Korea's Bulging FX Reserves

Bank of Korea strengthens risk management to safeguard FX reserves and earnings

One of the important changes in the reserves management environment since the start of the New Millennium has been the rapid build up of reserves in developing countries, especially in Asia, the Bank of Korea said in a report on the rising foreign exchange reserves.
The foreign reserves of Asian developing economies have grown at a pace two or three times faster than the reserves of developed nations. In 2004, in terms of total amount accumulated, they surpassed those held by developed nations.
In the case of Korea, since the near depletion during the 1997 financial crisis of its 30 billion dollars of foreign reserves, its coffers have been rapidly replenished, and have reached 250 billion dollars now, after just ten years.
This sharp increase of reserves in Korea and other countries has been in part attributable to the global economic imbalances caused by the large current account deficit of the US, and the corresponding surpluses of Asian developing countries.
As we think of a possible solution for tackling the global imbalances, we know that the reserve management strategies of developing countries can significantly affect the global financial markets.
Until very recently, the emphasis of reserves management was put on the intangible benefits of holding reserves, for example the positive impacts on sovereign credit ratings and the increased resilience of the economy to domestic and/or external shocks.
But with the huge increase in foreign exchange reserves recently, more attention is now being paid to their opportunity costs.
The build-up of reserves also places policy makers under growing pressure to improve returns on reserves, and to address other issues, such as central bank balance sheet risk.
In response, many central banks have expanded their investment universes away from their traditional government-bond-oriented portfolios.
Therefore, non-government securities with higher risk and non-traditional profiles are no longer outside the norm. for example, of MBSs, ABSs and corporate bonds.
Over the past six years, the US Treasury holdings of foreign central banks, as a percentage of total non-gold reserves held at the New York Fed, have fallen markedly―from 29.0% in 2000 to 22.5% in 2006. In sharp contrast, US Agency debt and MBS holdings have increased more than twofold over the same period―from 4.7% to 11.0%.
Now the key question is this: how far and how fast can such investment diversification be carried out?
As the concern with diversification and returns on investment increases, the effective management of risks arising from reserves management becomes ever more critical.
In particular, any failure in risk management on the part of a central bank will have a tremendous impact on the credit- worthiness of its entire nation.
It goes without saying, therefore, that a sound risk management system is of paramount importance.
The case for regional financial cooperation
We have come a long way since the financial crisis swept through Asia in 1997, seriously undermining the economic and social welfare of so many people in the region. This experience served us as a wake-up call, and regional financial cooperation has been greatly strengthened since then.
In May 2000, the Chiang Mai Initiative bore fruit leading to the first significant regional financing arrangement, specifically, a network of bilateral swap arrangements. The spirit and effort needed for further cooperation is currently embodied in the Asian Bond Market Initiative, which aims to broaden and deepen the domestic and regional bond markets.
And the regional cooperative body of central banks, better known as EMEAP, has successfully launched Asian Bond Funds, or ABFs I and II, which invest, respectively, in baskets of US dollar- and local currency- denominated bonds issued by sovereign and quasi-sovereign entities within the region.
Having successfully rebounded from the devastation of the financial crisis, through some very extensive and painful restructuring programs, the Korean financial markets have re-emerged now as attractive destinations for foreign investment.
As of the end of 2006, the size of Korea's capital markets was 1.6 trillion US dollars, or 1.8 times national GDP. The bond markets accounted for 49% of this, the stock market for the other 51%. But while foreign investors currently hold a whopping 39.3% of total stocks outstanding in Korea, they have invested in a mere 0.5% of domestic bonds.
Apparently, there is plenty of room for improvement in the Korean bond market. In this regard, regional and/or international financial cooperation must be an ongoing process, that stands up to the challenges of time.
The central bank said it sincerely hopes that investors, will continue to have interest in the Korean financial markets. Let this program be an occasion for the investors to establish and/or renew their acquaintance with the Korean financial markets and with Korea's truly dynamic population and unique culture. nw

Gov. Lee Song-tae of the Bank of Korea.