However, the global credit rating agency Standard & Poor's Ratings Services (S&P) believes that, while modest fiscal use of foreign exchange reserves will not necessarily result in a sovereign credit rating downgrade, governments will need to access such reserves in a transparent manner.

"Ultimately, accessing foreign exchange reserves for domestic purposes is akin to deficit spending," says credit analyst Agost Benard, 'sovereign and international public finance ratings group'.

According to S&P, central banks finance the acquisition of foreign exchange reserves either by creating new currency (i.e. printing money), or by borrowing money in one form or another. To prevent the uncontrolled growth in money supply, with its inflationary implications, central banks will often issue debt to finance purchases of foreign exchange. In the central bank's balance sheet, foreign exchange is recorded as an asset, which is balanced by a liability - debt. The act of selling foreign reserves and then passing on the proceeds to the government for spending replaces the foreign currency asset with a loan to the government.

"It is no different from the central bank issuing debt on the behalf of the government -except the intermediate process of buying then selling the foreign currency is omitted. Hence, using foreign exchange reserves is almost indistinguishable in its effects from increasing the budget deficit of the government concerned. To borrow an axiom, there is no such thing as a free lunch, and we believe this case is no exception," adds Benard.

Following China's use of foreign exchange reserves to recapitalise its public banks and recent plans by Taiwan, India, and Thailand, with Korea now joining the list of those who have mooted the idea of using a part of its central bank's mounting foreign exchange reserves (approximately $200 billion) to fund public sector investment.

"On the face of it, this would seem a perfectly reasonable thing to do. The popularity of using what is often perceived by the public and politicians to be "idle cash" to fund infrastructure projects - possibly adding to the country's stock of wealth and improving growth prospects - is understandable," states Benard. It is also a politically tempting one, with sure voter appeal through the implied preclusion of tax rises or spending cuts, as well as job creation.

According to him, a closer examination reveals that such plans for using central bank reserves are fraught with problems. The effective monetisation of fiscal deficits can be damaging for price stability and the efficacy of monetary policy, while the government's credit standing could be impaired through diminished external liquidity and inappropriate fiscal policies.

According to S&P, central banks acquire and dispose of foreign exchange reserves by acting as a principal in the foreign exchange market. A central bank is motivated to make a market in foreign exchange to facilitate the smooth flow of trade, to curb excess exchange rate volatility and, especially in the case of many Asian central banks, to influence exchange rate parity with the currencies of its major trading partners. In the case of many Asian central banks, accumulating foreign exchange reserves helps stem nominal appreciation of their currencies.

A nation's stock of reserves acts as a buffer against unforeseen adverse shocks, effectively tiding the country over a temporary decline in foreign exchange earnings relative to the country's foreign currency spending needs, until an exchange rate, or other kind of adjustment restores balance. "Allowing central government authorities unfettered access to borrow from this pool of funds can have various negative consequences, especially for inflation, monetary policy, external liquidity, and investor confidence," adds Benard.

Nonetheless, the temptation for governments in countries such as China, Taiwan, Korea, and India, to dip into reserves is understandably great, in the light of their extraordinarily large stock of reserves and pressing infrastructure needs.

Although defining the optimal level of reserves for any country is tricky, it is generally agreed that by most ratios these nations, and to a lesser degree Thailand, are sitting on reserves that provide a more-than-comfortable cushion when faced with temporary difficulties in balance of payments. The reserves expressed as months of current account payment cover (2004) ranged from 4.8 in Thailand, to 6.5 in Korea, to 14 months in Taiwan. Reserves covered short-term debt 3x in Korea, about 5x in China, Thailand, and Taiwan, and 25x in India, reflecting its negligible level of short-term external debt. The ratio of gross financing needs to unencumbered reserves, which takes into account a country's current account deficit plus its short-term debt payments, ranged between a low 7.9 per cent for Taiwan to a higher, but still comfortable 38 per cent for Korea.

Table 1: 2004 External Indicators
	China ('BBB+')	India ('BB+')	Japan ('AA-')	Korea ('A-')	Thailand ('BBB+')	Taiwan ('AA-')
Reserves / imports (months)	7.6	9.7	13.9	6.5	4.8	13.3
Gross financing requirement / reserves (%)	17.5	12.6	Unavailable	37.8	33.0	7.9
Reserves / short-term debt (%)	515.0	2,549.8	Unavailable	300.7	469.0	462.6

According to S&P, the one consideration in using reserves for public spending is the likely inflationary impact. The act of using central bank foreign exchange reserves to finance domestic public sector infrastructure is in practical terms indistinguishable from a straight central bank financing of the budget deficit. Such quasi-fiscal activities, whereby the central government deficits are monetised, not only undermine fiscal transparency by circumventing the budgetary process, but entail inflationary consequences through expanding the domestic money supply. To the extent that this creates excess liquidity in the system, this would add to inflationary pressure, and run counter to most central banks' explicit policy task of limiting inflation below a certain level. For most Asia-Pacific countries, such a move would exacerbate the inflationary momentum already present due to high oil prices and robust credit growth.

"To avoid the inflationary effects of the foreign exchange inflow into the domestic money supply, the central bank could sterilise those by issuing central bank bonds to absorb the excess liquidity. That, however, imposes a cost on the central bank through paying out on the bonds, and through loss of profits from the invested reserves, in turn reducing the profits it transfers to the government," adds Benard.

Moreover, issuing bonds to sterilise the foreign exchange inflows would render the process logically flawed, as these bonds could be simply issued by the central government to raise the local currency funds necessary for the designated project, without the need to enlist foreign exchange reserves.

"However, it should be noted that this is precisely where the attraction for some governments may lie in this method of financing, he adds. Central government debt issues are often subject to legal and / or legislative constraints, as opposed to borrowing by the central bank, where such restrictions tend to apply less. This is not the only advantage; given that the central bank debt is usually excluded from government debt figures, government balance sheets can appear healthier than they otherwise would.

Another potential problem in using foreign exchange reserves to finance local infrastructure is the factual costing of such financial resources. Thus, the tendency by politicians to view foreign reserves as 'free,' or 'idle,' may result in underestimating the cost of these funds, versus alternative sources of capital. The illusion of using 'cheaper capital' can then contribute to a lack of proper investment evaluation based on sound commercial principles, leading to sub-optimal resource allocation outcomes. These can range from the building of nonviable public infrastructure to inefficient use of funds through the mispricing of projects and capital.

Another facet of this moral hazard risk is that recourse by government to central bank foreign reserves to finance domestic projects creates a precedent. Deviating from the rule that foreign exchange reserves are to be used only for foreign exchange payments and as a buffer against external shocks means any subsequent temptation to draw on the reserve stock to meet perceived needs will be much harder to resist.

According to Benard, this could be particularly harmful in countries where the independence of central banks is still evolving, and where pressure from the legislative or executive could coerce the monetary authorities to make reserves available for various purposes, undermining monetary policy.

In addition to the issues raised, from a credit rating standpoint, S&P believes the implications of such use of foreign reserves are potentially negative. The amount of foreign exchange reserves against a country's gross financing needs (which includes debt service and its current account position) is one of the core indicators of its external viability.

"In other words, the level of reserves is strongly related to the sovereign's ability to obtain foreign currency in exchange for its local currency resources in order to meet foreign currency debt obligations. Hence, a lower level of reserves would likely in itself be negative for a government's credit standing as it implies a diminished ability to face terms of trade or other external shocks," remarks Benard.

This is on top of the attendant rise in uncertainty that such government usurping of foreign reserves would bring, given that businesses and international creditors could no longer be confident about the future availability of foreign exchange reserves. Likewise, pledging foreign reserves as security against borrowings reduces the amount of usable reserves available to pay for imports and service debt.

Last, but not least, careful consideration should be given to the sources from which the reserves were accumulated. A rapid rise in the reserve stock coming to a large extent from speculative capital inflows, such as in the case of China, can be reversed just as quickly and easily, possibly leading to a sudden increase in external vulnerability.

For countries with pressing infrastructure needs and large stocks of foreign reserves, the idea of using a portion of it for public works projects is tempting, as it seems both economically justifiable and politically advantageous. S&P believes that such schemes should be approached with much caution, given the potential pitfalls, and the possible negative implications for the country's external viability.

According to Benard, the primary quantitative measure in S&P's criteria for the external liquidity is the gross external financing gap (the current account deficit plus principal due on medium- and long-term public- and private-sector debt plus the stock of debt with an original maturity of less than a year) as a percentage of official foreign exchange reserves.

Foreign exchange reserves thus act as a financial buffer for the government during periods of balance-of-payments stress. Whether a given level of reserves is adequate or not is judged in relation not only to the gross financing gap, but also to the government's financial and exchange-rate policies and, consequently, the vulnerability of reserves to changes in trade and capital flows. Reserve management is also reviewed, with adjustment made for any reserves deposited with national banks, placed in questionable special purpose vehicles, or sold forward in the exchange markets.

"Bear in mind that reserves are needed to back the monetary base in the case of fixed exchange rates," warns Benard.

During the Asian financial crisis, several countries fell into balance of payment stresses because of mounting external debt profile, capital outflows, and the drain on foreign exchange reserves, but they also had inappropriate policies on reserves management. Some of Korea's reserves were placed in overseas subsidiaries of domestic banks, rendering it illiquid during the banking crisis, while Thailand had a substantial forward book obligation on its reserves.