Don’t break the central piggy bank

By Wu Hui-lin 吳惠林  / 

Wed, Mar 18, 2009 - Page 8

The central bank recently issued a press release denying reports that the government would use NT$1 trillion (US$29.2 billion) in foreign exchange reserves to fund increased expenditure on infrastructure.

The bank said that using foreign exchange reserves to support attempts to increase domestic demand would cause inflation, a deterioration in the bank’s finances and threaten domestic financial stability. I hope the bank can stand up to the various pressures it is currently facing and not give in to political factors.

The bank also cited the example of Singapore, saying the Singaporean government had no plans of using its foreign exchange reserves, but rather the yields from two organizations that the Ministry of Finance has invested in. The bank also said Japan was planning to lend US$5 billion in foreign exchange reserves to the publicly run Japan Bank for International Cooperation (JBIC), which would then lend this money to Japanese businesses overseas to meet their foreign currency needs.

The crucial point here is that this foreign exchange would never be used within Japan.

Foreign exchange reserves refer to the total amount of foreign currency held by the central bank at a given point in time. The central bank only plays a passive role in accepting foreign exchange, which they get because holders of foreign currency require the local currency.

So, where does this foreign exchange come from? Most US dollars, for example, come from earnings from exports to the US.

It is not the central bank that has earned the foreign exchange it holds. In addition, the value of foreign exchange reserves the central bank holds should be equivalent in value to the amount of local currency it releases. The central bank only “looks after” this foreign exchange and must constantly be ready to exchange it for NT dollars.

We can understand this by taking a look at how regular banks accept deposits but are ideally prepared at all times for those who make the deposits to come and withdraw their money. This is why banks have to exercise the due care of a prudent administrator.

We know that banks accept deposits, but they also lend money and pay interest on deposits. That interest comes from interest earned on loans that are higher than the interest banks pay on deposits. Therefore, it is a bank’s responsibility to find good investments that for every dollar invested will make more than one dollar in profit when interest is included.

This is required for people to be able to deposit money in banks without any safety concerns, and for the economy to run smoothly.

However, we must ask ourselves whether the central bank can play the role of a normal bank.

In theory, it seems it can, so long as it is sure it can increase the amount of foreign exchange it holds. As far as Taiwan is concerned, the central bank currently handles foreign exchange in a manner similar to private banks, although it cannot issue loans like regular banks.

Thus, those who really should have the right to use foreign exchange reserves are private individuals and organizations — in other words, those who earned that foreign exchange in the first place. However, if the central bank manages to increase the amount of foreign exchange it holds through financial planning, should it be allowed to use that part of its foreign exchange reserves?

At the end of the 1980s, when Taiwan’s bubble economy was at its highest, the late Academia Sinica academic, Hsing Mu-huan (邢慕寰), proposed the establishment of a central bank fund for foreign exchange development to lend a portion of the foreign exchange reserves to businesses through commercial banks at market rates rather than letting businesses use it free of charge. The suggestion was never adopted.

At the end of 2003, the Cabinet planned the establishment of a task force aimed at encouraging the investment and effective use of foreign exchange resreves.

Within two months, the Cabinet proposed a policy through which the central bank would take on the role of financier, which would have allow domestic businesses to import machinery and equipment and encourage investment in Taiwan.

The proposal was similar to Hsing’s suggestion, but it met with a lot of criticism and a decision still has to be made on whether the government should be allowed to use the foreign exchange reserves.

Maybe it would be acceptable for the government to use the foreign exchange reserves if it were fair and just and avoided extending preferential treatment to certain businesses. However, as central bank Governor Perng Fai-nan (彭淮南) said, they must exchange NT dollars for the foreign exchange reserves they want to use.

Wu Hui-lin is a researcher at the Chung-Hua Institution for Economic Research.