Asian central banks should consider allowing more currency appreciation to contain an expansion of their balance sheets that risks spurring inflation and financial instability, according to the Bank for International Settlements.

The balance sheets of nine Asian central banks surged to $6.4 trillion in 2011 from $1.1 trillion in 2001, the Basel, Switzerland-based BIS said in a report released Sunday. A high rate of increase may strain the ability of the financial system to absorb the funds and generate price pressures, it said.

Asian nations have built up foreign-exchange holdings to record levels since the 1997-98 regional financial crisis to bolster confidence in their economies after the turmoil depleted their reserves and led some countries to seek International Monetary Fund bailouts. The BIS said the increase in reserves since the mid-2000s was largely a result of Asian central banks resisting currency appreciation pressures generated by trade and capital flows in the region.

“The balance sheet expansion by these central banks has produced financial distortions,” Stephen Cecchetti, BIS economic adviser and head of the Monetary and Economic Department, said in a conference call on Friday. “The fact that inflation is low and financial systems are stable now does not mean that they will necessarily remain so in the indefinite future. There are no reasons to become complacent.”

While the increase in Asian central banks’ balance sheets isn’t an immediate inflation risk and policy makers have been successful in the so-called sterilization of foreign-exchange purchases, large balance sheets may leave central banks vulnerable to large financial losses, and the accumulation of foreign reserves may “crowd out” domestic lending, according to the report. 


Currency Gains

“Serious consideration should also be given to capping and then shrinking the size of central bank balance sheets,” the BIS said. “Greater tolerance of currency appreciation over time could be a key element of a framework to limit further accumulation of foreign assets.”

The central bank balance sheets in Hong Kong and Singapore are about equivalent to the size of their gross domestic products, compared with about 50 percent of GDP for China, Malaysia and Thailand and 35 percent for the region as a whole, the BIS said.

“The ratios as a share of GDP in emerging Asia generally exceed those in advanced economies even after the substantial expansion in the latter following the recent crisis,” it said. 

(Bloomberg)