Countries use different accounting standards for their declarations of foreign exchange reserves. South Korea bases its declaration on value at the time of acquisition, but some countries use market values.

While Korea focuses on analyzing long-term trends rather than short-term fluctuations resulting from changes in market values, the recent fall in government bond prices suggests that this can create a significant optical illusion.

Figures provided by the Bank of Korea on Wednesday place Korea’s foreign exchange reserves at US$436.4 billion as of the end of August, which ranks eighth in the world. That’s one step higher than last month.

Korea leapfrogged Hong Kong, the previous eighth-place holder, as Korea’s reserves only dipped by US$2.2 billion while Hong Kong’s dropped by US$10 billion.

The foreign exchange reserve ranking that’s maintained and published by the Bank of Korea is based on figures released by each country’s central bank.

The resulting impression can be misleading, like an optical illusion. Countries’ foreign exchange reserves are mostly composed of marketable securities, including stocks and bonds. In the case of Korea, 91.05% of its foreign exchange reserves (as of the end of September) took the form of marketable securities, with just 3.4% in bank deposits.

A large share of those marketable securities is reportedly government bonds from major countries around the world, including US Treasury bonds. The foreign exchange authorities’ attempts to mitigate volatility generally involve selling off US Treasury bonds and releasing the dollars earned on the market.

When government bonds fall in value, in other words, Korea’s foreign exchange authorities have less ammunition at their disposal.

The problem is that various accounting standards can be used to valuate marketable securities. The standard used in Korean accounting is acquisition cost. The upshot is that even if the market price of securities has fallen relative to the time of purchase, that won’t be reflected in the books.

In contrast, Hong Kong reportedly accounts for the price at which securities are currently being traded on the market.

“My understanding is that more countries use the standard of market price than acquisition cost,” said a source at the Bank of Korea.

Considering that the value of US government bonds has continued to fall this year, the presumption is that Korea’s nominal foreign exchange reserves are rather misleading. The yield on 10-year US Treasury notes climbed from below 2% at the end of last year to nearly 4% recently. Then on Sept. 27, the yield shot above 4% in the wake of tax cuts announced by the UK, reaching levels last seen during the global financial crisis of 2008.

The Bank of Korea maintains that the acquisition cost method is more appropriate for tracking long-term changes over time. Put another way, the zigzagging values resulting from bond yield fluctuations make it harder to track trends in foreign exchange reserves.

Another concern is that switching the accounting method could lead to more erratic market reactions, making the exchange rate more volatile. The Bank of Korea also pointed out that foreign exchange reserves are fundamentally different from corporate accounting, in which market prices must be reflected promptly so as to gauge companies’ ability to stay in business.

But when there’s serious short-term volatility in bond yields, as there is today, providing incomplete information has its own liabilities.

“The market price method could be appropriate if the market’s understanding that changes in foreign exchange reserves are merely the result of bond yield fluctuations kept it from overreacting. But there are grave concerns about the likelihood of that given Korean sentiment,” the source at the Bank of Korea said.

By Lee Jae-yeon, staff reporter

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