A large number of emerging economies, particularly those that have suffered Sudden Stops, have accumulated record-high stocks of foreign reserves in recent years. Two widely-cited explanations of this phenomenon attribute it to alternative interpretations of a New Mercantilism. 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, but they are actually quite consistent. Note first that the two can claim the label of New Mercantilism because indeed the original Mercantilists made both arguments in building their case in favor of accumulating large stocks of gold. On one hand, they argued that gold was wealth and that since gold was gained via external surpluses, maintaining large surpluses was optimal. But they also argued that gold was the only resource that could finance wars, and hence was crucial for strategic reasons (this made a lot of sense then because long and costly wars to conquer, colonize, or just get back at the monarch next door were the rule rather than the exception those days).
Many emerging markets are preparing their war-chests for a different kind of war: The kind of financial wars they have experienced in the form of Sudden Stops. The modern term used for this behavior is “self insurance” or “precautionary savings,” but the rationale is very similar to that of the old Mercantilism: Sudden Stops entail very deep (Great-Depression-like) recessions, so countries have very strong incentives to build up a war-chest of resources that can defend them against suffering these catastrophes.
The dots between the two New Mercantilisms are connected by the realization that, in the aftermath of the Sudden Stops of recent years, emerging economies set off to build up those precautionary reserves, and to do so they have to run external surpluses. In addition, these external surpluses put downward pressure in the prices of their nontradable goods relative to their tradables, so their real exchange rates become undervalued. This makes both views on the New Mercantilism consistent: emerging economies are building reserves by promoting external surpluses and undervalued exchange rates, AND they are doing it because they want to self insure against the risk of future Sudden Stops.
Bora Durdu, Marco Terrones and I put this argument to the test in a recent NBER Working Paper. We wrote down a model of optimal precautionary demand of foreign assets that are accumulated as self-insurance against the risk of Sudden Stops. Sudden Stops are an endogenous outcome that results from the combination of credit-market frictions and liability dollarization. In particular, we have in mind a world in which all international debts are denominated in units of tradables (e.g dollars), and an emerging economy can borrow up to a given fraction of its GDP valued in units of tradables (since all debts are in tradables). In this setting, domestic or external shocks of “standard” size (which in normal times would trigger a “standard” recession), can make the economy hit its borrowing limit. When it does, the output and the price of nontradables collapse, so the real exchange rate plummets, but as that happens the credit constraint becomes more binding, just like in Irving Fisher’s classic debt-deflation theory. The economy will thus build its war-chest of foreign reserves taking this mechanism into account, and considering exactly by how much the likelihood of Sudden Stops falls by holding a given amount of foreign reserves.
Our quantitative analysis shows that self-insurance against Sudden Stops can explain large surges in reserves similar to those we have witnessed in emerging economies. Moreover, we find that the process, starting from a Sudden Stop situation, is long and gradual, and during that process the economy maintains protracted external surpluses and undervalued real exchange rates.
This is not the whole story, however, because other recent research suggests that the surge in reserves may be a by-product of the globalization of capital markets in an environment in which many countries are lagging behind in domestic financial development. In fact, this hypothesis can account for the infamous global imbalances between the United States and the rest of the world with striking quantitative accuracy. Unfortunately, when seen from this perspective, there is good reason to worry about the possibility that financial globalization without financial development will hurt the poor in the less developed countries! More on this alternative view of the global imbalances coming up in my next write up.