Wednesday, July 18, 2012

The Optimal Level Of International Reserves

East Asia over the years have been variously accused of currency manipulation and neo-merchantilist policies. Massive reserve holdings in the region – e.g. China’s USD3.2 trillion, Japan’s USD1.3 trillion; nine of the top twenty reserve holdings are in East Asia  - can be pointed to as proof of this assertion.

A new research paper in this month’s NBER circulation disputes this view however (abstract; emphasis added):

Optimal Holdings of International Reserves: Self-Insurance against Sudden Stop
Guillermo A. Calvo, Alejandro Izquierdo, Rudy Loo-Kung

This paper addresses the issue of the optimal stock of international reserves in terms of a statistical model in which reserves affect both the probability of a Sudden Stop–as well as associated output costs–by reducing the balance-sheet effects of liability dollarization. Optimal reserves are derived under the assumption that central bankers conservatively choose reserves by balancing the expected cost of a Sudden Stop against the opportunity cost of holding reserves. Results are obtained without using calibration to match observed reserves levels, providing no a priori reason for our concept of optimal reserves to be in line with observed holdings. Remarkably, however, observed reserves on the eve of the global financial crisis were–on average–not distant from optimal reserves as derived in this model, indicating that reserve over-accumulation in Emerging Markets was not obvious. However, heterogeneity prevailed across regions: from a precautionary standpoint, Latin America was closest to model-based optimal levels, while reserves in Eastern Europe lay below optimal levels, and those in Asia lay above. Nonetheless, there are other motives for reserve accumulation: we find that differences between observed reserves and precautionary-motive optimal reserves are partly explained by the perceived presence of a lender of last resort, or characteristics such as being a large oil producer. However, to a first approximation, there is no clear evidence supporting the so-called neo-mercantilist motive for reserve accumulation.

For most people, there’s the idea that more international reserves is better. Some even think in terms of foreign currency “backing” the issuance of domestic currency, never mind that this was never strictly true even in the heyday of the gold standard, much less the general free float regimes in fashion today (the one modern exception being Hong Kong with its currency board arrangement).

But holding excess international reserves is not costless, as should be clear from the mechanism. International reserves are generally accumulated through central bank open market purchases of foreign currencies with domestic currencies. While this is rigidly done under a fixed exchange rate regime as under the Bretton Woods arrangements that prevailed from 1944-1972, it is not automatic under a floating rate regime.

Moreover, this mechanism implies (1) injecting greater domestic liquidity through central bank money creation, potentially boosting credit growth and indirectly inflation; (2) downward pressure on the exchange rate, which implies lower domestic purchasing power relative to imported goods but also greater export competitiveness; and (3) if this liquidity boost is “sterilised” through issuance of central bank debt, there’s the interest cost to bear.

So although reserve accumulation provides insurance (and deterrence) against sudden stop events (for an example, the Asian Financial Crisis of 1997-98), a rational central banker would be hesitant to hold more reserves than absolutely necessary. The neo-merchantilist idea really focuses on just the value of the exchange rate as a policy tool (weapon?) and its impact on export competitiveness. But if reserve holdings and accumulation are no more or less than where they should be relative to the risk of capital flight, that substantially undermines the charge of currency manipulation.

A note on East Asia’s propensity for slightly higher than normal reserve accumulation. There are a couple of reasons for this: (1) higher structural savings rates, which is consistent with higher current account surpluses; and (2) the fact that we underwent a region-wide sudden-stop scenario 15 years ago – once bitten, twice shy.

Technical Notes

Calvo, Guillermo A. and Alejandro Izquierdo & Rudy Loo-Kung, "Optimal Holdings of International Reserves: Self-Insurance against Sudden Stop", NBER Working Paper No. 18219, July 2012

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