Sometimes you need new evidence to confirm an old adage. A paper released by IMF research policy wonks on Monday, via Vox EU, came to the following conclusion:
| Over the past three decades, emerging economies have been stockpiling international reserves. We argue that accounting for this accumulation in reserves requires several explanations: precautionary demand against both current- and capital-account shocks as well as intentional or unintentional undervaluation of the exchange rate. No single explanation can account for the behaviour of all countries at all times. We find that insurance against current-account shocks was relatively more important in the early part of the sample, and for countries that hold low reserves more generally. Undervaluation of the exchange rate is also important for low reserve holders, but to the extent that it represents collapsed real exchange rates in the aftermath of debt or currency crises, it need not be indicative of deliberate mercantilism. |
The paper, penned by IMF researchers, Atish Gosh, Jonathan Ostry and Charalambos Tsangarides, used a so-called nested model and regression analysis to determine the factors driving FX accumulation in emerging markets and how these factors have evolved over time and differed across countries.
Its findings are unambiguous:
| Following the emerging-market capital-account crises of the 1990s, especially after the Asian crises of 1997–98, insurance against capital-account shocks became increasingly important. Moreover, the export booms that followed the real exchange rate collapses in these crises likely demonstrated the benefits of undervalued currencies for export-led growth. Starting in the early 2000s, currency undervaluation again becomes an important determinant of reserve accumulation – though this time in the context of rising reserves, and hence more probably due to deliberate undervaluation through sterilised intervention. |
But here’s the news; FX reserves build-up is now more fashionable than ever:
| Even including all these motives [precautionary demand against both current- and capital-account shocks as well as intentional or unintentional undervaluation of the exchange rate] for holding reserves, and allowing different motives to apply at different points in the reserves distribution, there remains a positive residual for the more recent years (except when the economies ran down reserves in the global financial crisis). Either emerging economies are becoming more risk averse – or they have learned that the potential shocks are even larger than past experience had led them to believe. |
There are obvious benefits to FX accumulation, namely fighting capital account crises, reducing FX volatility and beefing up sovereign creditworthiness, thereby, potentially reducing borrowing costs for the whole financial system. There is an even stronger rationale: becoming the dollar liquidity lender of last resort for the banking system, as was the case in Brazil post-Lehman.
As Emerging Markets reported at the time, during the Inter-American Development Bank meeting in Spring 2010, the-then Brazilian central bank Governor Henrique Meirelles summed up the mood among large EM central banksby explaining how recent global crises had actually hardened the resolve of countries to accumulate large-scale reserves:
“It is because we had $200 billion of reserves that eventually everything [the dollar liquidity crunch] came back to normal [in Brazil],” he said. “We are prepared to replace” capital providers in the “international financial system” as “we have the reserves [for] up to two years” to “self-insure” Brazil if the currency – or access to dollar liquidity – comes under fire, he declared.
In other words, becoming the lender of last resort for the whole financial system in dollars is now a fashionable benchmark for a comfortable FX reserves position, rather than the old-school rule of thumb that was six months of trade cover.
And recent market volatility has only reinforced the financial benefits of possessing large-scale – and easily accessible – reserves. According to UBS, the valuation-adjusted reserves among 25 of the largest EM countries dropped by $35 billion during the September 2011 sell-down, roughly equal to the liquidations of November and December 2008.
But individual self-interest leads to collective irrationality. Large-scale reserve acquisitions for currency manipulation purposes is delaying the rebalancing of global demand, which requires stronger currencies in the emerging world and thus, greater domestic consumption in EM via imports from the US and Europe.
Meanwhile, FX accumulation for self-insurance purposes triggers a massive bid for US Treasuries and arguably helps to legitimize US fiscal profligacy.
Exit IMF
And whither international co-operation. The IMF’s bid – launched by Dominique Strauss-Kahn (R.I.P) in 2010 – to deter key emerging economies from building up excess foreign exchange reserves by creating a global currency pool that could serve as an alternative self-insurance mechanism, has been scrapped. That’s not too much of a surprise given the huge economic and political hurdles to such a grand plan from the Washington-based policy lender- and there are competing regional initiatives to pool reserves - but it’s still dispiriting.
The IMF has now concentrated its efforts on creating precautionary credit lines – along with its pre-existing credit line – as a means of boosting the confidence of well-managed emerging markets about their access to liquidity during exogenous financial shocks, thus, at the margin, at least, disincentivizing FX build-up for insurance purposes. However, ironically, speculation is rife that such a mechanism might, initially at least, be best-suited to boosting eurozone liquidity in tandem with any sovereign debt restructuring plan among the PIIG economies.
It seems then the G20 is the only multilateral forum for discussions about addressing structural global monetary imbalances. At the spring IMF meetings, the G20 will unveil “indicative guidelines” on how to generate sustainable balanced global growth. But don’t expect this issue to be addressed in any material way – the eurozone crisis has taken the attention away from the dangers of the mercantilist acquisition of reserves among EM central banks.
In sum, globally-speaking, not good. Not good, at all.
