Comparing hoarding reserves in LATAM with East-Asia: Mercantilism, self insurance, or smoothing REER volatility?

Large hoarding of international reserves in the 1990s was done mostly by East Asia. Latin America joined the “hoarders club” during the 2000s. The unprecedented international reserves levels in LATAM [more than 160 B. dollar in Brazil, 23 B. dollar in Peru, 20 B. dollar in Columbia, etc…] are stirring a lively debate. Should LATAM follow the policies of Asia? To put these trends in a broader perspective, recent studies suggest that the international reserves in Asia are above the optimal level, whereas in LATAM reserves may be still below the desirable level [Jeanne (2007) Brookings Papers on Economic Activity]. In this note I argue that, while the case of hoarding more international reserves in Latin America is warranted, attempting to follow Asian hoarding in LATAM will backfire.

The strongest case for hoarding reserves in LATAM is the possibility of a reversal of its recent terms of trade improvement, and self insurance. My work with Riera-Crichton [NBER WP 12363] points out that countries exposed to terms of trade volatility may reduce the resultant real exchange rate [REER] volatility by hoarding international reserves. This gain is in addition to the benefits associated with self insurance against financial instability of capital flights [Aizenman and Lee (2007) Open Economies Review, Mendoza and Terrones (NBER WP 13123)]. The stabilizing role of reserves has been vividly illustrated during the recent financial upheaval triggered by the sub prime mortgage crisis in the USA. In addition, hoarding reserves by countries with external debt overhang provides the benefit of reducing the risk premium on sovereign spreads [Levy Yeyati (2006), The Cost of Reserves], and provides a country with the option of earlier external debt repayment. All these factors are more important in explaining the gains from hoarding reserves for LATAM than for East-Asia: LATAM relies more on exports of commodities and natural resources than East Asia, and LATAM external debt/GDP is much larger than that of East Asia.

While the self insurance argument for hoarding reserves in East Asia explains well the hoarding there in late 1990s, it falls short of explaining the remarkable takeoff of hoarding reserves by China during the 2000s. The strongest advocacy supporting China’s hoarding during the 2000s came from Dooley et al. [NBER WP 9971], viewing it as part of an export led growth, where the undervalued real exchange rate facilitates faster transformation from agriculture to manufacturing. The optimality of such a policy for East Asia remains debatable; and even more questionable for LATAM [Aizenman and Lee, NBER WP 12718]. First, monetary mercantilism may lead to competitive hoarding among countries competing in similar third markets, which in turn may dissipate most of the competitiveness gains from hoarding reserves. My ongoing research with Jaewoo Lee also points out another fundamental limitation of such a policy. We show that the case for REER undervaluation as industrial policy may rest on the learning by doing externality [LBDE], where productivity increases with the aggregate manufacturing output of the economy. Yet, this finding is not robust. First, subsidizing exports can be accomplished by direct policies of the type followed by Korea and Japan during the period of their rapid growth during the 1970s-1980s, without relying on hoarding international reserves as the prime policy instrument. A selective subsidy to targeted exports, when done properly, has the advantage of targeting directly the margin that one wish to impact. In addition, the LBDE may be embodied in capital, as has been modeled frequently by the endogenous growth literature [Romer (JPE 1986)]. This would be the case when knowledge creation is a side product of investment, as is when productivity increases with aggregate capital. In these circumstances, the desirable policy is subsidizing the capital employed in the traded sector, with no room for undervalued exchange rate policy.

A practical concern is that, in the best circumstances, the Chinese type of mercantilism will work if other necessary conditions are met, including well developed infrastructure, and relative abundance of human capital. Hence, before experimenting with monetary mercantilism as a tool for export promotion, Brazil and other LATAM countries would benefit by investing directly in the needed infrastructure and in alleviating human capital bottlenecks. Furthermore, a deliberate industrial policy of undervaluation by hoarding international reserves may backfire if the sterilization would increase the cost of investment in the traded sector. This concern is highly relevant for LATAM, but not as much for China – the smaller saving rate in LATAM and the greater financial integration of the region implies that the impact of international reserves hoarding on the cost of funds should be of greater concern to LATAM.

To conclude, the case for hoarding international reserves in LATAM remains strong, yet it would be a mistake to overdo it in an attempt to follow Chinese type of policies. The differences in saving rates, financial integration, infrastructures and endowments between LATAM and East Asia imply that replicating East Asian hoarding in LATAM will backfire.

6 Responses to "Comparing hoarding reserves in LATAM with East-Asia: Mercantilism, self insurance, or smoothing REER volatility?"

  1. Vitoria Saddi   October 30, 2007 at 8:48 am

    Professor, Do you think that Latin American countries, in different degrees, are following the BWII policies adopted by Asian countries? Your defense of hoarding reserves as a self insurance tool for ‘rainy days’ includes the sterilization costs that countries like Brazil have to pursue to avoid inflation?

  2. Charlie Smith   October 30, 2007 at 8:55 am

    What about the idea from Claudio de Sotto that a country should accumulate international reserves against sudden stops up to 10% of their GDP? If you agree with such idea why are Latin countries accumulating more than 10% of their GDP?

  3. Guest   October 30, 2007 at 1:55 pm

    Enrique Mendoza said in his piece here (Latin America Economonitor): “One view, largely sponsored by the work on the “revived Bretton Woods” by Dooley, Folkerts-Landau and Garber, suggests that countries like China are obsessed with maintaining undervalued real exchange rates and surpluses in their external accounts. The second view, supported by authors like Aizenman and Lee, argues that a large stock of foreign exchange reserves serves as a war-chest for defense against future Sudden Stops, given the lack of progress at the IFOs in developing arrangements that can help emerging economies cope with financial crises. These two views are often presented as incompatible (…)”Do you think that your view on reserve accumulation is not compatible with the one from Dooley, Folkerts-Landau and Garber?

  4. Tom Trebat   October 30, 2007 at 11:02 pm

    Thanks forr this very interesting piece and accompanying references. ITwo questions:1) Do you assume that “hoarding” leads to an undervalued REER? If so, how do you explain that Brazil’s forex reserves have surged to $160 bn + and yet the currency has appreciated very substantially, not depreciated. It defies belief that the Brazilian exchange rate (now about R$1.80/YS$) would be even stronger if reserve levels were lower. Rather, it seems likely that the presence of a large forex reserves (under conditions prevalent in most of Latin America today) attracts more capital without undermining export competitiveness. Hence, if anything, high reserve levels strengthen the exchange rate especially when the exchange rate (as in most of Latin America) is floating.2) While we usually look at “self-insurance” in terms of the debt/GDP ratio, shouldn’t Latin American countries be self-insuring as well against the floodtide of foreign capital inflows into equity investments? Do your studies take these newer forms of external liabilities into account when considering prudential reserve levels?

  5. Nouriel   October 31, 2007 at 9:31 am

    Joshua, thanks for this first most excellent contribution to the Latam EconoMonitor. I fully agree with your points that Latam should not join BW2. Nouriel

  6. Joshua Aizenman   November 3, 2007 at 10:18 am

    Thanks for the reactions and queries. Quick answers and suggestions dealing with the various points:*******************************************************Query: Professor, Do you think that Latin American countries, in different degrees, are following the BWII policies adopted by Asian countries? Your defense of hoarding reserves as a self insurance tool for ‘rainy days’ includes the sterilization costs that countries like Brazil have to pursue to avoid inflation?Written by Vitoria Saddi on 2007-10-30 08:48:13Reply: The BWII interpretation is a stool with (at least) “three legs” – mercantilism, collateral, and importing financial intermediation. Of the three legs, I agree that mercantilism is a proper view of China from 2001. I am doubtful about the relevance of the BWII view for Korea, Japan and other East Asian countries [both Korea and Japan do not embrace FDI inflows, and did not hoard reserves during the period of their fast growth, before 1997 for Korea, before 1991 for Japan]. I am skeptical about the BWII view for LATAM due to the reasons discussed in my papers and my short entry a week ago.*******************************************************Query: What about the idea from Claudio de Sotto that a country should accumulate international reserves against sudden stops up to 10% of their GDP? If you agree with such idea why are Latin countries accumulating more than 10% of their GDP?Written by Charlie Smith on 2007-10-30 08:55:47Reply: I doubt that there is a magic ratio like 10% that fits all. Instead, it is better to think about factors that should increase or reduce it. See Jeanne (2007) Brookings work and my discussion there that follows Jeanne’s contribution. The bottom line, analyses suggests that the “optimal IR/GDP ratio” for a developing country depends positively on financial and trade openness, Hot money/GDP, volatility of effective terms of trade shocks [volatility of the effective terms of trade shock is the trade openness times the s.d. of the % change in the relative price of exports/imports], depends negatively on political instability and polarization, and is impacted by financial depth, etc… ********************************Query: Enrique Mendoza said in his piece here (Latin America Economonitor): “One view, largely sponsored by the work on the “revived Bretton Woods” by Dooley, Folkerts-Landau and Garber, suggests that countries like China are obsessed with maintaining undervalued real exchange rates and surpluses in their external accounts. The second view, supported by authors like Aizenman and Lee, argues that a large stock of foreign exchange reserves serves as a war-chest for defense against future Sudden Stops, given the lack of progress at the IFOs in developing arrangements that can help emerging economies cope with financial crises. These two views are often presented as incompatible (…)”Do you think that your view on reserve accumulation is not compatible with the one from Dooley, Folkerts-Landau and Garber?Written by Guest on 2007-10-30 13:55:18Reply: My take is that the demand for IR is the sum of at least 5 motives [mercantilism, precautionary self insurance, smoothing TOT shocks, smoothing current account adjustment, reducing sovereign spreads, etc…]. The importance of each motive is time and country dependent. See “Cross-sectional analysis on the determinants of international reserves accumulation” [Hiro and Cheung] for a good paper on the instability and the evolution of the factors explaining IR. Answering your specific question, China’s hoarding is mostly the outcome of mercantilism and precautionary self insurance, which may reinforce each other. From 2001, the driver seems to be mostly mercantilism [for more details, see NBER WP 13277].*****************************************************Query: Thanks for this very interesting piece and accompanying references. ITwo questions:1) Do you assume that “hoarding” leads to an undervalued REER? If so, how do you explain that Brazil’s forex reserves have surged to $160 bn + and yet the currency has appreciated very substantially, not depreciated. It defies belief that the Brazilian exchange rate (now about R$1.80/YS$) would be even stronger if reserve levels were lower. Rather, it seems likely that the presence of a large forex reserves (under conditions prevalent in most of Latin America today) attracts more capital without undermining export competitiveness. Hence, if anything, high reserve levels strengthen the exchange rate especially when the exchange rate (as in most of Latin America) is floating.2) While we usually look at “self-insurance” in terms of the debt/GDP ratio, shouldn’t Latin American countries be self-insuring as well against the floodtide of foreign capital inflows into equity investments? Do your studies take these newer forms of external liabilities into account when considering prudential reserve levels?Written by Tom Trebat on 2007-10-30 23:02:54Answer: 1) Indeed, there is the possibility of instability [as would be the case if the cost of sterilization increases fast with hoarding IR, attracting more inflows, etc…]. This issue requires more work, and may be affected by the structure of financial intermediation. The challenge is to map the alternatives, and to choose the one that fits best. Note that a central bank has other policy options, including varying reserve ratios, etc….2) Yes, indeed. The best example of a country reacting to these challenges has been Korea, where foreigners’ shareholding has increased to about 40% of total Korean market capitalization! For more on this topic, see my work with Yeonho Lee and Yeongseop Rhee, NBER WP 10534 [Journal of the Japanese and International Economies March 2007, Pages 1-15].*********************************************Thanks for raising these questions and suggestions, and thanks to Nouriel for providing this opportunity to talk on pertinent issues. Joshua Aizenman