Faculty of Economics and Business
China‟s Reserve Accumulation
and its Global Implications
Thesis Project
M.Sc. International Economics and Business
Student Name: Gonda Lamberink Supervisor: Steven Brakman Student Nr: s1369199 Co-assessor: Ger LanjouwThe Hague, June 2010
Keywords: reserve accumulation, global imbalances
TABLE OF CONTENTS
Table of Contents………2
I. Introduction………..3
1.1. Reserve accumulation in China………3
1.2. Research questions………6
1.3. Methodology……….7
II. Sustainable versus Unsustainable Reserves………...8
2.1. Benefits and costs of reserve accumulation……….8
2.2. The BOP-identity and reserve accumulation………..14
2.3. Literature review on reserve accumulation………15
2.4. Hypotheses………..22
III. Analysis……….24
3.1. Building the model……….24
3.2. Running the regression………...27
3.3. Discussion of results………...28
IV. Global Imbalances and Financial Crisis...……….32
V. Adjusting Global Imbalances and Implications for Economic Growth……….37
VI. Discussion and Conclusions………41
References………47
CHAPTER I: Introduction
1.1 Reserve accumulation in China
Global imbalances have been a much-talked about, but perhaps still little understood, phenomenon for years now. In all markets equilibrium is dynamic and temporary imbalances are in place frequently. Everyone trusts price changes as the equilibrating mechanism, or else market imperfections exist. In principle this also holds true for accumulation of foreign reserves implying a balance of payment imbalance:1 the interest instrument exercised by central banks serves as the price mechanism, or alternatively, interventions of the central bank in foreign exchange markets influencing exchange rates, and thirdly, also fiscal policies exercised by the government can be employed to restore balance. However, the sheer size by which emerging markets, especially China, have been accumulating reserves seems to point at a permanent imbalance rather than at equilibrium: a shortage on the balance of payments of the United States and an accompanying large trade surplus for China.
The last decades the so-called „Washington Consensus‟ has considered imbalances a relatively innocent problem. Certainly it was unacceptable in the public eye to resort to protectionism to solve for imbalances. If at all, global imbalances were argued to be a benign rather than malign occurrence, and simply an inevitable corollary of under-development of financial markets in emerging market economies (EMEs).2 However, opinion has now swung in the opposite direction to the view that imbalances do matter. The financial crisis has demonstrated that it is flawed reasoning to argue that the United Sates and other developed
1 For a definition of the balance of payments (BOP) see Chapter II where this relation between reserve
accumulation and BOP-imbalance is clarified.
2
countries exhibit perfect capital market characteristics and can take on ever-increasing leverage without adding risk.3
Considering China, for a long time it looked as if the renminbi tied to the American dollar led to a stable situation in which China enjoyed export gains and the U.S. as the financial intermediary could import Chinese dollar reserves as capital. However, for this imbalance to be sustainable, will it last? For fact, international saving and lending can compensate one another: i.e. countries with high consumption can borrow money from countries with high saving rates, and this can provide stability also over longer periods of time. Plus it is desirable that globally capital is allocated to those places where productivity offers the highest returns, when corrected for risk of course. And this was the case for the U.S. as investment location in the „90s until in 2000 the dot-com bubble burst. Around that time the situation in the U.S. grew problematic: balanced government budgets or even surpluses transformed into ever growing and lasting deficits. Expansive macro-economic policies, coupled with declining investment- and productivity growth, this prevented any balance of payments correction.
In numbers, while the U.S. current account deficit during most of the 1990s remained close to 1-1,5% of GDP, the deficit started to widen through the end of the decade at an increasing pace reaching 6% in 2006, which because of the crisis thus far consists of a peak-level (see table 1 below).4
T able 1: U.S. current account balance
Units 1990 1995 2000 2005 2006 2007 2008 2009
USD (billions) -78.965 -113.571 -417.429 -728.994 -788.115 -731.214 -673.266 -393.250 Percent of GDP -1.361 -1.535 -4.252 -5.869 -5.980 -5.296 -4.720 -2.808
Source: Data derived from IMF WEO Database, 2010
3 Obstfeld and Rogoff, Global Imbalances and the Financial Crisis: Products of Common Causes, supra note 2 at
4.
4
For sure it can be shown that there is a strong correlation between reserve accumulation in EMEs and the U.S. current account deficit, indeed showing the official or public international saving-and-consumption relationship. But this has only truly been the case in recent years. Until 2003 the U.S. deficit was in large part financed by private capital transfers still. However, since 2003 reserve accumulation in these countries relative to the U.S. deficit has been accelerating, facilitated by substantial current account and quite often capital account surpluses, and in peak-year 2006 the change in EMEs‟ reserves also by far surpassed the U.S. trade deficit.5 To illustrate, see table 2 in connection with table 1. Note that for Middle Eastern countries reserve growth has been relatively less prevalent, since their balance of payment surpluses mostly flowed into investment vehicles other than reserves.6
Table 2: Balance of payments in emerging markets
Source: Derived from Mohanty and Turner (2006).7
To illustrate the increasing weight of EMEs‟ share in reserves, in comparison looking at Japan as a developed market it also holds a big share of reserves still: slightly over 1 trillion in U.S.
5 Source: IMF WEO Database 2010. In numbers, in 2006 the total amount of EMEs’ reserves, USD 2,701 billion,
constituted far more than the U.S. current account trade deficit of USD 788 billion.
6 Obstfeld and Rogoff, Global Imbalances and the Financial Crisis: Products of Common Causes, supra note 2 at
11.
7
dollars. But all of Euro area reserves together are relatively small: USD 672 billion, with larger shares for Germany (USD 181 billion) and France (USD 135 billion).8 China of all EMEs accounts for the most substantial share of reserves, which has been growing in recent years to almost 50% of reserves held by emerging countries in 2009 (see table 3 below). In absolute terms, China‟s stock of reserves last year surpassed the milestone amount of USD 2 trillion: a larger stock of reserves than any other country has accumulated thus far. This is still understating the total amount of foreign exchange reserves sinceonly reserves of the People‟s Bank of China are reported and reserves transferred to the balance sheets of state commercial banks or other entities are not accounted for. Reserve accumulation has even outstripped growth in the current account surplus because of inflows of FDI and „hot money‟ in recent years augmenting the balance of payment surpluses. Particularly in the case of China but also looking at reserve accumulation in other Asian economies, in light of a discussion on global imbalances the question rises whether the amount of reserves is sustainable or unsustainable.
Table 3: China’s reserves as a share of reserves held by:
Source: Prasad and Sorkin (2009)9
1.2 Research questions
This thesis aims to discuss the problem of sustainable versus unsustainable reserve accumulation. The discussion is all the more relevant now following the financial crisis of 2007-2009, to which attention is paid in Chapter IV of this thesis. Asian economies‟ stock of reserves and especially China‟s giant levels raise questions such as whether as measured by
8 Figures measure total reserve assets (stocks) until March 2010, derived from the IMF Principal Global
Indicators database. Note that according to IMF figures between 2000 to mid-2009 official reserves rose from USD 1,9 trillion to 6,8 trillion worldwide.
9
economic models levels are unsustainable, and what exact costs and risks both domestically and globally can be perceived, and if countries especially China were to limit reserve accumulation for the future what type of adjustment this would require. For the purposes of this thesis project the main questions below have been identified for answering.
Is foreign reserve accumulation in China unsustainable? What are the consequences? And what is the right way forward?
1. Are China‟s high reserves driven by precautionary or mercantilist motives. And based on this outcome are levels sustainable? Or instead are they unsustainable?
2. What „global imbalances‟ are caused by China‟s reserves? And how, if at all, do they relate to the financial crisis?
3. When balancing imbalances, what does this imply for economic growth?
1.3 Methodology
The three research questions are answered in separate parts: quantitative and qualitative. Following a brief discussion of benefits and costs of reserve accumulation in Chapter II a further discussion on reserve accumulation based on literature review is presented. Chapter III entails the empirical analysis answering research question 1 using data derived through the IMF International Financial Statistics (IFS) database and the World Bank World Development Indicators (WDI). Chapter IV places this empirical analysis in a larger perspective through a more general qualitative discussion answering research question 2. Chapter V, answering research question 3, follows with a discussion on adjusting global imbalances based on analysis conveyed in the most recent IMF World Economic Outlook of April 2010. In Chapter VI, Discussion and Conclusions, the empirical (Chapter II-III) and qualitative (Chapter IV-V) parts are linked and a few general conclusions drawn as to what would happen if China were to turn the tide of ever further reserve accumulation.
been performed by Aizenman and Lee (2006). Also they quantify the relative importance of alternative views, precautionary and mercantilist, that can explain international reserve accumulation. They find that although both motives are likely to be in play in Asia in comparison there is stronger empirical support for the precautionary or self-insurance motive.10 Even though this thesis in Chapters II and III aims at trying to answer the same question, because different variables will be used in association with both motives there lies added value in the results as this enables comparative analysis.
10
CHAPTER II: Sustainable versus Unsustainable Reserves
2.1 Benefits and costs of reserve accumulation
The concept of sustainable versus unsustainable reserve levels is based on benefits and costs of reserves, together determining an „optimal‟ level of reserves. Since optimal levels are hard to define, this thesis –apart from the literature review that follows- will more carefully discuss the sustainability or unsustainability of reserve levels. Commonly reserves by countries are treated as a type of inventory to correct for balance of payment imbalances, either caused on the current and/or capital account, to allow for „consumption smoothing‟, and as insurance against capital crises. The major opportunity cost for reserves in the end, if an undesirable deficit or also surplus on the balance of payments were to be alleviated and intervention actions through monetary and/or fiscal policies would be warranted, is the macroeconomic adjustment cost that would otherwise, in the absence of reserves for policy-intervention, have to be incurred. To be more specific, a number of concrete benefits and costs associated with reserves can be identified. Costs mentioned here refer to direct costs not the opportunity cost of reserves.11
Reserves provide for a number of benefits: 1. self-insurance against financial crisis – the precautionary motive; 2. export promotion – the mercantilist motive; and 3. a third motive sometimes mentioned, exchange rate stability: i.e. to accumulate foreign reserves and have foreign exchange market interventions stabilize the exchange rate.12 Whereas from a precautionary perspective reserve accumulation is looked upon favorably reducing exposure to sudden stops, capital flight and volatility, a mercantilist approach viewing reserve accumulation as a by-product of industrial policy mostly evokes criticism from trading
11 Later on in this thesis, when discussing a model for reserve accumulation in Chapter III, again reference is
made to opportunity cost, however with a slightly different meaning: not considering the eventual longer-run opportunity cost of reserves but the immediate opportunity cost: the interest rate that could be earned by alternative investments if liquidity were to be placed there rather than in reserves.
12
partners for imposing negative externalities in the form of reduced competitiveness.13 Particularly, based on these two different main motives, this thesis will regard the precautionary motive as benign, and therefore reserve levels based on this motive sustainable. However, as for the mercantilist motive, in fact constituting an unfair export competitive advantage, in as far as levels can be explained by this motive which would be illustrated by undervalued currencies and accompanying current account surpluses, levels will be deemed unsustainable.
Explaining the three benefits in more detail, especially in the aftermath of the Asian financial crisis the precautionary motive has been quite predominant and reserve levels are rationalized using so-called buffer stock frameworks.14 In fact, the Asian crisis displayed all the common properties of a classic bank run prompted by a sudden risk shock. This understandably raised risk aversion in Asian countries. Reserves form de facto self-insurance against crises making countries less dependent on foreign capital inflows and therefore less prone to „sudden stops‟, reducing both the cost, of macroeconomic adjustment considered necessary when a crisis occurs, and chance of financial crisis. This remains important because after the 1997 financial crisis, even though some Asian countries have „flirted‟ with the idea of limiting capital inflows -particularly the inflow of „hot money‟ (short-term capital)- through temporary resorting to capital controls, within two or three years post-1997 most countries maintained or increased their financial integration with the rest of the world.15 The increase in reserves in Asian countries after 1997 therefore mirrors a sharp expansion in both restored trade in goods and services but also capital over the last decade. And this implies an increase in potential volatility of gross capital flows. In other words, this has further raised the stakes of „sudden stop‟ of capital inflows.16
13
Aizenman and Lee, International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence,
supra note 10 at 2.
14
Avner Bar-Ilan and Nancy Marion, “A Macroeconomic Perspective on Reserve Accumulation” prepared for the UC Santa Cruz Conference on Global Liquidity, April 2008. Dartmouth College, January 2008 at 1.
15 Aizenman and Lee, International Reserves: Precautionary versus Mercantilist Views, supra note 10 at 1.
Accelerated financial intermediation, partly brought about by increasing inflows of FDI necessitating the development of local bond and equity markets, this has also raised the stakes for the case where outflows of capital from the domestic financial system would occur: a so-called „internal drain‟. This refers to a drain of domestic deposits or domestic capital flight. In fact this internal drain by policy-makers is considered the most worrisome. Obstfeld et al. (2009), comparing different sources of capital flight, indeed consider reserve-levels relative to M2 as an indicator exhibiting the most explanatory power among other factors in determining reserve levels.17 Estimates show that, for instance, were M2 to measure 20% of GDP, if half of M2 would flee the country in a panic this could occur in the short space of a week or two, which would imply that reserves measuring up to 5-10% of GDP might start to drain out of the country on a weekly basis.18 In short, both the risks of external and internal capital flight have motivated central banks in emerging economies to accumulate high levels of reserves.
The second benefit or motive for reserve accumulation stems from the idea that a new Bretton Woods has come to the surface with Asia as the fixed exchange-rate periphery and the U.S. as center country. Through export-led growth the periphery builds on economic development which is supported by undervalued currencies, limited capital liberalization (capital controls) and the buildup of reserve asset claims on the center country.19 Looking at China in specific, it maintains a depreciated currency with respect to the exchange rate that would have emerged had the People‟s Bank not intervened. A third perspective, related to this second motive, takes maintaining currency pegs as a starting point: Asian countries have an interest in pursuing soft dollar pegs -i.e. an informal currency peg as opposed to a formal peg such as in the case of the
17 Maurice Obstfeld, Jay C. Shambaugh and Alan M. Taylor, “Financial Stability, the Trilemma, and International
Reserves.” NBER and CEPR, Discussion Paper No. 6693, February 2008 .
18 Ibid. at 6.
19 Bar-Ilan and Marion, Macroeconomic Perspective on Reserve Accumulation, supra note 14 at 1. See also:
EMS- since most of their trade is invoiced in dollars, as is their international lending.20 Maintaining the peg to maintain price stability therefore is an important consideration.
Having dealt with potential benefits of reserve accumulation of course there are costs related to this as well. The main costs are: 1. inflation; 2. fiscal costs; and 3. higher interest rates.21 First, as a central bank will issue domestic currency to purchase foreign currency this increases the monetary base and in turn leads to inflation. In order to sterilize or neutralize inflationary impact of reserve accumulation a central bank will usually issue bonds, e.g. domestic liabilities, in exchange for currency in circulation (both domestic and foreign) and in doing so withdraw domestic liquidity.22 Still, inflation could occur when sterilizing the extra liquidity is incomplete. Secondly, costs emerge when sterilization involves a fiscal burden, if the interest rate the central bank pays exceeds the rate it earns on its foreign reserve assets.23 Rodrik (2006) calls this a „social cost‟: the government paying a higher interest rate than it is earning.24 A third major cost, higher interest rates, also relates to sterilization. Naturally, there is a threshold to the general public‟s appetite buying up sterilization bonds that at some point will be reached. Therefore, eventually sustained accumulation will lead to a higher interest rate domestically.25
There are a few additional costs related to reserve accumulation commonly identified in the literature, such as lost independency of monetary policy and indirect losses from suppression
20
Bar-Ilan and Marion, A Macroeconomic Perspective on Reserve Accumulation, supra note 14 at 1-2. See also: Phil Gharton, “Foreign Reserve Accumulation in Asia: Can It be Sustained?” Australian Government, The Treasury. Economic Roundup, Spring 2004 at 10 and 17.
21 Donghyun Park,and Gemma B. Estrada, “Are Developing Asia’s Foreign Exchange Reserves Excessive? An
Empirical Examination”. Asia Development Bank, No. 170, August 2009 at 6.
22
Ibid.
23
Ibid.
24
Dani Rodrik, “The Social Cost of Foreign Reserves.” NBER Working Paper 11952, 2006.
25
Park and Estrada, Are Developing Asia’s Foreign Exchange Reserves Excessive? An Empirical Examination,
of the financial sector overall which for households imply that they receive low real rates of return on their bank deposits.26 Also, and of course, there is a risk of depreciation of the foreign currency, i.e. the U.S. dollar, which due to high levels of reserves denominated in dollars would then lead to balance sheet or valuation losses.27 To illustrate the magnitude of the risk associated with potential dollar depreciation, see table 4 below. Based on these data China‟s share of reserves held in USD saw an increase of 7 percent from 2000 (58 percent) to 2007 (65 percent). However, by March 2009 the dollar share had fallen again to 61 percent. This still is a large share nevertheless and also these figures might be underestimating dollar shares as some accumulation is attributed to Chinese intermediaries abroad that conduct China‟s asset purchases. Therefore, in reality it is estimated that around 70 to 75 percent of China‟s reserve assets consist of dollar-denominated assets.28
Table 4: Dollar share of reserves (based on partial data)
Source: Prasad and Sorkin (2009)
26 Prasad and Sorking, Sky’s the Limit? National and Global Implications of China’s Reserve Accumulation, supra
note 9 at 4.
27 International Relations Committee Task Force, “The Accumulation of Foreign Reserves.” ECB, Occasional
Paper Series, No. 43, February 2006 at 35. See also: Mohanty and Turner, Foreign Exchange Reserve
Accumulation in Emerging Markets: What Are the Domestic Implications?, supra note 7 at 46.
28
2.2 The BOP-identity and reserve accumulation
In order to identify the exact variables driving reserve accumulation it is important to bear the following identity in mind: BOP = current account balance - capital account balance + errors and omissions. According to the principles of double-entry accounting, an entry in the current account gives rise to an entry in the capital account and together the two accounts should balance. 29 The reserve account, as element of the capital account, is operated by central banks and can be the source of large capital flows to counteract market-driven flows. Note that in any equation when excluding reserves from the capital account they can be considered “below the line”.
In simple words: the current account represents a country‟s net income whereas the capital account reflects net changes in national ownership of assets, i.e. capital flowing in a plus and capital flowing out a minus.
- Current account = recording trade in goods and services, earnings on investments (factor
earnings and payments) and unilateral transfers, i.e. remittances. Note that official aid is recorded under the capital account.
- Capital account = recording capital transfers and trade in non-financial assets. A sub-division of the capital account is the financial account recording transfers of financial capital and non-financial capital, including official reserves which is a positive term whenever a BOP-surplus is registered.
From this brief discussion on the BOP-identity, the main motives for accumulation emerge again: 1. for the current account surplus to be sustained, keeping the exchange rate around a
29
certain level. And 2. as for the capital account, a desire to self-protect against sudden stops of capital flowing in. To illustrate the mechanism of accumulation for most surplus countries: naturally in countries like China with large exports, due to dollar inflows the currency would appreciate if allowed to freely float and current account surpluses would adjust. Adjustment is prevented, however, because of central banks buying up foreign currency in exchange for domestic currency, meanwhile sterilizing the extra liquidity caused by this through issuing domestic bonds, and the central bank investing the reserves in foreign bonds. Hence, reserve accumulation implies increasing official capital flows invested abroad and the overall surplus external position reduces the vulnerability to sudden stops since the country as a whole is a net exporter of capital not relying on foreign capital.30
2.3 Literature review on reserve accumulation
Reserve accumulation generally is affected by variables accounting for economic size, external vulnerability31 and exchange rate flexibility: countries sticking to managed or fixed exchange-rates need reserves to intervene in foreign-exchange markets in order to alleviate pressure to re- or devalue currencies. More generally, it is helpful to perceive reserves as financial assets under the control of a country‟s central bank that are readily available to correct for balance of payments financing.32 To be more precise, in the literature there are five key factors explaining reserve holdings. These factors will be used in the empirical model that follows in Chapter III.33
30 Enrique Alberola and José M. Serena, “Global Financial Integration, Monetary Policy and Reserve
Accumulation, Assessing the Limits in Emerging Economies.” Banco de Espaňa, Documentos de Trabajo Nº 0706, 2007 at 12.
31 External vulnerability can be defined as exposure to trade and capital flow volatility, which is increasing in
the openness of an economy.
32 Hali Edison, “Are Foreign Exchange Reserves in Asia too High?” World Economic Outlook 2003 Update, IMF,
Washington, DC, October 2003 at 80.
33
1. Economic size: Since international transactions are assumed to be increasing with economic size, the expectation for reserves is that they will rise with population and real GDP per capita.
2. Current account vulnerability: A more open economy is more vulnerable to external shocks. Therefore, greater trade openness is linked to higher reserve positions. And the greater the expected shocks, for instance in export receipts, the higher the levels of reserves that are warranted.
3. Capital account vulnerability: Just as with the current account as regards trade in goods and services, greater financial openness can be associated with higher vulnerability to capital flight. In addition, as mentioned in the introduction an increase in potential for resident-based capital flight from the domestic currency demands higher levels of reserves as well.
4. Exchange rate flexibility: Greater flexibility implies less demand for reserves, because there is no need to manage a pegged exchange-rate with a stockpile of „intervention‟ reserves. Contrarily, greater exchange rate stability (fixed and managed exchange-rates) requires higher levels of reserves.
5. Opportunity cost: The opportunity cost of holding reserves measures the difference in yield on reserves and the marginal productivity of other, alternative, investments. Consequently, the higher the opportunity cost, the lower the level of reserves. To illustrate, with dropping interest rates over the last decade compared to the „90s in the U.S. and other Western markets, the opportunity cost for emerging markets to hold reserves has been increasing.
relevant for countries at risk of capital flight. Suggested adequate values range from 5% to 20%. Lastly, as for GDP-measures a reserves-to-GDP ratio can be employed, based purely on economic size.34
Graph 1: Reserve accumulation in selected emerging economies (scaled by standard ratios)
Source: Derived from Edison (2003)35
The theoretical and empirical literature exploring optimal reserve levels not by rules of thumb but in more formal ways was very limited until recently when a growing number of studies attempted to formally model and empirically estimate reserve levels.36 This recent growth in literature has been motivated by the surge of reserves in developing countries in general and developing Asia in particular. Recent studies examining the region‟s optimal reserves include Wyplosz (2007);37 Jeanne and Ranciere (2006);38 Gosselin and Parent (2005);39 Mendoza
34 Among others, see: Ruiz-Arranz and Zavadjil, Are Emerging Asia’s Reserves Really Too High?, supra note 12.
And Park and Estrada, Are Developing Asia’s Foreign Exchange Reserves Excessive? An Empirical Examination,
supra note 21.
35
Edison, Are Foreign Exchange Reserves in Asia too High?, supra note 32.
36
(2004);40 Aizenman, Lee, and Rhee (2004);41 Aizenman and Marion (2004 and 2002);42 and Dooley, Folkerts-Landau, and Garber (2005).43
The overall balance of evidence that can be found in all of these studies confirms the story told by the rules of thumb: that the region‟s reserve build-up has exceeded its optimal level, i.e. the level needed to prevent a sudden stop of capital inflow, externally, or a domestic flight of capital, „internal drain‟, although studies differ a great deal about the extent of the overshooting, of course also depending on the particular country involved. Differentiating between different periods in time these studies most commonly find that the region‟s reserves begin to exceed their optimal levels around 2001 or 2002. Another general conclusion is an evident structural increase in optimal reserves in the post-1997 period, which is to be understood as related to a stronger precautionary demand for reserves following the Asian crisis. Therefore, without investigating any change in the fundamentals there is a risk that too
37
Charles Wyplosz, “The Foreign Exchange Reserves Buildup: Business as Usual?” prepared for the Workshop on Debt, Finance and Emerging Issues in Financial Integration at the Commonwealth Secretariat in London, Graduate Institute of International Studies and CEPR, 6-7 March 2007, available at:
www.un.org/esa/ffd/events/2007debtworkshop/Wyplosz.pdf .
38
O. Jeanne and R. Ranciere, “The Optimal Level of International Reserves for Emerging Market Economies: Formulas and Applications.” IMF Working Paper 06/229, Washington, DC, 2006.
39
Marc-André Gosselin and Nicolas Parent, “An Empirical Analysis of Foreign Exchange Reserves in Emerging Asia.” Bank of Canada Working Paper 2005-38, December 2005.
40
R. Mendoza, “International Reserve-Holding in the Developing World: Self-Insurance in a Crisis-Prone Era?” Emerging Markets Review 5(1), 2004 at 61–82, .
41
J. Aizenman, J. Lee, J. and Y. Rhee, “International Reserves Management and Capital Mobility: Policy Considerations and a Case Study of Korea.” NBER Working Paper No.10534, National Bureau of Economic Research, Massachusetts, 2004.
42 J. Aizenman and N. Marion, “The High Demand for International Reserves in the Far East: What’s Going On?”
Journal of the Japanese and International Economies 17(3), 2002 at 370–400.
43 M. Dooley, D. Folkerts-Landau, and P. Garber. “The Revived Bretton Woods System.” International Journal of
much is being read into the growth of the region‟s reserves. Indeed, higher levels post-1997 could be duly warranted.44
1. In a study investigating data before 1997 Aizenman and Marion (2002) measure reserve
demand for a broad sample of 122 developing countries. Particularly they analyze and compare data for a smaller sample of Far East emerging markets (China, Indonesia, Korea, Malaysia, Philippines, and Thailand) and Latin American emerging markets (Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay, and Venezuela).45 Based on their analysis, Aizenman and Marion conclude that a standard regression equation explains Asian reserve holdings in the 1980 – 1996 period quite accurately. If at all, the explanatory variables used overpredict rather than underpredict reserve holdings for some Far East countries most significantly for China but to a smaller extent also for Indonesia, Korea, the Philippines and Thailand.46
However, with an out-of-sample check for 1997 – 1999 the model underpredicts reserve levels for Korea and China. In the case of Korea the regression still overpredicts reserve holdings for 1997 which is the year of Korea‟s financial crisis. Yet, in both 1998 and 1999 reserves are dramatically underpredicted by USD 14,6 billion in 1998 and USD 25,8 billion in 1999. To illustrate, the prediction error in 1999 constituted 37 percent of actual reserves.47 For China, in 1997 and 1998 levels are underpredicted by USD 12 billion and USD 11,4 billion respectively; however for 1999 its holdings are overpredicted again by USD 12,3 billion. For Thailand, for all three years 1997-1999 levels are underpredicted, with the greatest difference of USD 10 billion between predicted and observed levels in 1999. The same holds true for the Philippines. Interestingly, however, the estimation overpredicts Malaysian reserve levels in
44
Park, Beyond Liquidity: New Uses for Asia’s Foreign Exchange Reserves, supra note 36 at 17.
45 Aizenmand and Marion, The High Demand for International Reserves in the Far East: What’s Going On, supra
note 42 at 385.
46
Ibid.
47
the 3-year period. The Malaysian case suggests there is a trade-off between a willingness to adopt capital controls and a willingness to hold reserves. During the financial crisis Malaysia chose to impose capital controls which effectively reduced its integration with global capital markets and therefore its demand for international reserves.48 To expand on this latter note, in February of this year a path-breaking, yet controversial, IMF-study on the experience of post-Asian crisis capital controls stated that “capital controls – in addition to both prudential and macro-economic policy- is justified as part of the policy toolkit to manage inflows.”49 Importantly, the econometric analysis performed by the IMF revealed that countries using capital controls fared better compared to countries that did not use them in the run-up to the current financial crisis.
2. Following Aizenman and Marion, building on their results until 1999, Edison (2003)50
performs a similar analysis to predict reserve levels until the year 2002. Edison finds that actual reserve levels, taking into account an acceleration of reserve accumulation in 2001, are higher than the used model would predict for Mexico, Russia, and, when aggregated together, for China, India, Hong Kong and Malaysia.
Graph 2: Selected emerging economies in Asia: actual and predicted reserves (in billions USD)
Source: Derived from Edison (2003)
48 Aizenmand and Marion, The High Demand for International Reserves in the Far East: What’s Going On, supra
note 42 at 389.
49 IMF, “Capital Inflows, The Role of Capital Controls.” IMF Staff Position Note SPN/10/04, International
Monetary Fund, Washington, DC, February 2010. In Kevin P. Gallagher, “Policy Space to Prevent and Mitigate Financial Crises in Trade and Investment Agreements.” G-24 Discussion Paper No. 58, April 2010 at 4.
50
Also Gosselin and Parent (2005)51 have studied reserve accumulation. They restrict their sample of countries for which to estimate results to Asian emerging economies. Gosselin and Parent find similar results as Aizenman, Marion and Edison when predicting reserves in 2003-2004. In their sample they include China, South Korea, India, Singapore, Malaysia, Philippines, Indonesia and Thailand. Both Edison and Gosselin and Parent state that what they call „traditional‟ determinants of the demand of international reserves, imports to GDP etcetera, fail to explain the very high levels of reserves that have been found in 2002, and in 2003-2004 respectively. When using an informal rule of thumb for the current account, for instance one could find that the months of imports covered by reserves is much higher than the precautionary level. But also taking into account „capital account‟ variables, when observing the Guidotti-Greenspan rule for example looking at the ratio of short-term external debt, in Gosselin and Parent (2005) it is noted that overall the ratio was greater than one so liquidity needs in case of financial turmoil could be easily met.
3. Of course, one problem with this type of evidence is that it is backward-looking: the level
of reserves is made subject to the economic situation of the period investigated. Since the precautionary motive aims at insuring against prospective crises, it would be much more interesting to determine whether current levels of reserves would be enough to effectively face a crisis happening in the future. Actually this has been done in a study by Jeanne and Ranciere (2006).52 But still the finding is that the level of reserves is beyond the optimal, i.e. levels warranted to avert the risk of a crisis to occur, in most countries. In their study they compare Latin American and Asian countries and in particular find that foreign reserves would be accurate in Latin America but excessive in Asia.53
51
Gosselin and Parent, An Empirical Analysis of Foreign Exchange Reserves in Emerging Asia, supra note 39.
52 Jeanne and Ranciere, The Optimal Level of International Reserves for Emerging Market Economies: Formulas
and Applications, supra note 38.
53
In this thesis it will be tested whether, because of greater financial integration of Asian economies into the world in recent years it could be that the emphasis is now higher on the precautionary motive than before. Authors who have attributed continued increasing levels of reserves to a precautionary motive becoming more important over time include Aizenman and Marion (2002a, 2002b),54 Aizenman and Lee (2005),55 Garcia and Soto (2004)56 and Kim et al. (2005),57 also discerning different patters of reserve accumulation among emerging countries in Latin America and Asia.58
2.4 Hypotheses
It might be that increasing financial globalization and a higher magnitude and volatility of capital flows based on the precautionary motive rightfully call for a higher scale of accumulation. To explain further, on the one hand the quantity of reserves to manage the exchange rate is increasing in the magnitude and volatility of capital flows. In addition, the potential reversal of flows within a financial crisis is larger.59 Redrado et al. (2006) argue that the huge levels of reserve accumulation of countries in an intermediate level of development, taking into account global financial integration plus noting that a lender of last resort does not
54
J. Aizenman, and N. Marion, “International Reserve Holdings with Sovereign Risk and Costly Tax Collection,” NBER Working Paper No. 9154, Cambridge, Massachusetts, 2002a. And J. Aizenman and N. Marion, The High
Demand of International Reserves in the Far East: What’s Going On? , supra note 42.
55
J. Aizenman and Lee, International Reserves: Precautionary Vs. Mercantilist Views, Theory, and Evidence,
supra note 10.
56 Pablo S. Garcia and Claudio Soto, “Large Hoarding of International Reserves: Are They Worth It?” Central
Bank of Chile, Working Papers No. 299, Santiago, Chile, 2004.
57 J.S. Kim, Jie Li, S. Ozon, R. Rajan and T.D. Willett, “Reserve Adequacy in Asia Revisited: New Benchmarks
Based on the Size and Composition of Capital Flows,” Monetary and Exchange Rate Arrangement in East Asia, Korea Institute for Economic Policy, Seoul, 2005.
58 Alberola and Serena, Global Financial Integration, Monetary Policy and Reserve Accumulation, Assessing the
Limits in Emerging Economies, supra note 30 at 12.
59
exist, this could be explained by self-protective motives.60 Nevertheless, for this to be true one would then expect „capital account‟ variables, both those that denote external and domestic capital flows, to have contributed more significantly than „current account‟ and other traditional determinants to high levels of reserves in recent years.
For if not then the magnitude and persistence of increased reserve accumulation could suggest that exchange rate management motives have become increasingly relevant. This would apply to Asia but also to other countries such as in Latin America or oil producing countries. The stability of exchange rates in these countries would be caused by extensive interventions in the foreign exchange markets facilitated by reserve accumulation. This perspective on reserve accumulation has been advocated by Dooley, Folkerts-Landau and Garber (2004): they state that the process of reserve accumulation by Asian countries is a consequence of export-led growth strategies.61
To substantiate any answers to the research questions mentioned in the introduction, for the purposes of this thesis-project the following hypotheses will be tested:
1. Capital-account variables have grown more significant in time contributing to reserve levels compared to traditional current-account and GDP variables, indicating greater financial integration of emerging economies which warrants higher reserve levels because of higher vulnerability based on the precautionary motive.
2. Looking at exchange-rate volatility exclusively, the relative stability of the exchange rate in emerging economies ceteris paribus validates the allegation that they maintain high reserves based on a mercantilist motive: to enable export-led growth.
60 M. Redrado, J. Carrera, D. Bastourre and J. Ibarlucia, “The Economic Policy of Foreign Reserve Accumulation:
New International Evidence, BRCA Paper Series No. 2, 2006.
61
M. Dooley, D. Folkerts-Landau, and P. Garber, The Revived Bretton Woods System, supra note 43 and Dooley, Folkerts-Landau and Garber, The Effects of Periphery Intervention and Reserve Management on Interest
CHAPTER III: Analysis
3.1 Building the model
As stated in Chapter II, in formal modeling determinants of reserve levels can be grouped into five categories: economic size, current account vulnerability, capital account vulnerability, exchange rate flexibility and opportunity cost. Table 5 schematically lists potential explanatory variables for each of these categories.
Table 5: Empirical Determinants of Reserve Levels
Determinants Explanatory Variables
1. Economic size GDP, GDP per capita
2. Current account vulnerability Ratio of imports or exports to GDP, volatility of export receipts
3. Capital account vulnerability Financial openness: ratio of capital flows or broad money (M2) to GDP, short-term external debt, foreigner‟s equity position 4. Exchange rate flexibility Volatility of the exchange rate
5. Opportunity cost Interest rate differentials
Source: Derived from Gosselin and Parent (2005), based on Edison (2003).62
Referring back to the study performed by Aizenman and Lee (2006), here the difference between their and this thesis‟ methodologies is clarified. First, as for the precautionary motive, rather than determining the relevant significance of capital account variables contributing to reserve levels in a single regression analysis as done in this thesis they use a two-step approach: in the first place establishing what impact financial crises have on the dependent variables, namely on the reserves/GDP-ratio and the reserves/broad money ratio.63 They determine that this impact is significant. And then secondly they employ a regression equation to establish whether both, either or neither „crisis impact‟ and variables associated with mercantilist motives contribute significantly to reserve accumulation. To measure the significance of mercantilist motives adding to reserve accumulation Aizenman and Lee
62 Marc-André Gosselin and Nicolas Parent, An Empirical Analysis of Foreign Exchange Reserves in Emerging
Asia, supra note 39. Based on Hali Edison, Are Foreign Exchange Reserves in Asia too High?, supra note 32.
63
consider both export growth rates and the difference between real exchange rates and the fundamental PPP real exchange rate explanatory variables. Rather than including export growth rates as explanatory variable, based on economic size and trade account openness generally this thesis regards export growth as „benign‟ and will not consider this variable directly in trying to discern mercantilist motives. However, the volatility of export receipts will be taken into account but in the category of „traditional‟ variables: the higher the volatility, the higher levels of reserves will be to account for trade account imbalances. To signify mercantilist bias this thesis focuses on the exchange rate as the sole and main explanatory variable.
A) Referring to the first and second categories identified in table 5 above as variables to account for GDP-size and current account-balance these will be used in the model that will follow: 1. population; 2. real GDP per capita; 3. the propensity to import; 4. volatility of real export receipts; and 5. the opportunity cost of holding international reserves.64 Together these variables mainly dictate a certain level of reserves to accommodate imbalances that result from trade account transactions. These of course were the main type of balance of payment transactions before the development of international capital markets. Intuitively, since a country‟s international transactions increase with its economic size it is expected that population and real GDP per capita have a positive relationship with reserves. Since vulnerability to external shocks increases with economic openness also trade openness, particularly a high dependence on imports (the propensity to import) will have a positive relationship with reserve holdings. Here the propensity of imports is measured simply as imports over GDP. Larger external shocks (e.g. export volatility) will be associated with larger reserves. Note that a simpler variable is used in this thesis: namely total export receipts rather than year-on-year differences in exports. Indirectly then the larger the export receipts the higher the exposure to volatility. Therefore, the expectation is as well there will be a positive relationship. Logically, a negative relationship follows for the opportunity cost of holding reserves as measured by interest rate differentials.
64
B) A second group of „capital account‟ variables comparable to those mentioned in category 3 of table 5 contains: 1. money supply; 2. external debts; and 3. capital flows. Money supply in an economy is a proxy for potential capital flight by domestic residents. Therefore, it can be a measure of the intensity of the „internal drain‟. Immediately after the Asian financial crisis external debts and sudden capital flow reversals (sudden stops of inflows) have received considerable attention. For precautionary reasons high levels of either, and particularly a high volatility of capital flows, will warrant higher levels of reserves. This will be determined by testing for hypothesis 1. The expectation is there will be a positive relationship with these three variables. Note that volatility of capital flows per se is not measured but rather the size of FDI flows which forms an indication nevertheless of the exposure to the „sudden stop‟ risk.
C) Lastly, to detect any mercantilist motives emerging economies might have holding high reserve levels and to test for hypothesis 2, the significance of the exchange rate as a contributing factor to reserve levels will be determined. The expectation is there will be a significant relationship: for else, non-significance of the exchange rate reduces the need for central banks to maintain a large stockpile of reserves with which to manage the exchange rate. Hence, note that rather than differences in exchange rates year on year, measuring exchange rate volatility, simply the contribution of the exchange rate per se to reserve levels is measured and the significance of the relationship tested.
And the formal equation based on these variables that follows as a result:
Ri = c + αEi + βGi + γIi - δOi + εPi + δDEi + εFi + ζMi +/- ηXi With:
R = level of reserves c = constant
1. Variables accounting for GDP-size and current account-balance
E = export receipts (total export receipts) G = real GDP per capita
I = propensity to import (imports over GDP)
2. Variables accounting for capital account-balance
DE = external debts (external debt over GDP)
F = capital flows (FDI inflow over GDP)
M = money supply (broad money, M2, over GDP)
3. Variable accounting for the exchange rate
X = exchange rate (exchange rate in USD)
The sample of countries included in the model consist of 7 of the G20-economies, in Latin-America and Asia, apart from emerging economies also including Japan. Other than Japan, these are: Argentina, Brazil, China, India, Indonesia and (South-)Korea. Explaining the country-sample, since these countries form part of the 20 largest economies together they exert most influence on reserve accumulation compared to their regional peers. Taking into account both Latin-American and Asian countries, this offers the opportunity to look at regional differences. Data for the 9 independent variables are annually from 1990 – 2008 and to a large extent derived from IMF-IFS and WB-WDI.
3.2. Running the regression
As for the estimated coefficients for the 9 different variables, these are the H0 and H1 hypotheses:
H0 : coefficients α, β, γ, δ, ε, δ, ε, ζ and η are 0. H1: coefficients α, β, γ, δ, ε, δ, ε, ζ and η are not zero
Table 6: Summary of regression results Country Significant Positive Relationship (</= 5% one-tail) Significant Negative Relationship (</= 5% one-tail) Strong Positive Relationship (</= 10% one-tail) Strong Negative Relationship (</= 10% one-tail) Moderate Positive Relationship (</= 25% one-tail) Moderate Negative Relationshi p (</= 25% one-tail) ‘No’ Relationship (i.e. probability > 50% two-tail) Argentin a G, O E, P I, F, X DE M Brazil G P E, I, DE, X O, F, M China E F M G, DE I O, P, X India G, X P M E I, DE O, F Indonesi a X E, G, I, O, P, DE, F, M Japan E, G, DE, F P, M O X I Korea E, DE, M G, F, P I O, X 3.3 Discussion of results
Contrary to what was expected a negative relationship between reserve accumulation and a „traditional‟ macro-variable, population size, is obtained for many countries. An explanation could be that the private sector in these bigger countries is offsetting any efforts made by the central bank to accumulate reserves. However, noting constraints in the form of limited capital-account liberalization and underdeveloped financial sectors in emerging market economies, and also that a large part of the population remains fairly poor (not able to import products from abroad) a negative significant relationship is puzzling especially since GDP per capita for most of these countries does have a strong positive relationship with reserves. What remains, however, is the possibility of large income inequality. The gains from exports leading to higher GDP accrue to only a small segment of the population. Even though average per capita GDP is increased the impact on reserve levels considering the population at large may be diluted. As for other „traditional‟ variables an overall non-significant relationship with opportunity cost is found, apart for Argentina where a strong positive relationship between opportunity cost and reserves is obtained This result raises questions as well since the assumption prior to running the regression was a negative relationship. What is reassuring is that a positive relationship between export receipts and reserves is obtained for big surplus countries (China, Japan and Korea). For all countries the variable for import propensity relates to reserve levels fairly weakly.
Lastly, at least hypothesis 2, that emerging markets generally actively manipulate -stabilize at a low level- exchange rates and based on mercantilist motives accumulate reserves cannot be accepted. For most of the countries mentioned the exchange rate variable is not showing a significant relationship with reserves. However, just for India, a significant positive relationship is obtained (because of the two-tail testing this requires doubling of percentages in table 6 above as only those for one-tail testing are given). Note that this could point at either relationship: the exchange rate as a factor contributing significantly to reserve levels, and a reverse causal relationship as well: high exchange rate volatility necessitating high reserves rightly to have the policy-tools available in the end to arrive at a more stable exchange rate. Also Argentina and Indonesia, and to a smaller extent Brazil, show positive relationships albeit at much lower significance levels between the exchange rate variable and reserve accumulation. For some other countries that are more interesting to look at for indications of export-led growth strategies, China, Korea and Japan, a fairly non-significant relationship is obtained.
Comparing these results to those obtained by Aizenman and Lee,65 they find a statistically positive significant relation between the presence of crises –they used a dummy variable measuring impact of the Mexican (tequila) and East-Asian crisis- and a variable measuring reserves over broad money ratio as well as for the reserves over GDP ratio.66 Interestingly, what intuitively seems logic though, they find that the Mexican crisis is associated with higher demand for reserves in Latin America, but not in Asia, and that the East-Asian crisis is associated with higher reserves in Asia, but not in Latin America. All in all, results according to them prove the presence of precautionary motives leading to reserve accumulation. Aizenman and Lee find that the „mercantilist‟ variables, i.e. not just the exchange rate or exchange rate volatility but the difference between actual and PPP-based exchange rates67 and
65 The country sample comprises 53 countries, including advanced and emerging-market economies and
several major developing economies.
66 Note that for both measures, reserves over broad money and reserves over GDP, as dependent variables,
very similar results are obtained.
67
CHAPTER IV: Global Imbalances and Financial Crisis
Moving on from a discussion on precautionary and mercantilist motives behind reserve accumulation to argue (non-) sustainability of reserve levels, a qualitative discussion can prove worthwhile as well, particularly when linking the sustainability of reserve accumulation and global imbalances generally to the financial crisis. It has been argued that a key factor driving the ongoing financial crisis has been the presence and persistence of global imbalances. Yet, it can be called a raison d’être of financial systems that they are able to effectively deal with imbalances between savers and investors.68 However, should that be understood as if this were regardless their size and impact? In the past and at present still there has been fear for a sudden unwinding of global imbalances and this then through a collapse of the dollar consequently leading to crisis. I.e. the classic „doom scenario‟. Instead, the current crisis is of a different nature.
The financial crisis was not brought about by exchange-rate dynamics but rather emerged because of global imbalances enabling levels of household debt in the U.S. that turned out to be unsustainably large. With the collapse of Lehman Brothers in 2007, a domino-effect in the financial sector through linkages between highly leveraged institutions and the global nature of the housing bust led to crisis in the U.S., other developed markets and eventually in the rest of the world, not just in financial but also in real terms, the latter because of a decline in global demand and world trade.69 The inflow of Asian savings facilitated the consumption boom in the U.S., with deflationary impact enabling low policy rates (both short- and long-run) which in turn raised risk appetite among investors. This is the so-called „saving glut‟
68 Daniel Gros, “Global Imbalances and the Accumulation of Risk.” CEPS Policy Brief No. 189, June-July 2009 at
1.
69
perspective on the crisis.70 For instance, Warnock and Warnock (1997) show that official capital investments in Treasury bonds has been able to reduce the ten-year interest rate with 90 points between 2004 and 2005.71 On the contrary, a „liquidity glut‟ view maintains that expansive monetary policy, when the FED was led by Alan Greenspan whose policies were enabled because of low inflation in part caused by the dot-com bubble and in part imported from Asia, in combination with expansive fiscal policy have had most detrimental impact, causing the crisis. For instance, Taylor (2009) shows that the FED between 2002 and 2005 had decreased the federal funds rate (the short-term nominal interest rate) with 300 points under the level as prescribed by the Taylor-rule.72
To explain further arguing from a „saving glut‟ perspective. The U.S. deficit emerged from eventually unsustainable increases in household and residential consumption. And this excess in domestic spending was financed mainly through an increase in mortgage debt. Yet, these „long-term‟ assets were not met by sufficient demand levels. Excess savings from EMEs were mostly intermediated as currently still by their central bank. However, these were and are almost exclusively invested in short-to-medium term safe and liquid securities, U.S. Treasury securities and asset-backed securities (ABS) issued by U.S. agencies. These nominally are denominated as long-term securities. Treasury International Capital System (TICs) data indeed suggest that U.S. debt held by foreigners is almost entirely by way of long-term securities. Looking at China, even though the Chinese government does not publicize the currency and asset composition of its reserves it is possible to make some informed guesses based on data on foreign holdings of U.S. assets collected by the U.S. Treasury Department.73 For simplification purposes, for the numbers below it is assumed that all U.S. assets held by
70 For example, see: Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit." Federal
Reserve, March 2005, at http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm. Retrieved 2010-01-13.
71 F.E. Warnock and V.C. Warnock, “International Capital Flows and U.S. Interest Rates.” NBER Working Paper,
No. 12560, October 2006.
72 J.B, Taylor, “The Financial Crisis and the Policy Respons: An Empirical Analysis of What Went Wrong.” NBER
Working Paper 14631, November 2008.
73
China are in the hands of China‟s State Administration of Foreign Exchange (SAFE) and that SAFE holds no other dollar assets. As for U.S. Treasury bonds and bills China has substantially increased its holdings: it held USD 71 billion of Treasuries by the end of March 2000 compared to USD 768 billion by the end of March 2009.74 Also, and contrary to what is noted for average figures in the TICs system, a change in the maturity structure of Chinese purchases of U.S. Treasuries can be observed. Short-term bills (as opposed to long-term bonds) were responsible for almost two-thirds of total net purchases in 2008 whereas in previous years a much higher proportion consisted of bonds instead.75 For all countries investing in U.S. Treasuries data reveal the following information on their maturity structure: in 2008: around two-third of this debt had less than 4 years to maturity.76 All in all, for the U.S. there was a need for maturity and risk transformation at a thus far unprecedented scale to meet excess demand for safe and liquid assets (particularly coming from „crowded-out‟ investors – i.e. outcrowded by official investors from EMEs). And, further securitization offered a solution for providing these assets that were considered safe as they constituted AAA trances on securitized U.S. mortgages and other loans.77
However, in doing so the U.S. financial system undertook a huge macro-economic risk. The financial sector had to produce assets that were short-term, safe and liquid, from long-term risky and illiquid loans. Although in theory the so-called „originate to distribute‟-model entails a full transfer of risk to several buyers of the diverse forms of ABS and RMBS (a sub-class of ABS, residential mortgage-backed securities are slightly more risky than ABS for they exclude commercial mortgages),78 because of the buying of U.S. government paper by
74
Prasad and Sorkin, Sky’s the Limit? National and Global Implications of China’s Reserve Accumulation, supra note 9 at 3.
75
Ibid. at 1
76 Report on Foreign Portfolio Holdings of US Securities, US Department of the Treasury, Federal Reserve Bank
of New York and Board of Governors of the Federal Reserve System, June 2008 at 20, table 14.
77
Gros, Global Imbalances and the Accumulation of Risk, supra note 68 at 1..
78
EMEs in massive amounts which had displaced other investors, mostly domestic, European and Japanese, the excess demand could not be satisfied but through substantial credit and liquidity enhancements by banks. And general equilibrium modeling then showed that in fact clean securitization with full risk transfer to the investor in reality was no longer possible, also because the final creditor pur sang, China, was in large part shelled from the risks of financial transactions on the U.S. market. The ingredients for the financial crisis with excessive risky securitization were put in place, and then came to play out. The huge increase in the balance sheets of banks with accompanying increases in leverage when risk returned eventually acted as a giant amplifier. This occurred the moment when asset prices came down after low interest rates and rising asset prices had generated an environment in which too risky and sometimes dishonest financial transaction fared well.79 Caballero and Krishnamurthy (2009) argue in similar lines: because EMEs demanded safe U.S. assets, indeed U.S. residents were
left with higher risk assets and incentives to further increase leverage. And EMEs’ demand for these assets had severely distorted relative returns on Treasury bonds and other assets.80
A paper by Baclet and Vidon (2008) of the Central Bank of France discusses the functioning of liquid financial markets as an international public good.81 They state that the provision (private or public) of liquid financial assets is the key feature of an efficient financial market structure.82 In fact emerging economies import „public service‟ benefits that are provided by U.S. or European government securities. This is enabled by „financial globalization‟ that makes this public good produced in developed economies available to the rest of the world. The absence of a similar public good in EMEs themselves is thus „by-passed‟. However, although use of these assets because of financial integration ought to be a public good, i.e. non-rival and non-excludable and as such proving the sustainability of global imbalances,
79 M. P. Dooley, D. Folkerts-Landau and P.M. Garber, “Bretton Woods II Still Defines the International Monetary
System.” NBER Working Paper 14731, February 2009 at 6.
80 R. Caballero and A. Krishnamurthy, “Global Imbalances and Financial Fragility.” NBER Working Paper 14688,
January 2009.
81 Alexandre Baclet and Edouard Vidon, “Liquid Assets, Liquidity Constraints, and Global Imbalances.” Banque
de France, Financial Stability Review – Special Issue on Liquidity, No. 11, February 2008.
82
liquid assets can be subject to congestion if they are used by too many holders simultaneously. And indeed, EMEs as market participants „cornered‟ a disproportional share of U.S. Treasury bills and bonds. This caused liquidity to vanish for other market participants, namely U.S. domestic asset holders.
In sum, the current crisis does not demonstrate that current account deficits, or imbalances on the balance of payments more generally, are necessarily bad or that they will inevitably lead to crisis. Rather, this brief analysis shows that it is important to look at how current account deficits are financed. And then subsequently, how flow imbalances cumulate into large disequilibria of stock forming a severe threat to financial stability. Beyond the crisis, such analysis would also project that because of U.S. households now starting to save, running a U.S. deficit in comparison becomes less problematic as it is the U.S. government for real now over-spending –not the private sector- and they are able to supply exactly the type of assets needed by EMEs‟ central banks. Therefore no crowding-out effects that give incentive to ballooning banks‟ balances sheets ought to occur again.83
83
Chapter V: Adjusting Global Imbalances and Implications for Economic Growth
Fortunately, global demand balancing is not new and has been accomplished successfully before. Germany ran substantial current account surpluses in the late 1960s and early 1970s. As a share of global current account imbalances they were similar to China‟s today (around 20%), although of course the total size of current account imbalances was much smaller as capital markets back then were much less developed.84 Germany managed to rebalance its surplus during the 1970s. There have been other examples of countries reversing current account surpluses –although none with such a substantial surplus like China. In a few cases expansionary macroeconomic policy helped boost domestic demand. In other cases foreign demand fell because of exchange rate appreciation in the surplus country. And again in other cases imbalances were reduced because of more general structural reforms of the economy and/or because exports increased in product quality terms.85
In fact, in the most recent IMF World Economic Outlook of April 2010, 28 policy-induced surplus reversals have been investigated quite thoroughly. The sample of countries included in the analysis consists of 46 advanced and emerging market economies during 1960 – 2008.86 The analysis finds that during the policy reversal the current account narrowed sharply: on average the surplus narrowed by 5,1% of GDP.87 And after the reversal the current account balance was relatively small, 0,4% of GDP on average, and not statistically different from zero. The reversal process was typically accompanied by both a substantial reduction in savings and an increase in investment. More precisely, domestic savings fell by 2,1% of GDP on average. Private savings fell by an even larger amount: 3,3% of GDP.
84
IMF, World Economic Outlook (WEO), April 2010 at 25.
85 Ibid. at 26.
86
Note that surplus reversals in the fuel and non-fuel commodity-exporting economies were excluded from the analysis as these have more often been brought about by terms-of-trade shocks than by domestic policies.
