Mezinárodní konference "Česká a světová ekonomika po globální finanční krizi" International reserves and the financial crisis: monetary policy matters Sona Benecka, VŠFS, ČNB 25 Nov 2011

2 International reserves literature Buffer stock - to fluctuations in external transaction (Heller, 1966) Combined with inventory theoretic approach (Frenkel and Jovanovic,1981) Currency crisis – first and second generation models (Krugman, 1979; Obstfeld, 1986) IMF and international vulnerability (Bussiere and Mulder, 1999) Mercantilist motives – export promoting (Aizenman and Lee, 2007) Financial globalization – protection of domestic credit markets (Obstefeld, Shambaugh and Taylor, 2008)

3 Relevance: “fear of floating” or “fear of losing IR” Crisis 2008 – 2009 – IR served as a warchest? (Obstfeld, 2008; Aizenman, 2010) – implications for economic policy Inflation targeting countries highlighted Chile

4 Inflation targeting countries and the crises de Carvalho Filho (2011): „inflation targeting countries lowered nominal and real interest rates more sharply than other countries; were less likely to face deflation scares; and had sharp real depreciations without a relative deterioration in their risk assessment by markets“

5 Monetary policy and IR: Trilemma vs. Quadrilemma Mundell-Fleming’s impossible trinity Policy choice: Closed financial markets Policy choice: Give up monetary independence Policy choice: Floating exchange rate Policy goal: Financial integration Policy goal: Exchange rate stability Policy goal: Monetary independence New dimension: Accumulation of international reserves improves financial stability and allows for independent monetary policy (Aizenman, 2011)

6 The role of monetary policy and ER regime Comparable to Obstfeld et alt. (2008) Panel data analysis: Sample: 123 countries Time period: 1999 – 2009 (if data available) Data source: Worldbank, IMF, EIU Extended with MP/ER arrangements and financial stability Dummy variable for exchange rate regime (from currency union to free float, 2 classifications) Dummy variable for monetary policy arrangement Monetary independence Financial stability measured by M2/GDP and banking crisis dummy

7 Trends in explanatory variables Globalization in trade and capital Strong impact of financial crisis No clear trend of growing ER flexibility More countries with ER anchor and IT regime

8 Summary of main results I Openness to trade and the development of the current account is still a crucial for the determination of the reserves. So country with export-oriented growth may be sensitive to exchange rate, especially if not allowing for free capital movement. Opening capital account was a very dynamic process in 1990’s, while after 2000 it slowed down. If we account for the effect of wealth, this improves the estimate. Oil exporters have substantially higher reserves; the income from oil export may well be transferred to reserves or CB react more on ER movements to stabilize oil revenues.

9 Summary of main results II As for exchange rate arrangements, we find inverted-U relationship, with free floating and fixed arrangements holding most reserves. As for monetary policy regimes, the results are rather weak. The sign for inflation targeting countries is negative, but insignificant. Finally, the financial stability plays an important role. When the banking crises starts, the reserves are eventually used. But the measurement of the financial system vulnerability is difficult.

10 A proposal for the new framework The current framework is still not able to describe fully underlying forces behind huge accumulation of reserves. One possible explanation: failing monetary policy, non availability of other policy instruments/channels. The choice of monetary policy mix may be driven by specific conditions of emerging economies like 1) Relationship to fiscal policy and CB independence. 2) Stage of development of the financial system 3) Limited functioning of the standard transmission channels

11 Some evidence First hint: Central bank credibility – index from Meade and Crowe (2008) Still more work to be done: on-going reserach -> countries holding more reserves use them as the fist MP instrument

12 Economic policy implications Accumulation of reserves as a war chest against the crisis does not have to be the most effective way.. Optimal level of reserves to be doubted (dominance of non linear relationship between variables, country specific structural weaknesses and peculiarities of the individual financial markets) -> develop stress testing for balance of payment (in 2012)

13 Thank you for your attention Sona Benecka

14 Summary statistics

15 Explanatory variables General cross-country differences: population, GDP per capita, advanced countries dummy, share on net oil export Trade openness – export+import/gdp Financial openness – Chinn-Ito capital market openness index Monetary policy arrangements – de facto classification by IMF: inflation targeting (1), monetary aggregate targeting (2), IMF support (3), other (4), ER anchor (5), monetary union (6) Exchange rate regime – see below Monetary independence - Heritage monetary freedom index Financial stability: M2/GDP and banking crisis dummy

16 Traditional model and its extensions Note: standard errors in parentheses, dependent variable: ln(IR/GDP) *, **, and *** denote significance at the 10%, 5%, and 1% levels, respectively

17 Exchange rate regime matters… Note: standard errors in parentheses, dependent variable: ln(IR/GDP) *, **, and *** denote significance at the 10%, 5%, and 1% levels, respectively

18 … more than monetary policy arrangement.. Note: standard errors in parentheses, *, **, and *** denote significance at the 10%, 5%, and 1% levels, respectively

19 … while financial stability is difficult to measure. Note: standard errors in parentheses, *, **, and *** denote significance at the 10%, 5%, and 1% levels, respectively

20 Appendix:IR/GDP ranking

21 Ranking IR in bill. USD

22 GDP per capita vs Advanced countries dummy

23 IT is a way out? Missing empirical evidence Optimal vs. Real behaviour

24 Capital account openess (KAOPEN)

25 Exchange rate regimes De facto classification – for IR (Choi, Baek) IMF (from 1997) Reinhart and Rogoff (2004) 1Exchange arrangement with no separate legal tender 2Currency board arrangement 3Conventional pegged arrangement 4Pegged exchange rate within horizontal bands 5Crawling peg 6Crawling band 7Managed floating with no predetermined path for the exchange rate 8Independently floating 1 No separate legal tender; Pre announced peg or currency board arrangement; Pre announced horizontal band that is narrower than or equal to +/-2%; De facto peg 2 Pre announced crawling peg and crawling band, that is narrower than or equal to +/-2%; De facto crawling peg and band that is narrower than or equal to +/-2% 3 Pre announced crawling band that is wider than or equal to +/-2%; De facto crawling band that is narrower than or equal to +/-5%; Moving band that is narrower than or equal to +/-2%; Managed floating 4Freely floating 5Freely falling 6Dual market in which parallel market data is missing. Data available: Data available:

26 ER regimes (IMF)

27 Monetary arrangements