Asia's Central Banks - The Risks of Ballooning Balance Sheets

In recent weeks, I have posted several articles in this blog looking at the rapid expansion of the balance sheets of three of the world's major central banks; the Federal Reserve, the Bank of England and the European Central Bank.  Since the middle of 2008, all three of these banks have seen rapid increases in their balance sheets as they've made desperate attempts to stimulate their respective economies through the purchasing of their local sovereign debt instruments.  What we rarely read about, are the balance sheets of the central banks of the emerging Asian economies and how the actions of these banks could impact the economy.

In a Bank of International Settlements research paper entitled "The expansion of central bank balance sheets in emerging Asia: what are the risks?" by Andrew Filardo and James Yetman outlines the growth in the balance sheets of Asia's central banks because of the huge buildup in foreign reserve assets and the risks associated with this rise.

First, let's look at how assets and liabilities are looked at from a central banker's viewpoint and exactly what a central bank's balance sheet is used for.  A central bank's balance sheet assets consist of foreign and domestic assets including government bonds, foreign exchange and gold and its liabilities consist of currency in circulation, bank reserves, central bank securities, government deposits and equity capital (accumulated profits).  Policies that result in an increase in the size of a central bank's assets by necessity require a corresponding increase in the bank's liabilities.  This is where problems can occur.

What does a central bank use its balance sheet for?  Historically, central bankers have used their balance sheets as a lender of last resort.  They can alter the size of their balance sheets to achieve certain economic goals (either controlling inflation or, as we are now experiencing, stimulating economic growth) as we have all seen from the recent rather futile actions of Ben Bernanke and Mervyn King.

Let's open by looking at two graphs from the report, the first which shows the increase in the size of the balance sheets for the Fed, the Bank of England, the ECB and the People's Bank of China (PBOC) since the 2001 reference year and the second graph which shows the increase in the balance sheets since the reference year 2001 for Hong Kong (HK), Singapore (SG), Malaysia (MY), Philippines (PH), Thailand (TH), Indonesia (ID), India (IN) and Korea (KR): :

Most of the Asian central bank balance sheet growth has been in the form of foreign exchange reserve assets, some of which is related to the bolstering of reserves after the 1990s Asian crisis, however, at least some of the growth is attributed to central banks efforts to keep their local currency from appreciating.  The combined size of the balance sheets of all aforementioned 9 nations (including China) has risen from $1.1 trillion in 2001 to $6.4 trillion in 2011.  In some nations, the central bank balance sheets are now close to 100 percent of GDP as shown on this graph:

In general, central bank balance sheets in the Asian region are far larger as a share of the GDP in these nations than in the more developed economies of the world as shown on the right.

How have Asia's central banks behaved differently than those of the developed nations?  In the world's more advanced economies, central banks generally purchase domestic assets (i.e. government bonds like Treasuries, gilts etcetera) that results in lower interest rates (i.e. QE and "The Twist") and is accompanied by an increase in central bank liabilities in the form of bank reserves.  In contrast, Asia's central banks have intervened heavily in foreign exchange markets and have accumulated massive foreign reserve assets as shown on this graph:

Every action by central bankers results in an economic reaction, some of which are totally unanticipated.  What are the risks to the economy associated with the increased size of Asia's central bank balance sheets?

1.) Inflation:  Rapid expansion of central bank balance sheets is generally associated with higher inflation.  Most experts agree that it is not the size of the balance sheet that matters, rather, it is the speed at which the balance sheet expands.  A high rate of expansion can result in inflation when the financial system cannot absorb the expansion of the bank's monetary liabilities.  Fortunately, in the case of Asia's central banks, the expansion of their balance sheets does not appear to pose an inflationary risk at this point in time, however, history is not on their side since there are numerous examples where strong growth of central bank liabilities is associated with higher increases in prices.

2.) Financial Instability:  The accumulation of foreign reserves can lead to the crowding out of domestic lending.  A study of the balance sheets of private Asian banks between 2003 and 2007 suggests that a 1 percent increase in central bank foreign exchange reserves led to a 1.3 percent decline in the rate of growth of total loans made by the private banks.  On the other hand, a persistent expansion of central bank foreign exchange assets held on deposit at central banks on behalf of the private banking sector can result in a glut of very low-yielding, no risk assets on the books of the private banks.  Many banks will continue to hold these low-yielding assets as long as there is risk in the economy, however, when it appears that an economy is about to enter a growth phase, the private sector banks will look to sell these assets in a search for higher yielding investment.  This could lead to overly exuberant and unsustainable lending practices.

3.) Financial Market Distortions:  When an emerging market central bank finances its accumulation of foreign exchange assets with thinly traded local currencies, it can quite quickly become the dominant player in a given market.  This can lead to the market responding to moves made by the central bank rather than responding to economic reality.  Central bank actions can, in this case, distort interest rates from what they would normally be in the open market (take note Mr. Bernanke et al).

Central banks are also running the risk of large financial losses that grow along with the size of their balance sheets.  Here are three risks to central banks associated with expanding  of their balance sheets:

1.) Central banks normally get a lower rate of return on their foreign assets than the cost of financing these assets; this means that the asset may well be yielding less than the cost of issuing central bank paper and the interest rate paid on excess private bank reserves.

2.) The central bank may incur losses on its foreign portfolio when the domestic currency appreciates against the foreign currency. 

3.) The central bank may face a mark-to-market loss when interest rates rise, pushing the value of the asset down (since interest rates and asset (bond) prices operate in opposition).  As well, the central bank may face additional losses if the asset issuer defaults.

In conclusion, the rapid growth in Asia's central bank balance sheets is concerning since the ramifications of such actions are neither fully understood nor is the response of the world's economy to such actions completely predictable.  According to the authors, the ballooning of central bank balance sheets "...raises concerns about distortions in financial markets and implications of central bank losses...", an issue that is rarely discussed.  The world's central banks and their bloated balance sheets are entering uncharted territory and, "...the risks associated with the size and structure of central bank balance sheets should not be overlooked."

China's Impact on its Neighbours and What Lies Ahead for Asia

The IMF recently released its latest prognostication for Asia's economy and things are not particularly looking great.  The world's economic engine is looking like it might be starting to show evidence of "Euro Influenza" as the impact of Eurozone debt and banking issues spill over into Asia.  Here's a brief summary of what the IMF predicts in its Regional Economic Outlook for Asia and the Pacific.  I'll also post a bit of information from the Outlook showing how big China's impact is on the world's economy and how a slowdown there would impact its neighbours and the rest of the world.

The IMF opens by noting that the world economic recovery is much more sluggish than it appeared to be back in the spring of 2011, particularly because of the eruption of Eurozone financial turbulence.  Economic growth from advanced economies is weak and is unlikely to improve; this will most likely lead to decreasing external demand for goods produced in the Asia-Pacific region.  Despite the drop in external demand, internal demand is expected to remain robust which will lead to both an increase in both credit and inflation in the area.  Internal demand has been resilient largely because of increased employment and gains in real wages, the complete opposite to what is being experienced in Europe and the United States.  In the Asia-Pacific, the conflict between a potential economic slowdown because of dropping exports and an increase in inflation as a result of high domestic demand means that Asian central bankers are walking a very fine line between over-tightening and not tightening enough.  Here is a look at the year-over-year change in inflation rates since January 2011 for selected Asian countries:

On a year-over-year basis, inflation increased from 4.6 percent in January to 5.5 percent throughout the entire region due to both increases in commodity prices and the pressures of increased demand for goods.  Inflation remains above central bank targets in Vietnam, Korea, Hong Kong and China.  Contrary to this, Japan is still mired in deflation with negative core inflation when food and fuel are excluded.  Here's a rather cool graph showing which countries are within their inflation targets by month with the red months showing that inflationary pressures are above target and rising and which are not:

The IMF has changed its growth forecast for the region since its last report in April.  Growth for 2011 is expected to be 6.5 percent (down 0.5 percent from their previous prognostication) and for 2012 is expected to be 6.75 percent (down 0.25 percent).  Growth levels of this magnitude would be positively amazing for the world's advanced economies where many nations are on the cusp of seeing economic contraction.  The drop in economic growth in the Asia-Pacific region is almost exclusively related to a drop in exports to the world's advanced economies where the IMF's economic forecast shows declining growth levels.  Here is a chart showing the IMF's latest Asian growth projections by country:

Taking a closer look at the economic giants of the area we note that China is still expecting growth of 9.0 percent in 2012, Taiwan is expecting 5.0 percent , Korea is expecting 4.4 percent and India is expecting 7.5 percent growth.  On the downside, Japan is expecting growth of only 2.3 percent following a contraction of 0.5 percent this year and Australia is expecting growth of only 3.3 percent following 1.8 percent growth this year.  With this economic dichotomy, if Asia's central banks raise interest rates too much, they risk either pushing their weaker local economies into a slowdown or increasing the value of their local currency which will make their exports even more expensive to consuming nations.  Oh what a tangled web!

Despite the very high growth levels in many Asian nations, their stock markets have not been immune from the "Eurozone Influenza" which struck with a vengeance during the summer.  Here is a look at how three of the Asian markets responded to the multi-country debt debacle:

1.) Nikkei 225 Index:

2.) Shanghai Composite Index:

3.) Hang Seng Index:

Stock markets throughout the Asia-Pacific noted declines that paralleled those seen in advanced nations in August and September.  This demonstrates that there is no safe place to hide from the "Eurozone Influenza" and from the after-effects of the United States debt near-default.  You may try to run, but you definitely cannot hide!

Now, let's change gears and take a closer look the impact that China's economy has on the rest of the world and on its neighbours.

Let's start by looking at China's inflation.  This graph shows you how volatile consumer price inflation has been in China (blue line) over the past five years when compared to the rest of Asia (green line):

Inflation in China spills into the surrounding nations (and from there into the rest of the world) with a one percentage point increase in China's inflation that is related to supply and demand shock leading to a 0.25 percent increase in the rest of the Asia-Pacific. Because China is the dominant importer of many of the world's commodities, in particular metals, the impact of their demand on the world's supply and price reaches far.  Here's a graph showing how much of the world's total imports of certain commodities are imported by China noting that the country is not yet impacting the world's food supply and demand equation:

In 2009, China consumed 65 percent of the world's imports of iron ore and 53 percent of the world's soybeans, nearly doubling since 2000.  China has been the world's largest consumer of iron ore since 1992 and produces 47 percent of the world's steel.  In total, China imports 29 percent of the world's total imports of all metals and 13 percent of the world's imports of all raw materials.

Looking even further into the problem of China's growing demand for commodities, the IMF calculates that a one percentage point increase in China's output may raise commodity price inflation by about 5 percent!  Now that's what I call an economic powerhouse!

China's ASEAN neighbours have been big suppliers of exports to China with commodities including iron ore, petroleum and rubber which have replaced exports of information technology.  This increase in commodity exports is expected to continue for the foreseeable future as China ramps up its construction of social housing projects.  Here is a graph showing how much exports to China from its neighbours have grown over the past three years, in some cases doubling in value:

Should China's economy slow down in a meaningful way, the impact on its commodity-rich neighbours would be widespread, leading to a slowdown in their economies.

With this information in mind, it is interesting to see the issues facing the world's new economic powerhouse.  With China reporting its lowest economic expansion since 2009 for the third quarter of this year, a deceleration in their economic growth pattern seems to be in place.  While growth is still a robust 9.1 percent, it is at its weakest level since the second quarter of 2009 when it hit a low of 8.1 percent.  While growth levels of this magnitude are unheard of among OECD nations, the impact of China's economy on the rest of the world cannot be denied, most particularly on its Asian neighbours.  Should China's economy continue to slow, the "Asian Influenza 2011 Variant" could create further nightmares for central bankers and other policy makers throughout the Eurozone and America who are already struggling to keep their economies above water.  Apparently we really do have most of our eggs in a single basket.  Three cheers for globalization!