Banks and Asian Central Hedge Funds

A number of Asian central banks, among the biggest investors in U.S. government debt, are looking at alternative targets for their vast dollar holdings.

Since 1997, currency reserves at Asia’s central banks have risen to about $3 trillion, leaving fewer dollar denominated securities in which hedge funds can trade, putting hedge funds on the defensive.

A report showing the U.S. economy is holding its ground may drive the dollar higher. Central banks such as the People’s Bank of China may see that as a perfect opportunity to sell a chunk of their U.S. holdings, pushing the market in a direction that traders don’t expect.

Central banks often carefully choose the moments when they expect an increase in market liquidity, when Federal Reserve officials speak or Japan releases inflation data, to make adjustments in their holdings. More and more, it’s turning Asia’s central banks into market heavyweights.

In the last couple of years, many speculators bet on a drop in U.S. debt prices. That left plenty of securities for purchases by foreign central banks.

The issue may be high on the list of topics discussed at next week’s IMF meeting in Singapore. It’s not about looking out for hedge funds; it’s about taming volatility in economies. Yet it’s also about exploring the wisdom of central banks amassing ever-growing stockpiles of reserves.

A recent paper from the Bank for International Settlements underlines the urgency. In it, BIS staffers Madhusudan Mohanty and Philip Turner express surprise that the reserve buildup hasn’t caused inflation.

In Taiwan, the current system for managing the nation’s $206.63 billion in reserves, the third-largest in the world, “might not be an efficient use of our resources,” says government minister Hu Sheng-cheng. Taiwan’s central bank has accumulated “too much” foreign exchange from Taiwanese exporters and from inflows to its capital markets, he says. Mr. Hu is heading a task force that will announce in the next few weeks details of a plan to use reserves to help local companies buy machinery and intellectual property rights overseas, he says.

Elsewhere in Asia in recent weeks, however, some governments have begun discussing plans to chip away at their dollar mountains. The initial amounts are small, but taken together they send a clear signal. South Korea’s plans are the most ambitious and could have the biggest impact on the dollar.

The International Monetary Fund’s last meeting in Asia was in 1997 and featured a debate about hedge funds. U.S. Treasury Secretary Robert Rubin argued that hedge funds were a vital source of liquidity when markets dry up. Asian policy makers saw them as predators causing undue volatility and overwhelming central banks. Either way, hedge funds are taking a backseat in Asia to the new Asian central banks.