FRBSF Economic Letter
2003-11; April 25, 2003
Foreign Exchange Reserves in East Asia: Why the High Demand?
Pacific Basin Notes. This
series appears on an occasional basis. It is prepared under the auspices
of the Center for Pacific Basin Monetary
and Economic Studies within the FRBSF's Economic Research Department.
Since the 1997-1998 Asian financial crises, monetary authorities in emerging
markets in East Asia have more than doubled their stockpiles of foreign
exchange reserves; by the end of May 2002, they held $845 billion, or
38% of the world total. Of these countries, China, Taiwan, Hong Kong,
South Korea, and Singapore rank just behind Japan as the world's biggest
holders of foreign exchange reserves--together those five countries hold
reserves totaling nearly $700 billion.
There is a growing debate about the need to hold so many reserves. Some
critics point out that holding a lot of reserves is costly. Reserves held
in U.S. Treasuries, for example, earn a modest return, far below these
countries' own cost of borrowing either in local currency or in dollars.
Why hold cash in the bank and pay high interest on outstanding liabilities?
Critics also note that the yield on reserves is much lower than the potential
return they could earn by using those reserves to make real investments
in the economy, such as building roads, bridges, and schools.
Those who support holding large reserve balances argue that the cost
of doing so is small compared to the economic consequences of a sharp
depreciation in the value of the currency that is often associated with
financial crises in emerging markets. A devaluation of the currency raises
a country's costs of paying back debt denominated in foreign currency
as well as its costs of imported goods, and it also raises the spectre
of inflation. With a large stockpile of foreign exchange reserves, a country's
monetary authority can buy up its currency in the foreign capital markets,
which helps to uphold its value. By having its own ammunition to defend
its currency in a crisis, a country with large holdings of reserves also
avoids being shut out of international capital markets due to concerns
that the government or the private sector will default on foreign debt
payments. Therefore, these proponents argue, holding large reserve stockpiles
is prudent policy for those occasions when defending the value of the
currency makes sense.
In this Economic Letter, we report some of the factors that influence
the decision to hold foreign exchange reserves in developing countries
based on our recent research (Aizenman and Marion 2002a and 2002b). We
also explore why these holdings surged in East Asia after the 1997 crises.
Trends in reserve holdings by emerging markets
Several factors may explain how much foreign exchange reserves a country
wants to hold. One factor is related to the size of international financial
transactions that occur there; that is, reserves holdings are likely to
increase both with the size of the country's population and with its standard
of living. Another factor is related to the volatility of international
receipts and payments, insofar as reserves are intended to help cushion
the economy; that is, reserve holdings are likely to increase with more
volatility in a country's export receipts. A third factor is vulnerability
to external shocks; reserve holdings are likely to increase with a country's
average propensity to import, which is a measure of the economy's openness
and vulnerability to external shocks. Finally, a country's tolerance for
greater exchange rate flexibility should reduce its demand for reserves,
because its central bank would not need a large reserve stockpile to manage
a fixed exchange rate; therefore, reserve holdings are likely to be lower
the more variable the country's exchange rate is.
We conducted statistical analyses using a panel of data consisting of
122 developing countries between 1980 and 1996--that is, before the Asian
financial crises--and found strong correlations between these factors
and reserve holdings. The scale factors--population size and real GDP
per capita--were positive and highly significant. The volatility of real
export receipts and the vulnerability to external shocks measured by openness
also were positive and highly significant. Greater exchange rate variability
was associated with significantly reduced reserve holdings. These five
variables account for between 70% and 90% of the variation in actual reserve
holdings depending on the estimation specification.
Our study (Aizenman and Marion 2002a) extended this analysis by adding
two political measures that may lower the demand for reserves, namely,
political instability and political corruption, in the sense that they
act as a tax on the return to reserves. Because data on these measures
are available for only a limited number of countries, the sample we examined
was smaller. As a proxy for political instability, we used a measure of
the probability that the government's leadership would change by constitutional
means. For data on political corruption, we used a corruption index from
Tanzi and Davoodi (1997). We confirmed that an increase in an index of
political corruption significantly reduces reserve holdings, as does an
increase in the probability of a government leadership change by constitutional
means.
Next we examined whether the model with these specifications was successful
at predicting reserve holdings during and after the Asian financial crises,
that is, from 1997 to 1999. The results suggest that countries indeed
have changed their behavior in terms of holding foreign exchange reserves.
For example, in the case of Korea, the model over-predicts its reserve
holdings for 1997, the year of the crisis, but it substantially under-predicts
reserve holdings for both 1998 and 1999. These results suggest that, during
and immediately after the crisis, Korea had limited access to global markets
and could not immediately adjust its stock to the higher level it chose
to maintain in 1998 and 1999. For the other emerging Asian economies,
the underprediction of reserves over this period is less substantial but
still significant (see Aizenman and Marion 2002a for full details). It
is interesting to note that the model over-predicts Malaysian reserve
holdings in all three years, suggesting the country may have faced a trade-off
between being willing to adopt capital controls and being willing to hold
international reserves. Because Malaysia chose to impose capital controls
during the financial crisis, it reduced its effective integration with
the global capital markets and its demand for international reserves.
Why have East Asian markets increased their
reserves?
As the foregoing showed, the standard set of factors that affects the
demand for foreign exchange reserves does not account for the very large
buildup that has occurred in many emerging markets in East Asia. Therefore,
we examine the possibility that the buildup may represent "precautionary"
holdings, and we find two situations that can give rise to increased demand
for such holdings (Aizenman and Marion 2002a).
The first is the government's desire to "smooth consumption"--that
is, to spread out over time the costs of shocks, such as sudden outflows
of international capital--when it faces difficulty raising funds either
through international capital markets (because investors perceive a high
risk that the government or the private sector will default) or through
domestic tax collection. The model also helps us understand why some developing
countries have not chosen to hold large precautionary reserve balances
in the aftermath of the last decade's crises even when there are concerns
about default risk or when domestic tax collection is costly. Specifically,
we find that countries whose policymakers care less about the future,
countries that are politically unstable, and countries suffering from
political corruption find it desirable to hold smaller precautionary balances.
The second situation leading to a buildup of reserves is "loss aversion"
after the 1997-1998 Asian financial crisis. Loss aversion is the tendency
of people in the economy to be more sensitive to reductions in their consumption
than to increases. In our model, we modify a generalized expected utility
framework so that it attaches bigger weights to "bad" outcomes
and smaller weights to "good" outcomes. We show that the government
will choose to hold a small stock of reserves if it believes the populace
is indifferent between reductions and increases in their consumption,
while it will choose to hold a much larger stock of reserves if it believes
the populace is loss-averse. We also show that, even when the return on
domestic capital far exceeds the return on the safe asset, it can still
be desirable for the government to hold large reserve balances if agents
are loss-averse.
Conclusion
Our research found that a standard set of explanatory factors does a
good job in explaining central bank reserve holdings of developing countries
through 1996, but it under-predicts reserve holdings of countries in East
Asia after that. Undoubtedly, the recent large buildup of international
reserve holdings in East Asia is motivated by the experience of the recent
Asian financial crisis. When countries' access to capital markets is diminished
because their governments and private sectors appear to be at high risk
of defaulting and when it is costly either to raise taxes or to cut government
spending, countries will find it desirable to hold large precautionary
reserve balances. When countries attach more weight to bad outcomes than
to good ones, they also find it desirable to hold sizeable precautionary
balances of international reserves, even if the return on investing domestic
capital far exceeds the return on reserves. Not all developing economies,
indeed not all emerging markets, will hold large reserve stockpiles in
the aftermath of crises, however. Countries that strongly favor current
consumption, that experience political instability, or that suffer from
political corruption face a lower effective return on holding reserves
and will acquire more modest stockpiles.
While our study is consistent with the view that hoarding foreign exchange
reserves may serve a useful role, it does not follow that all countries
will benefit from adopting this strategy. In particular, our results suggest
that the benefits accrue only when countries optimally control both the
saving of precautionary reserves and external borrowing. Attempts to focus
only on the reserves side may disappoint if the borrowing side is abused
as a result of political uncertainty or corruption.
Joshua Aizenman
Professor of Economics
UC Santa Cruz, NBER, and
Visiting Scholar, FRBSF
Nancy Marion
Professor of Economics
Dartmouth College
References
Aizenman, Joshua, and Nancy Marion. 2002a. "International
Reserve Holdings with Sovereign Risk and Costly Tax Collection."
NBER Working Paper 9154 (September).
Aizenman, Joshua, and Nancy Marion. 2002b.
"The High Demand for International Reserves in the Far East: What's
Going On?" NBER Working Paper 9266 (October).
Tanzi, Vito, and Hamid Davoodi. 1997. "Corruption,
Public Investment, and Growth." International Monetary Fund Working
Paper 97/139.
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