Trade protection is an ever present threat in the current economic climate. Politicians have become animated about currency "manipulation", unlevel playing fields and other obstacles to export led recoveries. One barometer that is often watched closely is the level of foreign exchange reserves accumulated by central banks around the world. Because foreign exchange reserve accumulation is (broadly) a consequence of intervention in markets, the accumulation of foreign exchange reserves is often used as a proxy for "unfair" competitive practices.
The accumulation of foreign exchange reserves is often cited by European and American politicians in their complaints against Asian trade and foreign exchange market practices. That global foreign exchange reserves have increased significantly is beyond doubt - though in a higher risk environment, this may simply reflect the realities of modern international trade.
One reason central banks may want to hold more reserves simply to protect themselves and their economies against the risks of problems with trade finance or problems in short-term foreign currency funding.
It makes sense for a central bank to hold a higher level of foreign exchange reserves than has been considered normal in the past, if there is an increased risk that the domestic economy will need foreign cash. Looking at other possible drivers for this reserve accumulation, however, it produces some interesting results.
The obvious place to start in looking at foreign exchange reserves is with current account surpluses. Countries that run fixed or managed exchange rate regimes (including many Asian economies) have collectively increased their foreign exchange rate reserves significantly in recent years.
Those countries that chose not to operate managed regimes are unlikely to have significantly added to their stock of reserves (barring shocks to the system, as with Japan recently). Therefore it is the managed exchange rate regimes of the world that are of most concern.
When we look at the countries with managed or fixed exchange rates, we find that they were running a collective current account surplus of around half a trillion dollars in 2009 (which was, generally speaking, a bad year for trade - which makes the size of the surplus all the more remarkable).
This would seem to support the contention of trade protectionists, who argue that central banks are building reserves in order to suppress the value of their currencies and boost their current account surpluses.
However, current account surpluses are not the only motive for accumulating foreign exchange reserves. Monetary authorities that are seeking to manage their exchange rates will have to offset not only the current account position, but also any capital inflows which are directed towards their countries.
To some extent, capital controls can contribute to the manipulation of capital flows by changing the risks and incentives to invest in a specific economy, but that may not be sufficient.
Capital flows into those countries with fixed and managed exchange rate regimes have been significant in the recent past. In 2009, portfolio flows (buying financial instruments, like shares) and foreign direct investment (for instance, investing in factories) accounted for roughly half a trillion dollars.
In other words, the capital inflows into countries that manage their exchange rates are exactly as important as the current account surpluses of those countries.
Of course, private sector outflows by local investors buying overseas assets may offset these capital inflows to some extent, but there is still a need for these capital flows to be compensated for if the monetary authorities wish to maintain a fixed or semi-fixed exchange rate regime.
Only half of the reason for building foreign exchange reserves is the current account surplus. The other half of the reason for building foreign exchange reserves in those countries than manage their exchange rates is that international investors want to invest in those countries.
This highlights a critical issue for the debate surrounding foreign exchange reserves, exchange rate regimes and trade protection: current account surpluses are not the overwhelming cause of reserve accumulation by those countries that seek to manage their foreign exchange rates. Capital inflows into fixed and managed exchange rate regimes assume as much importance as current account balances.
Foreign exchange reserve accumulation may still be a signal that a currency is undervalued - but it might be undervalued from a capital account perspective, rather than a current account perspective.
That is to say, controlling the exchange rate may make assets appear cheap to foreign investors, which may be more important than making domestically made goods appear cheap to foreign consumers.
It is perfectly possible that the accumulation of foreign exchange reserves could be curtailed through capital controls or shifts in expectations about asset market returns, without there being any noticeable rebalancing of current account positions.
The writer is managing director of global economics, UBS Investment Bank.
