Viewpoint: The new gorillas of finance
International Herald Tribune
SEPTEMBER 17,, 2006
William Pesek

Predator? Savior? Either way, hedge funds are taking a back seat to the new 800-pound gorillas of global finance: Asian central banks. The International Monetary Fund's last annual meeting in Asia featured a debate about hedge funds.

At that 1997 event in Hong Kong, Robert Rubin, who was then Treasury secretary, argued that hedge funds were a vital source of liquidity - saviors when markets dry up. Asian policy makers saw them as predators causing undue volatility and overwhelming central banks.

Things culminated in a surreal dustup between the U.S. billionaire George Soros and then Prime Minister Mahathir Mohamad of Malaysia. Mahathir blamed Soros for driving down the Malaysian currency, calling him a "moron." Soros called Mahathir a "menace to his own country."

How things have changed. Since 1997, currency reserves at Asian central banks have risen to about $3 trillion, much of it parked in U.S. Treasuries. On the one hand, that development is leaving fewer dollar-denominated securities in which hedge funds can trade. On the other, it sometimes causes illogical moves in markets and puts hedge funds on the defensive.

"Central banks aren't really supposed to think about maximizing returns, but given the magnitude of holdings in Asia, they're having to manage them as never before," said Marshall Mays, director of the Asian Bond Market Forum, an organization focused on creating a regional debt market.

Here's an example of what could happen. A report showing the U.S. economy is holding its ground drives the dollar higher. Central banks like the People's Bank of China may see that as a perfect opportunity to sell a chunk of their U.S. holdings, pushing the market in a direction that traders don't expect.

Aside from prompting considerable head-scratching around Asia, the sheer weight of sell or buy orders that traders suspect may come from central banks is altering the dynamics of markets.

Nowadays, one increasingly hears traders chattering about how central banks are swapping large amounts of this currency for that one.

Of course, all of this is virtually impossible to confirm. Central banks are highly secretive about their transactions. Yet when you consider the unprecedented buildup in reserves since the 1997 Asian crisis, it stands to reason that central banks would be ever-growing players in currency and debt markets.

It's not just about manipulating currencies, but managing massive portfolios. While central banks don't amass reserves for profit, an unintended consequence over time may be that their growing status in markets reduces returns of currency investors.

Like any good trader, central banks are apt to choose moments when they expect an increase in market liquidity - say, when Federal Reserve officials speak or Japan releases inflation data - to make adjustments in their holdings. More and more, it's turning Asian central banks into market heavyweights.

"U.S. bond yields seem unsustainably low to us, and they have recently been squeezed by large speculators shifting from record-short to record-long U.S. Treasury positions," Bridgewater Associates in Westport, Connecticut, wrote in an Aug. 31 report.

In the last couple of years, many speculators bet on a drop in U.S. debt prices. That left plenty of securities for purchases by foreign central banks.

"Recently, however, large speculators betting on a significant slowdown in growth have switched and are now buying into a market already squeezed by foreigners who own 60 percent of the Treasury market," Bridgewater wrote.

The issue should be high on the list of topics discussed at the IMF meeting in Singapore. It's not about looking out for hedge funds; it's about taming volatility in economies. Yet it's also about exploring the wisdom of central banks amassing ever-growing stockpiles of reserves. Isn't there a better use for the money?

Asian economies are still using exchange rates as a crutch to maintain exports. What they really should be doing is letting currencies rise and bringing home the money now sitting in U.S. debt. It could be put to good use improving roads, bridges, ports and power systems, as well as upgrading education, health care, supporting entrepreneurship or reducing bad loans in banking systems.

The IMF could play a vital role in enlivening the debate. A recent paper from the Bank for International Settlements underlines the urgency. In it, the BIS staffers Madhusudan Mohanty and Philip Turner express surprise that the reserve buildup hasn't caused inflation.

"Nevertheless," Mohanty and Turner said, "large and prolonged reserve accumulation can still create risks other than near-term inflation. These include high intervention costs, monetary imbalances, overheated credit and asset markets and very liquid and, perhaps, distorted banking systems."

Of course, one reason the IMF might like to discuss reserves is to preserve its own relevance. Asian nations have accumulated so many reserves that they're unlikely to need the IMF's help anytime soon. The bigger problem is that monetary authorities may be reaching the point of no return in their ability to reverse course.

If markets get a whiff that central banks are trimming reserves, debt prices and currencies may plunge, leaving them with huge capital losses. That's why Asia needs to think about halting such purchases, and fast.

"That situation is unsustainable," said Mukul Asher, professor of public policy at the National University of Singapore. "That kind of macroeconomic balance has put global growth and financial stability on a knife's edge."

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