Global Imbalances, Financial Crises, and Central Bank Policies

Andreas Steiner

• Publisher: Academic Press
• Year: 2016
• ISBN:
  9780128104033
• Topic: Negocios y empresa
• Subtopic: Negocios internacionales

Global Imbalances, Financial Crises, and Central Bank Policies assesses the relationships between global imbalances, financial crises, and central bank policies, with a specific focus on their reserves. The book contains a strictly international perspective with an analysis based on empirical research that enables the reader to develop an analytical model that emphasizes interactions among individual central banks. With this innovative approach, the book develops a new method for defining an optimal demand for reserves. In addition, the book describes implications for financial reforms that might ultimately be more important than its empirical findings.

• Presents a systematic account of the relationship between the build-up of reserves and central bank policies
• Emphasizes a global view of currency reserves, which is usually ignored in analyses of their effect
• Includes datasets as well as all illustrations and figures in online ancillary materials

1

Overview

Abstract

The chapter entitled “Overview” is intended to set the scene: It describes the process of financial globalization, the removal of capital controls, the surge in capital flows and their volatility, global imbalances as well as the occurrence of financial crises in the period since the breakdown of the Bretton Woods system. In this setting many central banks of emerging and developing countries have turned to policies of reserve accumulation. This book focuses on the global effects of this policy. The second part of this chapter provides a summary of each of the following chapters.

Keywords

Financial globalization; Reserve accumulation; Global spillovers; Central banking; Current account balances

Chapter Outline

1.1 Introduction

1.2 Summary

1.1. Introduction

When in the mid-1980s a new wave of financial globalization started, countries' willingness to remove capital controls and to become part of the world capital market was associated with the anticipated benefits from financial liberalization. Theory predicts that an efficient allocation of capital, better risk-sharing opportunities and technological spillovers linked to foreign investment raise domestic welfare. Its contributions to the development of the domestic financial sector, to macroeconomic policy discipline and efficiency have been referred to as indirect, collateral benefits. Besides theory, international organizations like the IMF were advocates of financial liberalization (see Joyce and Noy, 2008).

The series of financial crises during the 1990s and the Asian financial crisis of 1997/98 in particular, however, mark a turning point in countries' attitude toward financial liberalization. By highlighting the flip side of increasing financial integration, these crises made countries rethink the benefits and costs of their integration in the international financial system.

International capital flows to emerging and developing countries have been proven to be temporary and volatile. They can be large relative to the size of the domestic economy. First, capital-receiving countries have faced periods of surges of capital inflows, which might cause appreciating exchange rates, asset price bubbles and over-heating of the domestic economy. In this wake, the expression “the capital inflow problem” was coined (Calvo et al., 1994). Second, these capital flows may reverse suddenly. Episodes of sudden stops of capital flows, capital flow reversals and the loss of reserves have been pervasive. They were often associated with financial crises.

These experiences indicated the need for a reappraisal of the effects of financial globalization (see Kose et al., 2009a). Based on a large number of papers and the use of different approaches (cross-sectional, panel and event studies) the empirical literature on the effects of financial liberalization provides mixed results with respect to direct or indirect positive net effects of financial opening on welfare (see, among others, Obstfeld, 2009; Prasad et al., 2007; Rancière et al., 2008).

Despite these mixed blessings of financial openness, measures of de jure and de facto financial openness show that in the aggregate the policy of financial liberalization has not been reversed. Countries rather tried to reap the benefits of financial integration while being better prepared to cope with capital outflows and crises. A large stock of international reserves was considered as a form of self-insurance that provides a buffer in the face of volatile capital flows. Reserves have been found to reduce the incidence and severity of financial crises.

This policy manifests itself in the remarkable increase in central banks' international reserves during the last two decades. This increase is observable both in the level of reserves and in indicators of reserve adequacy, which use to scale the level of reserves by GDP, a measure of broad money (M2) or imports.

A variety of papers on the causes, costs and benefits of foreign exchange holdings emerged during the 2000s. Besides mercantilist explanations, precautionary motives have been identified as an important driver of countries' demand for reserves. One common feature of this literature is its focus on individual countries: Papers explain the domestic motives for reserve accumulation, provide an analysis of domestic costs and benefits and highlight the effects of reserves on domestic variables like the probability of crises, capital flows and inflation. This country-centered partial equilibrium analysis neglects spillovers across countries.

The present book starts with this observation and tries to turn the tables by focusing on the global effects of central banks' reserve policies independently of their motivation. This perspective concentrates on two related aspects: First, reserve policies in one country affect the reserve-providing country. This is due to the fact that the present international monetary system uses national currencies as reserves. Reserve accumulation constitutes an official capital flow between two countries. Second, global reserve accumulation might increase the indebtedness of the reserve-providing countries and destabilize the international monetary system. In this view, reserve accumulation has a negative externality, which affects all countries depending on their real and financial linkages.

In the following chapters I am going to elaborate on the international dimension of central banks' reserve policies and official capital flows. I first show that reserve accumulation increases the indebtedness of the dominant reserve currency country (Chapters 3 and 4): Reserve accumulation lowers both the current account balance and the public budget balance of the reserve-currency provider. This relationship is theoretically motivated and empirically tested. These findings motivate the reconsideration of the optimal amount of reserves: Chapter 5 integrates the idea that reserve accumulation creates systemic risk in a standard model of the optimal demand for reserves.

In sum, I track how central bank policies contribute to global imbalances and sovereign debt, which, in turn, are a backdrop of financial crises. I thereby contribute to different strands of the literature in international macroeconomics and international finance: The analysis of current account balances adds to the literature on the determinants of trade and capital flows. The chapter on public budget balances bridges the gap between the fields of international economics and public economics. Finally, we contribute to the literature on the consequences of international capital flows and add a new perspective by focusing on the source of capital flows: To better understand the behavior of capital flows, it is important to distinguish between private and official sources. Motivation, intention and decision-making processes of these different types of investors might differ fundamentally.

1.2. Summary

Chapter 2 is descriptive and provides an illustration of the importance of official capital flows. While the literature on cross-border capital flows focuses on private flows, we show that official flows cannot be treated as marginal. They rather constitute an important determinant of net capital flows across countries.

Chapter 3 entitled “Current Account Imbalances: The Role of Official Capital Flows” explains the US current account deficit and global imbalances as the natural outcome of a monetary system based on the dollar as key currency. The empirical results are corroborated by an application of the portfolio balance model.

Our panel data analysis over the period 1970–2009 confirms the hypothesis that the global demand for reserve assets by central banks lowers the current account balance of the reserve-issuing country: Any dollar of provided reserve assets decreases the US current account by more than one dollar. On average, the demand for dollar reserves has lowered the US current account by 1 to 2 percentage points relative to GDP. The flip side of this effect is a higher current account balance in reserve-accumulating countries. These novel findings show that the worldwide demand for international reserves has contributed to the buildup of global imbalances.

Chapter 4 examines the relationship between global reserve accumulation and public finances of reserve-providing countries. Since central banks invest their foreign exchange reserves predominantly in government bonds, their global accumulation affects the equilibrium in the market for government bonds of reserve currency countries.

By means of a panel data analysis we examine this relationship during different constellations of the international monetary system: the sterling period (1890–1935) and the dollar dominance (since World War II). We show for both periods that reserve currency status significantly lowers the fiscal balance. Any additional dollar of reserves lowers the center's balance by 0.7–1.4 dollars. These new findings show that reserve currency status increases sovereign debt of the center country.

A consequence of these empirical findings is that the center country of the international monetary system gets increasingly indebted over time. As such, these papers provide a first empirical test of the Triffin dilemma, which argues that the use of national currencies as reserve assets is destabilizing in the long run. Chapter 5 integrates these findings in a model of the optimal demand for reserves. It provides a new perspective on the relationship between countries' international reserve holdings and financial crises: While the “local” view holds that reserves may prevent domestic crises, it overlooks that the accumulation of reserves eases the financing constraint of the reserve currency country and may cause a financial crisis in the center, which is transmitted globally. According to this “global” view reserve accumulation might destabilize the international financial system. Since the crisis affects all countries alike, the accumulation of reserves imposes a negative externality on non-accumulating countries.

Based on the model, we illustrate the gap between local and global optimality: The consideration of systemic risk lowers the demand for reserves. Moreover, if a supranational authority determines the optimal level of reserves, it internalizes the negative externality and accumulates fewer reserves. A macroprudential tax on reserve hoardings might implement the socially optimal solution. Our calibration analysis shows that these considerations are economically significant: They lower the optimal amount of reserves in the benchmark case remarkably.

Chapter 6, the final part of this book, relates our findings to various aspects of global central banking: First, based on our theoretical and empirical results, we provide suggestions for a reform of the international monetary system. Second, we show how financial integration and global liquidity spillovers have increased the importance of central bank cooperation. This section provides some examples of how central banks have coordinated their actions in the past. Finally, by illustrating the interbank payment system of the European Union (Target) we show that Target balances arise from net cross-border capital flows. These balances are a form of official financing and may be considered as a substitute for reserves. They have contributed to balance-of-payments imbalances.

Bibliography

Guillermo A. Calvo, Leonardo Leiderman, Carmen M. Reinhart, The capital inflows problem: concepts and issues, Contemporary Economic Policy 1994;12:54–66.

Joseph P. Joyce, Ilan Noy, The IMF and the liberalization of capital flows, Review of International Economics 2008;16(3):413–430.

M. Ayhan Kose, Eswar S. Prasad, Kenneth Rogoff, Shang-Jin Wie, Financial globalization: a reappraisal, IMF Staff Papers 2009;56(1):8–62.

Maurice Obstfeld, International finance and growth in developing countries: what have we learned? IMF Staff Papers 2009;56(1):63–111.

Eswar S. Prasad, Kenneth Rogoff, Shang-Jin Wei, M. Ayhan Kose, Financial globalization, growth and volatility in developing countries, In: Ann Harrison, ed. Globalization and Poverty. National Bureau of Economic Rese...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright
• Dedication
• Foreword
• Preface
• 1: Overview
• 2: Accounting for Official Capital Flows
• 3: Current Account Imbalances: The Role of Official Capital Flows
• 4: Determinants of the Public Budget Balance: The Role of Official Capital Flows
• 5: Reserve Accumulation and Financial Crises: From Individual Protection to Systemic Risk
• 6: Global Aspects of Central Bank Policies
• Bibliography
• Index