Asia & Reserve Accumulation "Crowding Out" and the Cost of Sterilization :: JPMorgan

Asia’s FX reserves have increased +54% since the end of 2008, boosted by a
rebound in trade & accelerating capital inflows. Today, Asia sits on $6.7 trillion
of FX reserves, over 61% of the world’s total. “Sterilized” intervention has both
managed currency appreciation & limited domestic inflation; but this ignores the
very real cost of FX reserve accumulation. Policies that delay or resist currency
appreciation ultimately lead to the misallocation of capital & over-dependence
on exports (China). Moreover, sterilized intervention “crowds out” private credit,
by redirecting domestic liquidity away from loans, and towards sterilization
instruments (China, Phils). This results in both lower profitability for banks, as
well as higher interest rates & less access to credit for private sector borrowers.
Ultimately, there’s no free lunch to FX reserve accumulation. Continued QE in
the West – with more aggressive action by the BOJ in particular – is forcing Asia
to make tough choices between further “crowding out” & allowing faster growth
in money supply (“unsterilized” intervention). We focus on how these issues are
forcing policy changes in the Philippines, Thailand, and China in particular.
 FX reserves are generally viewed positively, reflecting the strength of the export
sector & the ability to attract inflows; unfortunately, these reserves come at a
price, and sterilized intervention results in a number of distortions.
 The central bank can lose money when the yield on foreign reserve assets is
below the cost of issuing sterilization instruments. This "negative spread"
increasingly became an issue post-08 as US/EU rates collapsed, and led to
falling capital ratios at central banks across the region. In the case of the
Philippines, it recently required a capital injection from the government.
 The issue is not unfamiliar to Asia. In the early ‘90s, rising domestic rates &
falling US rates forced Malaysia to scale back sterilization. When a central bank
buys FX, it sells domestic currency; if it doesn’t sterilize, the monetary base
expands. So it was in Malaysia: after sterilization was put on hold, base money
surged from +11% Y/Y to +41%; a year later, loan growth followed, rising from
+12% to +30%. Credit growth accelerated right into the Asia Crisis.
 Sterilization also “crowds out” the private sector by forcing banks to divert
domestic liquidity away from loans/bonds and into sterilization instruments.
High RRRs in China (big 4, 20%) & the Philippines (18%) is the key reason
why loans are just 50% of bank assets in both countries. This weighs on bank
NIMs (RRRs = low yields in CH, no yield in PH) & pushes up borrowing costs.
 Continued QE in the West, and more aggressive actions by the BOJ more
recently, are putting further pressure on sterilization policies. Given the negative
spreads on, and current size of, sterilization measures, we see countries pursuing
a number of alternative measures.
 In the Philippines, the BSP has cut SDA rates twice & cut off foreigners from
using SDAs. This should boost onshore liquidity, supporting stronger loan
growth going forward. Likewise, Thailand has pursued unsterlized intervention;
but here we worry more about adding fuel to an already-robust credit cycle.
China is also pushing to recycle liquidity abroad, hence the headlines on RMB
swap agreements recently signed with a number of countries. This should help
reduce the need to stockpile reserves going forward, but China still faces a long
adjustment if it wants to de-emphasize exports in favor of consumption

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