International reserves in emerging market countries: Too much of a good thing?

Brookings Papers on Economic Activity

Volumn , Issue 1, 2007, Pages 1-55

  Jeanne, Olivier ^a  

^a INTERNATIONAL MONETARY FUND   (United States)

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EID: 34848836091     PISSN: 00072303     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Conference Paper

References (46)

1. See, for example, Aizenman and Marion (2003) and Stiglitz (2006). According to a survey of central bankers of developing and emerging market countries, the main reason for the recent buildup in reserves was to "secure protection from volatile capital flows" (Pringle and Carver, 2005). In the words of Stiglitz (2006, p. 248) "The East Asian countries that constitute the class of '97 - the countries that learned the lessons of instability the hard way in the crises that began in that year: have boosted their reserves in part because they want to make sure that they won't need to borrow from the IMF again. Others, who saw their neighbors suffer, came to the same conclusion - it is imperative to have enough reserves to withstand the worst of the world's economic vicissitudes."
2. See, for example, Summers (2006).
3. My sample of emerging market countries is based on JP Morgan's Emerging Markets Bond Index Global (EMBIG); my sample of industrial countries includes all countries that were members of the Organization for Economic Cooperation and Development in 1990. Appendix table A-I lists the countries in both samples. Neither sample includes three large reserves holders in Asia: Hong Kong, Singapore, and Taiwan.
4. Summers (2006).
5. The ratio of reserves to imports should equal 0.25 according to the three-months-of-imports rule. The ratio of reserves to short-term external debt should equal 1 according to the Greenspan-Guidotti rule, the idea being that reserves should allow a country to live without foreign borrowing for up to one year. A conventional range for the ratio of reserves to broad money is 5 to 20 percent. The rationale for this ratio is that broad money reflects a country's exposure to the withdrawal of assets (Calvo, 1996; De Beaufort-Wijnholds, Onno, and Kapteyn, 2001).
6. See IMF (2003), Aizenman and Marion (2003), and Aizenman, Lee, and Rhee (2004).
7. Heller (1966). The dynamic aspect of the authorities' optimization problem was treated more rigorously in the buffer stock models of international reserves of Hamada and Ueda (1977) and Frenkel and Jovanovic (1981).
8. Whereas Heller (1966) interpreted the adjustment cost as a transitory fall in domestic absorption, Ben Bassat and Gottlieb (1992) and Garcia and Soto (2004) define it as a fall in domestic output. The two are not equivalent for domestic welfare.
9. The representative-consumer assumption implies that one must look at the optimal level of reserves from the point of view of the country as a whole, without distinguishing between the private sector and the public sector. See, for example, Caballero and Krishnamurthy (2004) for a model of international reserves that includes a meaningful distinction between the private sector and the government.
10. Aizenman and Marion (2003) and Miller and Zhang (2006) present two-period precautionary savings models of reserves. Caballero and Panageas (2005) and Durdu, Mendoza, and Terrones (2007) present more dynamic precautionary savings models of international reserves. These models do not yield closed-form solutions for the optimal level of reserves but can be solved numerically.
11. Note that the consumer always repays the short-term debt that is not rolled over; that is, default is ruled out by assumption as a way of smoothing domestic consumption.
12. See, for example, Heller (1966), Ben Bassat and Gottlieb (1992), and Garcia and Soto (2004).
13. In line with the model, my discussion will focus on crisis management and will not deal with some benefits that reserves may have in noncrisis times, such as limiting exchange rate volatility (Hviding, Nowak, and Ricci, 2004) or providing liquidity to the foreign exchange market. Reserves can also yield benefits if the government is able to invest them more wisely than the average citizen, or if they promote capital market integration and domestic financial development.
14. IMF (2000, p. 6).
15. Those conclusions were presented in two documents: "Debt- and Reserve-Related Indicators of External Vulnerability" (IMF, 2000) and "Issues in Reserves Adequacy and Management" (IMF, 2001). One study that contributed to crystallizing the official sector's conventional wisdom about the importance of this ratio was Bussière and Mulder (1999). See also Mulder (2000).
16. The literature on early warning signals and the empirical determinants of crisis in probit/logit regressions is too large to be reviewed here-the reader is referred to the reviews by Kaminsky, Lizondo, and Reinhart (1998), Berg, Borensztein, and Pattillo (2005), and Frankel and Wei (2005). Another way in which reserves might stabilize the domestic economy is by lowering the interest rate on foreign debt (Levy Yeyati, 2006). Evidence that larger reserves decrease the sovereign spread is provided in Hauner (2005), Duffie, Pedersen, and Singleton (2003), and Eichengreen and Mody (2000). By contrast with currency crises, Calvo, Izquierdo, and Mejía (2004) and Frankel and Cavallo (2004) did not find that reserves had a statistically significant effect of reducing the probability of sudden stops.
17. Frankel and Rose (1996).
18. Frankel and Wei (2005).
19. The precise definitions are given in table A-2 in appendix A. The crisis dates for SS2 to SS4 are taken from Frankel and Cavallo (2004), who apply the criteria of Calvo, Izquierdo, and Mejía (2004) to a larger sample of countries and a longer time period.
20. More precisely, the measure of short-term debt that works best is that from the World Bank Global Development Finance database rather than that in the Bank for International Settlements (BIS) data. This result is surprising because the BIS data should be a better measure of the denominator in the Greenspan-Guidotti ratio (the BIS reports debt maturing in the following year, whereas the World Bank data are based on maturity at issuance). However, the BIS debt measure might be less significant because it is available for fewer of the countries in the regressions.
21. This ambiguity is certainly present in the theoretical literature on crises and reserves. In some models, a large volume of reserves effectively reduces the probability of crisis by making the economy more resilient to adverse shocks (Chang and Velasco, 2000; Aizenman and Lee, 2005) or to self-fulfilling changes in market sentiment (Morris and Shin, 1998). By contrast, in the Krugman-Flood-Garber framework, a speculative attack made unavoidable by excessive money growth is merely delayed by a larger stock of reserves (Krugman, 1979; Flood and Garber, 1984). In addition, countries often shorten the maturity of their debt before a crisis, further reducing the Greenspan-Guidotti ratio (Detragiache and Spilimbergo, 2001).
22. Jeanne and Wyplosz (2003) and Calvo (2006) emphasize that lending the reserves to domestic agents is a more effective tool than foreign exchange intervention in preventing and mitigating crises. Calvo (2006) points to an interesting example of a nonstandard way of disposing of international reserves: in August 2002 the central bank of Brazil employed some of its international reserves to make loans to the export sector through commercial banks.
23. t is the current account balance (the sum of the trade balance and income and transfer from abroad), can be used to substitute out the trade balance from the first identity.
24. The dollar value of output and domestic absorption falls by a larger amount than indicated in figure 8 because of the real depreciation of the domestic currency. The variables are converted from current dollars to constant local currency units using the nominal dollar exchange rate and the local GDP deflator. IMF loans are counted as a loss of reserves rather than as capital inflows.
25. My discussion focuses on the opportunity cost of carrying the reserves and does not deal with the challenges to monetary and financial stability posed by large-scale sterilization (see Mohanty and Turner, 2006, and European Central Bank, 2006, for a discussion of those costs). Another cost that I do not discuss is the false sense of confidence that reserves may instill in foreign investors, allowing the domestic authorities to postpone necessary adjustments. Finally, large-scale purchases and sales of reserves could induce exchange rate changes that cause valuation losses on the reserves.
26. Caselli (2007) computes the return to capital using production functions calibrated as in the development accounting literature. They find that the return to capital is not higher in developing countries than in industrial countries once one adjusts for non-reproducible capital (land).
27. See, for example, Frenkel and Jovanovic (1981), Flood and Marion (2002), and Mohanty and Turner (2006).
28. This measure was initially proposed by Edwards (1985). It is used by Garcia and Soto (2004) and Rodrik (2006).
29. The differential between ten-year U.S. Treasury bonds and three-month U.S. Treasury bills was almost 2.5 percentage points on average over 2000-05. Expectation-adjusted measures lead to even lower estimates of less than 1 percentage point (Rudebusch, Sack, and Swanson, 2007).
30. This is consistent with the estimates obtained by Rodrik (2006) and Bird and Rajan (2003).
31. Using instead the ratio of short-term external debt to GDP would give similar values for L. For my sample this ratio is 8.2 percent on average over the period 1980-2000 according to the World Bank's Global Development Finance (GDF) data set, and 11.7 percent according to the BIS database.
32. Hutchison and Noy (2006) find that the cumulative output loss of a sudden stop is around 13 to 15 percent of GDP over a three-year period. Becker and Mauro (2006) find an expected output cost of 10.2 percent of GDP for currency crises and 16.5 percent of GDP for sudden stops. On one hand, the estimated output cost of a crisis can be significantly larger if the output gap is cumulated until output has returned to potential, which typically takes longer than two or three years. On the other hand, using the precrisis growth rate to estimate postcrisis potential output may exaggerate the size of the output gap if the crisis was preceded by an unsustainable economic boom.
33. However, this may not be an implausible order of magnitude for the cost of a severe banking crisis.
34. Another alternative is the view that the high-growth developing countries are exporting their savings abroad because of a shortage of domestic assets for their residents to invest in (Caballero, 2006). These capital outflows must take the form of reserves accumulation if residents' holdings of foreign assets are restricted by capital controls.
35. The nonmercantilist variant would hold that these countries' competitiveness results from natural factors (for example, that wages are kept low in the export sector by a reserve army of labor migrating from the traditional sectors) rather than policy-induced distortions. Mercantilism is at the core of the "Bretton Woods II" view (Dooley, Folkerts-Landau, and Garber, 2004) of the international financial system. Although many commentators find this view quite plausible, it is not obvious how to confirm or reject it empirically. For example, Aizenman and Lee (2005) find that variables associated with the mercantilist motive (lagged export growth and deviations from predicted purchasing power parity) explain very little of the cross-country difference in reserves accumulation.
36. The correlation is less significant for capital account restrictions than for the current account balance or the growth rate, and it seems less robust-it is no longer significant if one uses Edwards' (2001) measure of capital mobility rather than Chinn and Ito's (2005).
37. As Gourinchas and Jeanne (2006) have shown, high-growth developing countries tend to export capital, a puzzle that is explained in part by reserves accumulation. See also Prasad, Rajan, and Subramanian in this volume.
38. See Rozanov (2005) and Johnson-Calari and Rietveld (2007). Another approach would be to give the private sector more direct control over the allocation of the country's foreign assets, as in Prasad and Rajan's (2005) proposal to set up closed-end mutual funds that purchase reserves from the central bank and invest the proceeds abroad.
39. See Jen (2007).
40. On recent trends in reserves diversification see Knight (2006), Woolridge (2006), and Truman and Wong (2006).
41. Figure 12, which is based on data from the Treasury International Capital (TIC) database, does not report foreign official investment in onshore or offshore dollar deposits and repurchase agreements, which amount to about one-fourth of the total (Knight, 2006, table 2).
42. See Parisi-Capone and Setser (2006).
43. Warnock and Warnock (2006) find that foreign demand for Treasury securities has a significant impact on Treasury yields. A study by the European Central Bank (2006) finds that the interventions conducted by Asian central banks cannot be shown to be responsible for the low yields in the United States, although they have certainly played a role.
44. Using various models of the demand for IMF loans, Ghosh and others (2007) project that IMF credit outstanding will decline from an average of SDR 50 billion over 2000-05 to SDR 8 billion over 2006-10, in part because of the increase in the reserves-to-short-term-debt ratio in emerging market countries.
45. See Becker and others (2007).
46. Eichengreen (2006) recommends that the Latin American Reserve Fund follow a similar course of action.