still just talk. The majority of people in China are still very poor. Around the world, those that have held Olympic Games have mostly failed to generate revenues out of the games or fully utilize Olympic-designed infrastructure after the game except Los Angeles.

The way China has gone about organizing the Games has been very drastic -- borrowing loans from banks to build the infrastructure without calculating the cost, which will eventually worsen its already high bad-loan ratio.

Lessons can be drawn from Japan, which was the biggest economy in Asia in the 1980s, but entered a recession in the 1990s that they're still in even now. Besides, financial institutions in China are not performing as well. So, we may soon witness a Chinese collapse.

All the people in the world are now living in a global village, where citizens of one country can not avoid the negative impact of a financial crisis in another country. For example, China exported deflation not long ago, but now it exports its inflation [to neighboring Asian countries].

We do want China to prosper, but not in the way that the Chinese communists rule. China should lose its controls, open up its market and embrace democracy to counter-balance different interest groups while making the best of its resources.
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