Mae West once maintained that "too much of a good thing can be wonderful", a sentiment that appears to have struck a chord with Asian central bankers, as they hoard increasingly vast sums of FX reserves.

Their behaviour may also reflect the view expressed, somewhat less prosaically, by history's most notable and successful mercantilist, Jean-Baptiste Colbert (minister to Louis XIV between 1647 and 1669), that "It is simply, and solely, the abundance of money within a state which makes the difference in its grandeur and power."

The current reality of unprecedented global imbalances and surging global FX reserves (which now top the $5.3trn (€3.9bn) mark, more than doubling since 2002 and growing by around $600bn a year), suggests an increasing disconnect between economic theory and market reality.

Among the top 10 holders of FX reserves are China (at $1,202bn, up from $609bn in 2004 and on track to surpass $1,750bn by the end of 2008), Japan ($888bn), Taiwan ($267bn), South Korea ($244bn), Singapore ($137bn) and Hong Kong ($135bn), with Asian central banks together accounting for about two-thirds of the world's total.

While Ms West might have argued that, if having a moderate level of FX reserves is good, then having a massive level should be wonderful, those stodgy economists contend that the optimal level is determined by a wearisome balancing of their benefits against their costs.
Beginning with benefits, precautionary holdings of FX reserves allow central banks to: insure against currency crises (particularly notable as we mark the 10th anniversary of the Asian crisis), serve as lender of last resort to banks with large foreign currency liabilities, facilitate day-to-day transactions (involving foreign goods or services) and intervene in FX markets.

There are three cost categories: opportunity costs (as the resources typically could be put to better use), central bank balance sheet (and reputational) risk, and the costs associated with sterilisation - both the direct fiscal cost, as well as the indirect cost of preventing current account adjustments from occurring (while inherently uncertain and highly imprecise, reasonable assumptions suggest something in the neighbourhood of a 1.1% annual opportunity cost, which amounts to an astonishing $58bn per year)

A recent cost-benefit analysis by the US Treasury concluded that "reserves are an expensive insurance mechanism" and many countries "have acquired such high levels of international reserves that the conventional benchmarks for reserve adequacy have been met several times over", concluding that the cure is to improve exchange rate flexibility. So far, the largest holders of FX reserves have not found these arguments very convincing and, rather than repudiating mercantilism, several have decided to focus on reducing the costs associated with excess FX holdings by establishing sovereign wealth funds (SWFs).


SWFs have assets under management of about $2.1trn and can be categorised in two groups. One group is primarily funded by oil and gas revenues, with the largest being in Abu Dhabi (estimated at $550bn), Norway ($314bn), Saudi Arabia ($250bn), Kuwait ($200bn), Russia ($108bn), Alaska ($38bn) and Brunei ($30bn). These are a quite different kettle of fish from those that are primarily funded by excess FX reserves, the largest of which are in Singapore, which hosts two SWFs - GIC, which invests primarily in the more liquid asset markets and Temasek, which makes direct investments in companies. Others in this group are in Korea, Taiwan and Malaysia.

Additionally, China's State Investment Corporation (SIC) is to be established in a few months with "seed money" of $250-300bn, possibly modelled on Temasek.

Further, the establishment of a Japanese SWF is under advanced discussion and may also be modelled on Temasek.

Morgan Stanley forecasts that SWFs are likely to grow by about $500bn annually, overtaking central banks' official reserves in six years, and could account for an eye-popping $12trn by 2015, roughly evenly split between those funded by oil and gas, and those funded by FX reserves.

China's SIC is expected to be the largest single SWF, surpassing even Abu Dhabi by 2009.

The issues associated with this growth are a key topic for the world's central bankers as they diversify, via SWFs, beyond Treasuries and other highly liquid assets, and start investing more like private funds.

One issue is that liquidity management and wealth management are two very different disciplines, and SWFs may initially be investing in assets in which they have little experience and for which local investment management talent remains scarce (crucial even if assets are managed externally). This also raises reputational risk issues, especially important given that central banks are in a business in which credibility is the key asset they bring to the table. Further, most SWFs are incomprehensibly and inexplicably opaque.

The most prominent counter-example is Norway's SWF, which is highly transparent regarding the fund's objectives, investment strategy, remuneration principles, corporate governance and ethical guidelines, and provides extensive reporting of actual performance results.

What are the likely implications for financial markets as official reserves are allocated away from classic risk-averse liquid assets? Many SWFs have adopted a total return-oriented approach to asset allocation, with a relatively long-term horizon, which has allowed them to move considerably out the risk curve and to include non-traditional asset classes.

Morgan Stanley estimates that SWFs will target equity exposure north of 60% (central banks already hold more than enough sovereign bonds), typically with a high exposure to non-domestic equities. Thus far SWFs have been big investors in Asian equities, real estate, infrastructure and natural resources (especially oil and gas). Of particular interest will be places like resource-rich Canada, which is home to, according to CIBC, 56% of global investable oil reserves (those not off limits due to restrictive FDI policies).

The investment strategy of China's SIC merits special attention given its projected size and expected asset growth. About three-quarters of China's FX reserves are in dollar-denominated assets, split between Treasuries and other traditionally safe assets (mortgage-backed securities and agency bonds). As this proportion declines, investments in commodities and natural resources, especially oil and gas, and private equity, will likely rise precipitously.

Indicative of the dramatic rotation to come was the 18 May announcement that the SIC will purchase a $3bn equity stake in Blackstone, the private equity group.

The recent tide of events appears to endorse the views of Ms West and M Colbert, suggesting that SWFs are set to become increasingly important and active players in global financial markets. So one of the big questions for world financial markets over the coming quarters is how China's SIC and the other SWFs will deploy their massive cache of capital.

Kevin Hebner is macro stratefist at Third Wave Global Investors based in Greenwich, Connecticut