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A number of countries have started delegating the management
of part of their foreign currency reserves to external fund managers,
be they private or government-owned entities outside the central bank.
Could it be time for Indonesia to follow suit?
Over the past few years, financial markets worldwide have experienced a
surge in asset prices. Global liquidity has undoubtedly played a role,
as foreign currency reserves in countries with surplus current account
positions make their way to the international financial markets.
The global increase in foreign reserves has indeed been remarkable.
Foreign reserves in the 9 key economies of Asia, including those of
China and Japan, have tripled in size compared to the position in
mid-2002, and are now nearing US$3,000 billion. A similar trend
probably also exists in the secretive oil producing countries of the
Middle East.
By tradition, foreign reserves are managed by central banks. But,
overtime we have seen more and more countries delegating a small
portion of their reserves to be managed by external fund managers. A
few examples are the GIC (Government Investment Corporation) of
Singapore, ADIA (Abu Dhabi Investment Authority) of the U.A.E., and,
most recently, the Korea Investment Corporation of South Korea.
The amounts that countries delegate to external fund managers vary,
from an estimated hundreds of billions of U.S. dollars in Singapore and
the UAE, tens of billions in Korea, Brunei Darussalam and Kuwait, to
hundreds of millions in Chile.
Why this new tendency? In reserves management, there used to be a stark
trade-off between return and liquidity. Countries need liquid reserves
to be able to intervene quickly during currency market turbulence. By
investing in liquid assets, such as U.S. treasury bonds, they not only
forego risk, but also return.
However, with increasing market depth in developing countries, the
trade-off has eroded substantially. Some emerging markets have all the
characteristics one could wish for: risk, return and liquidity.
A key advantage of delegating funds to external fund managers is
obviously income and asset diversification. Foreign reserves are
invested in more aggressive asset classes vis-…-vis the usual
G-7 sovereign bonds or commercial bank deposits; not ruled out are
bonds and even stocks in emerging markets.
The authorities in China recently even handed over a portion of their
reserves to an international buyout firm, a high risk-high return
investment indeed.
A second advantage, some also say, is that the central bank is provided
with benchmarks for its own returns. However, this argument doesn't
look very convincing if the bank and the external fund manager are
investing in different asset classes.
Third, there is often a transfer of knowledge dimension. In countries
where financial markets are well developed, the private sector may have
an edge in investing internationally that the central bank could learn
from. In many cases, it is the central banks that are on the receiving
end in terms of financial market knowledge transfer.
So that's the global picture. How are things here in Indonesia? Are our
foreign reserves sufficient for the country to even think of having an
external fund manager? Probably yes.
At around US$50 billion, the size of Indonesia's reserves seems tiny as
compared to say, China on $1.2 trillion, or even Korea on $250 billion.
But the number doesn't look small at all compared to, say, Chile which
delegates some three percent of its limited US$18 billion in reserves
to an external fund manager.
In terms of import coverage, Indonesia would seem to have sufficient
reserves. Reserves are sufficient to cover some 9.5 months of imports,
higher than Chile's 5.6 months.
Admittedly, one main obstacle would probably be the ill-preparedness of
the domestic financial industry. While appointing a foreign-based fund
manager to manage reserves could spark political debate, there are only
a limited number of domestic players, if any, with considerable
experience in managing funds in other emerging markets.
So in Indonesia's case, opportunities for knowledge transfer from the
private sector to the central bank are limited. The central bank may
even have the upper hand in international financial market investing,
having already been investing in U.S. and other G-7 sovereign
securities for some time.
However, being ill-prepared is not a good reason for standing still.
Indonesia should treat its lack of readiness as a challenge. With
globalization in full swing, it is crucial to lift the domestic
financial services industry to the same level as in other parts of the
world.
A number of regional players already have a strong foothold in the
Indonesian markets, but unfortunately we can't say the same for
domestic players in regional markets. From this point of view,
considering external fund managers does make sense.
Of course, the precise way forward is up to the authorities to figure
out.
Indonesia's foreign reserves have been reaching record highs. Along
with global demand for natural resources, this trend could continue in
the years to come. The country has a lot to gain from optimally using
those reserves. Apart from income reasons, external reserves management
could be a way of developing the domestic financial markets.
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