On 8/11/07, Mike Beggs <mbeg7842 at mail.usyd.edu.au> wrote:
> Doug wrote:
> __________________________________
> > MARKET ALERT
> > from The Wall Street Journal.
> >
> > Aug. 10, 2007
> >
> > U.S. stocks rebounded, stopping a global market swoon, after the Fed
> > stepped in to provide liquidity. The Dow ended trading about 30
> > points lower, after earlier being down by more than 200.
> >
> > http://online.wsj.com/article/SB118674492611394201.html?mod=djemalert
>
> Did somebody mention Hyman Minsky? I don't think so but I'll talk about him
> anyway. Here in Australia at least there's quite a bit of secondhand Minsky
> in the press coverage.
>
> Although Minsky's normally thought of as a prophet of debt deflation, Ponzi
> schemes and all that, it strikes me that this is exactly what he would have
> predicted. In every example of financial instability since the 1950s he
> discusses in 'Stabilizing an Unstable Economy' (and his articles) doom was
> staved off by the central bank, either at the expense of tight
> counter-inflationary monetary policy, or allowing the next upswing of
> asset-price inflation to start from a higher baseline. This seems to be
> the more important story of financialised capitalism, not imminent
> collapse.
Capitalism will never collapse on its own. So, whether the world is heading into a "crisis" that can bring about the "final battle" is a wrong question, as always. But whether this is a Minsky moment is also a wrong question.
Underlying the conditions that led to the current liquidity problem are two trends: American workers', and America's, increasing inability to make ends meet, requiring bigger and bigger debts; and global financial liberalization that has led the states worldwide to accumulate larger and larger foreign exchange reserves,* the trend particularly aggravated by the ways in which Japan, China, and petrodollar exporters are financially integrated into US economy.
These two trends, which stem from the contradiction of American hegemony -- American economy has become increasingly hollow, but the Washington consensus has become global, which helped create the so-called "global savings glut," helped lower interest rates, and helped inflate asset bubbles here and elsewhere -- demands a solution that squarely addresses the contradiction of American hegemony.
* <http://www.aeaweb.org/annual_mtg_papers/2006/0108_1015_1101.pdf> The Social Cost of Foreign Exchange Reserves Dani Rodrik Harvard University December 2005
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II. The Rapid Rise in Reserves
Figure 1 shows the massive increase in developing countries' foreign exchange reserves in recent years. Reserves have risen from a range of 6-8 percent of GDP during the 1970s and 1980s to almost 30 percent of GDP by 2004. Reserves begin to trend sharply up just around 1990, the year that is commonly identified with the onset of the era of financial globalization. Note that there is no similar jump in the reserves held by industrial countries, which have remained roughly steady at below 5 percent of GDP since the 1950s. As the figure shows, the trend for developing countries looks identical regardless of whether China is included in the sample or not. In other words, the increase in recent years cannot be attributed to China's efforts to prevent the appreciation of the yuan.
Prior to the era of financial globalization, countries held reserves mainly to manage foreign exchange demand and supply arising from current account transactions. The traditional rule of thumb for Central Banks was that they should hold a quantity of foreign exchange reserves equivalent to three months of imports. Therefore at least part of the increase in reserves may be due to the increased commercial openness of developing countries. But as Figure 2 shows, the increase in reserves is equally evident when looked at in relation to imports. Prior to 1990, developing country reserves fluctuated between 3 and 4 months of imports. They now stand at a record high of 8 months of imports. Once again, there has been no corresponding increase in the industrial countries' reserves-imports ratio, which still stands at less than 3 months.
It is pretty clear that the increase in developing country's reserves is related to changes not in real quantities (such as imports or output) but in financial magnitudes. Financial liberalization has led to an explosion in financial assets and liabilities since the 1980s, with which reserves have barely kept pace. For example, Figure 3 shows the ratio of reserves to M2 in a sample of emerging market economies. The figure reveals that the increase in Central Bank reserves starting around 1990 has served simply to restore the reserves-M2 ratio to the levels that prevailed in the pre-liberalization period. Moreover, this ratio has remained more or less flat since the early 1990s, indicating that reserves are barely keeping pace with the expansion of bank liabilities in these countries. It seems clear therefore that developing countries began to accumulate reserves as a consequence of financial liberalization and globalization, and that they actually embarked on this path before it became part of the conventional policy wisdom.
The policy guidance that the IMF provides to emerging nations on reserves was summarized by Stanley Fischer in 2001 in the following manner:
An IMF staff study discussed by our Executive Board
last year agreed that holding reserves equal to short-term
debt was an appropriate starting point for a country with
significant but uncertain access to capital markets. But it is
only a starting point. Countries may need to hold reserves
well in excess of this level, depending on a variety of factors:
macro-economic fundamentals; the exchange rate regime;
the quality of private risk management and financial sector
supervision; and the size and currency composition of the
external debt.
This analysis is now reflected in the way we treat reserve
adequacy in our lending and surveillance activities. (Fischer
2001)
The rule that countries should hold liquid reserves equal to their foreign liabilities coming due within a year is also known as the Guidotti-Greenspan rule, after a principle enunciated by Pablo Guidotti (then deputy finance minister of Argentina) and subsequently endorsed by Fed Chairman Alan Greenspan (see Greenspan 1999). As Figure 4 shows, most emerging market economies had short-term debt/reserves ratios that were significantly above unity in the early 1990s. Since then, practically all of them have built up enough reserves to abide by the Guidotti-Greenspan-IMF rule, most with some room to spare. The only exception in 2004 was Argentina, a country that was just coming out of a severe financial crash.
Finally, Figure 5 shows a geographical breakdown of reserve trends. The surprise here is that the increase in reserves has not been restricted to "emerging markets." In fact, the increase in Africa's reserves is as striking as that of Asia. By 2004, Africa held reserves worth around 8 months of imports, compared to 6 months in the Western hemisphere and close to 10 months in Asia. So the reserve buildup is a phenomenon that affects the world's poorest countries as well.
III. Calculating the Cost of Reserve Holdings
Consider a country that lives by the Guidotti-Greenspan-IMF rule. Suppose a domestic private firm or bank takes a short-term loan from abroad of $1 million. The Central Bank now has to increase its reserves by an equivalent amount. The usual strategy that the Central Bank will follow is (a) to purchase foreign currency in domestic financial markets to invest in U.S. government or other foreign short-term securities and (b) to sterilize the effects of its intervention on the money supply by selling domestic government bonds to the private sector. When all these transactions are completed, the domestic private sector ends up holding $1 million of domestic government bonds balancing its foreign liability of $1 million, while the Central Bank has $1 million more in foreign assets and $1 million less in domestic government bonds.
Three consequences are noteworthy. First, the application of the Guidotti-Greenspan-IMF rule implies that, even when the process is initiated by borrowing from abroad, the home economy ends up with no net resource transfer from abroad. The increase in the private sector's foreign liability matches the increase in the Central Bank's foreign assets. Second, short-term borrowing abroad does not enhance the private sector's overall capacity to invest. This is because the private sector ends up holding additional government securities equal in magnitude to its borrowing abroad. And third, aggregating the domestic private and public balance sheets, the net effect is that the economy has borrowed short term abroad (at the domestic private sector's cost of foreign borrowing) and has invested the proceeds in short-term foreign assets.
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Yet the striking fact is that short-term debt exposure has continued to climb in many countries, even as these same countries were investing valuable resources in increasing reserve assets. As Figure 7 shows, half of the emerging market economies had higher short-term debt-GDP ratios in 2004 than they did in 1990. In contrast, none held lower reserves in relation to GDP. Looking at the group of emerging market economies in aggregate, the average short-term debt-GDP ratio has risen from 5.4 (6.5) percent to 6.1 (8.4) percent in weighted (unweighted) terms between 1990 and 2004, while the reserves-GDP and reserves-short-term debt ratios have increased by a multiple (Table 1). The minimum that can be said is that there has not been a clear downward trend in short-term debt exposure, a fact that looks all the more astonishing when we put it together with the massive boost in reserves.
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Certainly gross fixed capital formation has not been visibly affected by the vast pool of short-term flows moving into emerging market economies (Figure 8). In the apt words of Joshua Aizenman (2005, 959), "the 1990s' experience with financial liberalization suggests that the gains from external financing are overrated."
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V. Concluding Remarks
We are left with the inescapable conclusion that developing countries on the whole have responded to financial globalization in a highly unbalanced and far-from optimal manner. They have over-invested in the costly strategy of reserve accumulation and under-invested in capital account management policies to reduce their short-term foreign liabilities.
The reasons are perhaps not hard to fathom. Unlike reserve accumulation, controls on short-term borrowing hurt powerful financial interests, both at home and abroad. Somehow "market intervention" in the form of taxing short-term capital inflows has developed an unsavory reputation that "market intervention" in the form of buying reserves does not have. Perhaps it is time to start viewing the Guidotti-Greenspan-IMF rule as an admonishment that applies to short term foreign borrowing, and not just reserves. -- Yoshie