The spectacular increase in hoarding of international reserves (IR) by emerging markets, in the aftermath of the East Asian crisis, has been one of the defining features of global imbalances (Summers 2006). This accumulation reflects, among other factors, the self insurance provided by international reserves against sudden stops and deleveraging crises (Aizenman and Lee 2007). Dani Rodirk, evaluating the cost-benefits of such a strategy, concluded that emerging markets “have over-invested in the costly strategy of reserve accumulation and under-invested in capital-account management policies to reduce their short-term foreign liabilities.” (Rodrik 2006).
In my recent research, I analyse the lessons of the 2008-9 global liquidity-crisis regarding alternatives to sizeable hoarding of international reserves (Aizenman 2009). I find that the crisis validates the need for external debt management policy, and I apply a cost benefit analysis to identify a superior tax-cum-subsidy policy that would reduce the cost and the scale of hoarding international reserves.
The experience of Korea during the last 15 years outlines the contours of the debate about self-insurance by means of hoarding reserves. To recall, following the 1997-8 East Asian crisis, Korea embraced financial integration, buffered with a sizeable hoarding of IR. The large stockpiles of IR provided Korean authorities with precautionary savings to cushion against sudden stops and deleveraging.
Figure 1 overviews these trends, tracing the short and long run external debt to GDP ratio, and the IR to GDP ratio in Korea, 1992-2008. While IR/GDP hovered around 5% before the 1997-8 crisis, the financial upheaval triggered by the East-Asian crisis induced massive hoarding, quintupling Korea’s IR/GDP by 2004. By that time, Korea’s IR were more than twice its short term external debt, and more than its total external debt. Less than 10 years after the 1997-8 East Asian crisis, by conventional yardsticks Korea’s IR/GDP ratio seemed more than adequate, with IR exceeding short term external debt and allowing for the financing of several quarters of imports.
Figure 1. South Korean experience, 1994-2008, IR/GDP, External Debt/GDP
IR = International Reserves, SED = short-term external debt, TED = total external debt.
Following the sizable increase in Korea’s external debt after 2005, this sense of blissful abundance of IR in Korea evaporated.
- The Korean external short term debt/GDP ratio increased from 7.5% in 2004 to 20% in 2008.
- The overall external debt/GDP increased during that period from 23% to 50%, without a significant change in the IR/GDP ratio.
The onset of the current global liquidity crisis and the ensued deleveraging illustrated vividly the fragility of Korea’s balance-sheet.
During the first stage of the 2008-9 global liquidity crisis, Korea’s reserves declined by about 25%. Observers noted that despite the use of Korea’s sizeable IR hoarding to finance a bailout package of its banking system, market concerns were not abated. “Only when it was made clear that the Fed would renew the swap agreement, foreign investors’ confidence in the Korean economy improved and stability in the foreign exchange market returned toward the end of the first quarter of 2009.” (Yung Chul Park 2009). Korea’s experience in the last five years illustrates the hazard of the absence of a pro-active external debt management policy, and the limits of relying only on hoarding IR as the defence against a deleveraging crisis. Similar challenges have been experienced by most emerging markets.
Reserves and sudden stops
As is well appreciated by now, bank intermediation facilitated by short term external borrowing in hard currency exposes the economy to balance sheet vulnerabilities – increasing the costs of sudden stop and a deleveraging crisis (Eichengreen, Hausmann and Panizza 2003). Such a crisis frequently induces a costly premature liquidation of tangible investments. If international reserves are not plentiful, a deleveraging crisis induces a large number of banks to liquidate investments at the same time. This would depress the selling price of tangible capital, increasing the cost of deleveraging -- the fire-sale effect.
Deleveraging pressure in emerging markets increases the demand for foreign currency, needed in order to meet the deleveraging. If foreign currency reserves are limited, the deleveraging pressure would bid up the price of foreign currency, requiring each bank to liquidate more of its investment to fund a given deleveraging pressure. While each bank takes potential fire-sale prices as given, as a group, they induce the fire sale prices. This leads to a fire-sale externality, akin to congestion (see Krugman (2000) on the experience of Korea in the 1997-8 crisis).1
The “fire-sale externality”
In Aizenamn (2009) I consider an emerging market where investment in a long term project is financed by banks, relying on external funds. Similarly to Diamond and Dybvig (1983), the investment should be undertaken prior to the realisation of liquidity shocks. Premature liquidation of tangible capital entails costly liquidation. This cost increases with the aggregate deleveraging pressure. In these circumstances, competitive financial intermediation induces each bank to overlook the impact of its deleveraging on the liquidation costs of all the other banks, inducing a fire-sale macro externality.
I find that fire-sale externalities reduce the marginal social benefit of borrowing below the private benefit, and increase the marginal social benefit of hoarding IR above the private one. This in turn entails an externality akin to “congestion”, calling for a Pigovian tax-cum-subsidy scheme inducing borrowers to take into account the externality associated with external borrowing and a deleveraging crisis. Properly designed, the scheme reduces the distorted activity (external borrowing), inducing the borrowers to co-finance the precautionary hoarding of IR by means of a borrowing tax. Such prudential supervision would tighten the link between short-term external borrowing and hoarding IR, thereby mitigating the exposure to deleveraging risks induced by short term external borrowing.
If the only policy applied is an external borrowing tax, then the optimal tax needed to induce banks to internalise the fire-sale externality is proportionate to the fire-sale externality. This policy may fall short of inducing the optimal demand for international reserves. Achieving both optimal external borrowing and hoarding reserves requires two policy instruments -- an external borrowing tax and an international reserves subsidy. I show that the fiscal revenue from the borrowing tax exceeds the cost of funding the hoarding subsidy. Thus, the optimal borrowing tax funds the optimal subsidy on hoarding IR. Consequently, the combination of these policies tends to reduce the cost and the scale of hoarding international reserves.
In the absence of a deep reform of the global financial architecture, emerging markets remain exposed to sudden stops and deleveraging crises, and the proper management of the external debt of a country remains a key challenge.
Moving to financial autarky is overkill; the proposed external borrowing tax-cum-reserves hoarding-subsidy would facilitate a more sustainable financial integration. By now, the fastest growing countries in Asia (China and India) and in Latin America (Brazil) are applying versions of taxes on inflows of funds, policies that implicitly subsidise the costs of the sizable IR stocks held by these countries.
These policies reduced their exposure to the delivering crisis of 2008-9, and may reduce the costs of the renewed inflows of hot money. Alternatives to massive hoarding reserves include a deeper use of swap lines and of IR pooling arrangements; and channelling the reserves into potentially higher yielding but riskier assets, managed by sovereign wealth funds.
While potentially useful, these alternatives are not a panacea. Swap lines are typically of short duration, and are limited by moral hazard considerations. Diversification by means of sovereign wealth funds exposes the economy to the risk that the value of the fund may collapse precisely at the time that hard currency is needed to fund deleveraging, as has been the case during the 2008-9 global liquidity crisis.
The recent resumption of inflows to emerging markets and the hoarding of international reserves may provide the illusion that ‘all is well.’ Though the crisis of 2008-9 vividly illustrated that hoarding IR remains a potent self-insurance mechanism, it is rather expensive and less efficient in the absence of assertive external debt management policies. An optimal external borrowing-tax cum hoarding-subsidy may also mitigate the political demand in emerging markets to spend the accumulated reserves to finance various expenditures. Taxing external borrowing would scale down the needed reserves, and fund the accumulation of reserves by the activities that expose the economy to the need to self-insure by these reserves.
1 See Caballero and Krishnamurthy (2004) and the references therein.
Aizenman, Joshua (2009). "Hoarding international reserves versus a Pigovian Tax-Cum-Subsidy scheme: reflections on the deleveraging crisis of 2008-9, and a cost benefit analysis,” NBER Working Paper No. 15484.
Aizenman, Joshua and Jaewoo Lee (2007) "International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence," Open Economies Review, 2007, 18 (2), pp. 191-214.
Caballero, Ricardo and Arvind Krishnamurthy. (2004): Smoothing Sudden Stops, Journal of Economic Theory, 119(1), 104-127.
Diamond, Douglas and Philip Dybvig. (1983) “Bank Runs, Liquidity and Deposit Insurance,” Journal of Political Economy 91, pp. 401-419.
Eichengreen B., R. Hausmann and U. Panizza. (2003) “Currency Mismatches, Debt Intolerance and Original Sin: Why They Are Not the Same and Why it Matters” NBER Working Paper 10036.
Krugman, Paul (2000) “Fire-Sale FDI,” in Flows and the Emerging Economies: Theory, Evidence, and Controversies, S. Edwards, editor, University of Chicago Press, 43 – 60.
Park, Yung Chul (2009) “Reform of the Global Regulatory System: Perspectives of East Asia’s Emerging Economies”, presented that the ABCDE World Bank conference, Seoul, June 2009.
Rodrik, Dani (2006) “The Social Cost of Foreign Exchange Reserves.” International Economic Journal 20, 3.
Summers, Larry (2006) “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation” L.K. Jha Memorial Lecture, Reserve Bank of India, India, March 24.