In the late 1980s and early 1990s, emerging market countries embraced growing financial liberalization and openness. However, by trying to maintain both exchange rate fixity and monetary independence, they experienced severe financial crises. In the aftermath of these crises, many developing countries have adopted a policy configuration involving greater, though still managed, exchange rate flexibility, together with ongoing financial integration and some degree of domestic monetary independence. Hoarding of international reserves has become a key ingredient enhancing the stability of this new pattern. Concerns about the cost of maintaining monetary stability with this new policy mix suggest the need to support hoarding international reserves with more aggressive sterilization. Apprehensions about the opportunity costs of accumulating reserves and the fiscal and distortionary financial costs of sterilization, in turn, have raised questions about the long-run viability of this new policy mix, particularly the efficacy of sterilization.
In a recent paper with Reuven Glick [“Sterilization, Monetary Policy, and Global Financial Integration” NBER WP 13902] we evaluate these considerations by estimating the marginal propensity to sterilize foreign asset accumulation over time for selected countries in Asia and Latin America. We also analyze how sterilization depends on the underlying source of reserve accumulation, i.e., association with net exports and various forms of capital inflows. Our results confirm that the greater accumulation of foreign reserves in recent years has been associated with a greater intensity of sterilization by developing countries in Asia as well as in Latin America. In particular, we show that there has been a significant increase in the coefficient of sterilization following the 1997-98 Asian crisis. Thus, not withstanding concerns about sterilization costs, the policies of hoarding international reserves and sterilizing the potential inflationary impact have complemented each other during recent years. In addition, we find that sterilization of foreign direct investment (FDI) inflows typically is less than that for current account surpluses and for non-FDI inflows, suggesting that misgivings about monetary instability depend on the composition of balance of payments inflows. We also discuss the benefits and costs of sterilization. For many countries the costs of sterilization appear to be below the perceived benefits associated with monetary stability and reserve accumulation. However, we also present evidence suggesting that relative benefits to China have fallen in recent quarters. This implies limits to the sustainability of the new policy configuration in the near term.
There are several reasons for the massive foreign reserve accumulation that has occurred. First, some countries may acquire reserves to satisfy precautionary demand needs. Reserves provide self insurance against sudden stops of foreign capital inflows, thereby offsetting the downside risk of greater financial integration. Secondly, they may cushion the effects of terms of trade shocks on a country’s real exchange rate and its exports, smoothing the adjustment of the current account. In addition, they allow countries to avoid relying on the IMF, World Bank, and other international financial organizations etc. for implicit insurance. Lastly, reserve accumulation may occur as a byproduct of managing exchange rates to promote exports by undervaluing domestic currency.
Reserve accumulation has monetary implications. When a central bank purchases foreign reserve assets, it must decide whether to fund it by increasing the reserve money base, which is potentially inflationary, or by reducing its net domestic assets, which sterilizes the impact on the domestic reserve money base. Central banks may offset the effects of reserve accumulation on the monetary base in a number of ways, including selling market instruments, such as government bonds or central bank bills or by using swaps or repurchase operations. With foreign exchange swaps, the central bank typically agrees to buy foreign exchange forward, while with repurchase operations (“repos”) the central bank sells securities with an agreement to buy them back in the future. When markets are thin, some authorities rely on non-market instruments, such as transferring the deposits of government and public financial institutions from the commercial banking system to the central bank or selling foreign exchange reserves to the government (perhaps to allow it to reduce external sovereign debt).
Our analysis suggests that in the case of China, the extent of sterilization was relatively limited until the early 2000s, as the monetary impact of reserve inflows was generally augmented by monetary stimulus from central bank acquisition of domestic assets. Since mid-2002, however, as China experienced sharply rising foreign reserve inflows, these inflows were accompanied by negative changes in domestic asset holdings by the central bank, primarily through sales of PBC bills, implying the reserve inflows were being sterilized. The increase in the extent of sterilization in the early 2000s implies a possible break from China’s prior sterilization behavior.
Other countries in Asia also have experienced significant reserve inflows in the aftermath of the Asia crisis. In the case, of Korea, for example, reserve inflows increased in 1999 and 2000, subsided somewhat, and then rose again in the period 2002-2005 around the time China began accumulating reserves at a rising rate. Korea’s monetary authorities responded to the monetary impact of these inflows by sterilization. A similar pattern of inflows and sterilization is apparent for other countries in Asia, particularly in Thailand, Malaysia, and India.
For comparison, we also show results for selected Latin American countries — Argentina, Brazil, and Mexico. In the case of Argentina, modest reserve inflows emerged in 2003 in the aftermath of the country’s financial crisis of 2001-02; however, these inflows were not evidently sterilized until the latter half of 2004 when changes in the domestic asset holdings of the central bank turned negative. In Brazil, reserve inflows began increasing in the latter half of 2004, accompanied by sterilization. A similar pattern of reserve inflows and offsetting declines in central bank domestic assets occurred in Mexico in 1996 in the aftermath of its 1994-95 peso crisis.
For several countries – notably Korea, Thailand, Malaysia, Singapore, Argentina, and Brazil, our analysis suggest an increase in anti-inflation monetary management by the central bank in recent years. We also find evidence that the sterilization response to foreign direct investment is lower in several countries, including China, Korea, Thailand, Malaysia, and Singapore, as well as Brazil and Mexico.
Summarizing our empirical evidence on sterilization: The extent of sterilization of foreign reserve inflows has risen in recent years to varying degrees in Asia as well as in Latin America. This is consistent with greater concerns about the potential inflationary impact of reserve inflows. Sterilization depends on the composition of balance of payments inflows, i.e., for some countries the response to foreign direct investment inflows is less than that to the current account surplus or non-FDI inflows. This is consistent with the view that these countries are less anxious about the monetary impact of direct investment flows.
While providing useful services, international reserve management is subject to serious limitations. First, there are direct opportunity costs of reserves associated with the marginal productivity of public capital and/or the cost of external borrowing. Second, sterilization has fiscal costs associated with the difference between, on the one hand, the return paid on central bank liabilities issued to sterilize domestic liquidity (or the opportunity cost from foregone returns on domestic assets, such as government bonds, sold to the private sector) and, on the other hand, the return earned on foreign reserve assets.
Sterilization and hoarding international reserves also involve macro and micro moral hazard costs. The macro moral hazard arises when reserve hoarding encourages opportunistic spending in regimes characterized by political instability and limited monitoring (see Aizenman and Marion (2004), who show that countries characterized by greater political instability and polarization opt to hold less international reserves). Micro moral hazard arises when reserve hoarding subsidizes risk taking. (Levy-Yeyati (2005) calls for liquid reserve requirement on banks, and an ex-ante suspension-of-convertibility clause.) Lastly, reserve accumulation and sterilization can encourage financial sector distortions. For example, greater use of non-market instruments (e.g. reserve requirements, direct credit controls) can hinder the development of corporate bond market and alter the behavior of banks. Also it may hinder financial development by segmenting the public debt market through the issuance of central bank liabilities instead of Treasury securities.
Our paper suggests that the extent to which a country may continue to sterilize depends also on the degree to which it is willing to tolerate financial repression and other distortions to its economy. The stability of the current policy mix is further complicated by the extent to which each country’s cost-benefit calculation depends on the actions of other countries. Countries following export-oriented growth strategies may choose to engage in competitive reserve accumulation to improve and maintain their competitiveness in exporting to industrial countries. Thus, for example, as long as China and its East Asian neighbors are trying to maintain competitiveness in exporting to the United States, there is an unstable equilibrium depending on their relative abilities to avoid competitive appreciations and limits to sterilization. Those countries with lower costs of sterilization, due for example to greater willingness to distort their financial systems, might end up hoarding increasingly large amounts of international reserves, winning the hoarding game at least in the short run. Arguably, this interpretation explains China’s unprecedented increase in foreign reserves from 2002, now amounting to almost 50 percent of GDP and well above the levels of other East Asia countries (see Aizenman and Lee, 2006). Yet, this outcome may be fragile if it induces a country to accumulate to levels where the costs of sterilization exceed the benefit. These observations are consistent with the World Economic Outlook (2007), finding that resisting nominal exchange rate appreciation through sterilized intervention is likely to be ineffective when the influx of capital is persistent and large. Indeed, China’s recently rising costs of sterilization may account for its recent decline in sterilization and increasing inflation rate.