Sunday, October 5, 2008

Foreign reserves still growing - a place to tap for liqudity ?


The foreign reserves of many central banks around the world are still growing and may be a potential key to providing more liquidity during this crisis. A quick review of the latest reserves shows that if you focus on just the top holders there is over $3 trillion in dollar assets. We know most of these assets are in Treasury and US agency securities. If some of those funds were redeployed to buy top quality short-term paper there could be a significant enhancement in liquidity without ballooning the global money supply.

Some of the current problem is a portfolio rebalancing issue. Money moves to safe havens and there is a shortage of liquidity in some market sectors. This money is already invested in many money market alternatives, but there has to be a rebalancing to "riskier" asset. If the reserves move into non-Treasury investments, they would be able to receive higher yield. There is a gain on taking on the liquidity risk. Additionally, the Treasury could provide some guarantee for this activity. The risk to the Treasury would be as a backstop and not as a direct investor.

It may be necessary to have coordination across these reserve funds for two reasons. One, all of the reserve funds may not have an incentive to bail-out the developed world. Two, no one wants to be be the first investors, so a pool or SPV administered by a third party like the Treasury or the IMF would be appropriate.

The most important policy objective is to try and tap into funds that are already available without forcing a change in central bank liabilities. Many of these foreign reserves will be socked with inflation loses if the dollar or the Euro see a debasing of the currency, so help now may diminish risks later.

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