Accumulation of International Reserves in Emerging Markets
Is there a Problem of Excessive Reserve Holdings? The Case of Brazil (with extensive appendix)
Scientific Essay 2010 20 Pages
Table of contents
I. List of Tables
II. List of Figures
1. A Macroeconomic Perspective on Reserve Accumulation
2. The Motives
3. Economic Implications and Evidence
4. The Case of Brazil
List of Tables
Table 1: Reserves in Emerging and Developing Economies
Table 2: ECB - Emerging market countries estimated adequate and actual reserves
Table 3: Emerging and Developing Economies by Region, Net External Position, and Status as Heavily Indebted Poor Countries
List of Figures
Figure 1: Alberola/Serena: Exchange Rate and Reserve Accumulation 2004-2005
Figure 2: Exchange Rate Development of Brazil's real against the $ after the end of the Dollarization
Figure 3: International Reserves
Figure 4: GDP of Brazil in Billion US$
Figure 5: GDP Annual Percentage Growth Rate
Figure 6: M1 base (12 month % change in US$)
Figure 7: Gross Foreign Reserves (in billion US$)
Figure 8: Change in net international reserves (%)
Figure 9: Consumer Price Index (annual % change)
Figure 10: Interest Rates (Prime Rate as Annual % rate)
Figure 11: Current Account in Billion (US$)
Figure 12: Current Account (as % of GDP measured in Billion US$)
Figure 13: External Debt 1995 - 2008
Figure 14: Merchandise Trade Balance (Billion US$)
Figure 15: Capital and Financial Account (Billion US$)
Figure 16: Brazil’s inflation rate 1998 - 2009
1 A Macroeconomic Perspective on Reserve Accumulation
In the aftermath of various crises such as the Asian financial crisis at the end of the nineties, which had a huge impact on the national and globalized political economies worldwide, a process of massive reserve accumulation started, especially in East Asia [Bar-Ilan/Marion 2009: 802]. This process of reserve accumulation initiated a rapid change of the world’s pattern causing changing demands that need to be handled since the beginning of the new century.
The so called globalized world realized that not only the power they were given to affect own policies and long term contingency approaches should be taken into account, but also they had to admit that intergovernmental interaction needs to play a decisive role in every deliberation of political and financial activity. Having the present economic situation in mind, almost every day new banks and financial institutions are collapsing while driving down the world further in a downward spiral. Obviously, the confidence and reliance on the conceptual skills concerning financial matters is suffering tremendously ever since these crises and need to be reestablished contemporarily in order to stimulate the indispensable demand for goods and services.
Since 1997, the emerging markets have boosted their international reserve holdings by 60% [Walters/Cruz 2008: 665] and even the developing nations increased their foreign exchange reserves from around 8% in the 80s to almost 30% of GDP in 2004 [Rodrik 2006: 4]. Therefore, this paper will have a closer look on what the immanent theoretical justifications declare from the economical point of view and clarify what effects this process has especially on the Brazilian economy. The reason for having this discussion is the fact that “reserve inadequacy could affect individual countries differently” and thereby each country “opted to hold more reserves than others and it seemed only natural to ask at what point reserves became inadequate; or indeed excessive” [Bird/Rajan 2003: 873]. Consecutively the different reason and goals for performing reserve accumulation will be discussed in an idiosyncratic sense.
2 The Motives
When it comes down to economical research justifications there are clearly different approaches to explain why international reserve accumulation is desirable especially for emerging markets. Summing up the generally accepted theories there are mainly three different views on the reserve accumulation from a countries’ point of view.
The first approach “emphasizes the role of international reserves in providing self-insurance.” For emerging markets, this clearly implies that “reserves reduce the cost of a financial crisis and may also reduce the chance of crisis” [Bar-Ilan/Marion 2009: 802]. Reserve stocks will provide a self-insurance against unexpectedly bad market and economic development. By that the benefits need to be traded off for the opportunity costs holding these reserves and the country will remain functionable while otherwise a high volatility of shocks and inflation would cause recession [Aizenman/Marion 2003: 389]. This theory basically illustrates the fact that countries are willing to accept the affiliated costs caused by the accumulation of reserves because they consider this funds as an protection against the by far higher losses that might occur due to a possible crisis [Cruz/Walters 2008: 666]. This approach is well known as the precautionary motive.
A second approach emphasizes the role of reserve accumulation as a tool to enable a country to be capable of competing on the world market by an undervalued exchange rate and capital controls while almost fully rely on export-led growth [Bar-Ilan/Marion 2009: 802]. This model is characterized as the mercantilist model which intends to accumulate reserves in order to obtain intense export competitiveness. Thereby, the countries try to effectuate and retain a beneficial exchange rate that enables to enhance competitiveness what therefore hopefully results in higher export growth rates [Cruz/Walters 2008:669]. Obviously, this approach relies on the intervention in the market of foreign exchange and thereby following the path of own currency undervaluation.
A third approach is to a certain extent the financial latitude that comes along with reserve accumulation. Thereby “a larger stock of international reserves may increase a government’s financial room for maneuver” and while having achieved this power such reserves may provide the agility “to finance the deficits associated with countercyclical fiscal responses to economic shocks” [Zhou 2009: 942]. This effect must not be underestimated, since a larger stock of such reserves will obviously support the country’s agility and by that the exoteric credibility borrowing money. This will support the already mentioned countercyclical monetary and fiscal intervention. Unfortunately, the costs of borrowing money are always pretty inopportune when the money is needed the most.
In a research paper the economist Fischer summarized the importance of reserves as follows: “Reserves matter because they are a key determinant of a country's ability to avoid economic and financial crisis. This is true of all countries, but especially of emerging markets open to volatile international capital flows. [...] We have also seen in the recent crises that countries that had big reserves by and large did better in withstanding contagion than those with smaller reserves” [Fischer 2001]. This perception supports the already mentioned third approach where additional reserves represent an unconditional and assured source of liquidity supply.
3 Economic Implications and Evidence
This chapter will now provide an explicit and in-depth view on the economic results of the abovementioned motives discussed in the present economic literature. Hereby both, the negative and positive effects should be clarified due to a complete and a well-rounded understanding.
Besides the theoretical implications, there seems to be some support on the part of empirical analysis. Thereby it was found out that those countries who strived to expand their foreign exchange reserves in relation to the GDP tended to have higher and more distinctive growth ratios, capital productivity and further economic variables than those countries without continuous reserve growth [Popov/Polterovich: 1]. Although this process is mainly driven by the three approaches mentioned above, not every impulse of accumulation is influenced in an equal manner. In fact, especially for the decade since 2000 the economist Aizenman found out that the accumulation in this period was often affected by efforts to enhance the stability of the emerging markets and not only because of precautionary motives as often assumed. This supports to a certain extent the existence of the mercantilist motive, where accumulation is used to affect the export-led growth as a key determinant of fiscal intervention [Aizenman 2008: 501].
Moreover, as already mentioned, a further approach of justification is to accumulate reserves in order to assure and remain financial stability - by diminishing the probability of speculation attacks - and political autonomy even in hard times. This perception is circumstantiated by the work of Rajan and Bird (2003) who pointed out that “access to international capital markets depends on creditworthiness which may itself change in positive association with the level of reserves” [Bird/Rajan 2003: 878]. Having this deduction in mind it seems reasonable to gain reserves in order to be capable of acting not only in the short run but also in the future. Nevertheless, sophisticated empirical evidence is still lacking at this point.
At least even the precautionary motive deserves particular attention since this approach appears to be one of the most immanent strategies especially in the aftermath of the Asian Crisis at the end of the 90's. Thereby Aizenman and Marion (2003: 397) as well as Rodrik (2006: 2-9) point to the empirical research results which imply that there often is a coexistence of both, the precautionary motive and the mercantilist model. In this case, it can be concluded as a matter of fact that the present precautionary motives, which intend to prohibit a crisis caused by an intrinsic shock or speculation attack, go often hand in hand with the idea of the mercantilist model, which forms the basis of accumulating reserves in order to obtain intense export competitiveness and remaining to play a decisive role on the world market.
Unfortunately there is not only the bright side of reserve accumulation. Apparently, there is a large contingent of economists who negate to sugarcoat these approaches while having possible sustainable negative impacts in mind.
For instance Walters and Cruz claim that the positive outcomes can only be obtained as long as the imbalances occur within micro- and macroeconomic indicators [Cruz/Walters 2008: 673]. A further effect that must not be underestimated is the case of rising opportunity costs with holding and expanding accumulation reserves. Thereby the economist Rodrik points out that this opportunity costs appear to be around 1% of GDP per annum in the case of developing countries, which he outlines to be “a large number by any standard” [Rodrik 2006: 261]. By that the economist Mendoza (2004) corresponds to the costs caused by accumulation reserves. Hereby Mendoza concludes that in his study where he had a closer look on 65 developing countries the quarterly costs of reserve accumulation have been around US$ 450.000.000 (Mendoza 2004: 73).
Summing up the results it becomes quite clear that there is not the one and only reason and justification for accumulating reserves. The motivation for pursuing the one or the other approach really depends on the situation the country finds itself in. A lot of recent data contributes to the Asian Crisis and the upcoming and already present developed countries such as China and India. Thereby it becomes clear that, more often than not, multiple goals are obsessed.
In detail this subject matter will be discussed continuative for the case of Brazil where such policies played a decisive role since the Asian Crisis in the late 90's.
4 The Case of Brazil
The intention of the following chapter is to discuss to what extent Brazil adapted the economical motives of reserve accumulation mentioned above. Therefore it is of great importance to determine a specific time frame in which Brazil's monetary policy will be illuminated in detail. Having this in mind, this paper will use and interpret data between 1998, the year of Brazil's Balance of Payments and currency crisis, until 2009, where the financial turmoil as a consequence of the US subprime crises can be observed. Hereby a diverse range of performance indicators will be taken in order to connect the literature with economic numbers. However, the findings will be supported by data within the given time frame mostly taken out of the IMF “World Economic Outlook” report (2009) as well as several OECD data.
Starting in 1994, the Brazilian Government decided to impose a new currency, the so called real in form of a “Dollarization” having the real pegged to the US Dollar. Although Brazil was successful in impairing the tremendous inflation rate of over 2600 percent (1994) down to 10 percent in 1997, the economic growth remained underwhelming [Krugman/Obstfeld 2009: 477]. As market skepticism rose in respect of the dissipating believe that Brazil could maintain their credibility to guarantee financial stability and its peg to the dollar due to very high interest rates that Brazil's government had to pay on its debt, the currency crisis began. In 1999 this ended up in a free floating currency whereby the real lost more than “40 percent of its value against the dollar. Recession followed as government struggled to prevent the real from going into a free fall” [Krugman/Obstfeld 2009: 636].
Obviously, since this experience Brazil followed the aim of reserve accumulation in order to remain financial stability. As can be seen in Table 1, Brazil raised their amount of reserves from $35 Billion in 2001 to $157.3 Billion in 2010 which implies an overall growth of 442%. The reason for such a huge enhancement was clearly pointed out in the 2007 paper of the ECB: “The extent to which the rapid increase in reserves can be attributed to self-insurance against financial crises”, such as the Brazilian currency crisis, was clearly verified. Hereby it falls into place that in the aftermath of “severe financial crises, many emerging market countries have built up foreign exchange buffers to deal more efficiently with potential runs on their currencies” [ECB 2007: 31]. This statement pretty much clarifies that the idea of Brazil’s government to boost their reserves comes from the already discussed precautionary and credibility motive, which implies a hybrid-model consisting of the first and third approach.
In the recent time, especially in the aftermath of the subprime crisis, the Latin America region “suffered from plummeting commodity prices as well as financial strains and weak export demand” [WEO 2009: 5]. Hereby the tremendous reserve accumulation of Brazil played out well in order to stabilize the global instabilities [Figure 16]. Brazil was “able to use policy buffers to alleviate pressures, letting exchange rates adjust downward but also applying reserves to counter disorderly market conditions and to augment private credit, including in particular to sustain trade finance” [WEO 2009: 7]. To a certain extent this also turned out to be an effective move since “the cost of external borrowing has also risen [...] but remains relatively low for other countries with better initial positions and larger policy buffers, including Brazil” and therefore supports once again the third approach [WEO 2009: 87]. Nevertheless there is still the justified perception that reserve accumulation is needed because of mercantilist matters. This presumption is supported by Alberola and Serena and can evidently be verified in Figure 1, 2, 7 and 8, where the reserve accumulation and the development of the exchange rate can clearly be observed. Thereby, all four figures underline the fact that Brazil pursuits a strategy of increasing reserves and is maintaining a slight appreciation of its own currency, while using the accumulated reserves in difficult times in order to stabilize its own economy and therefore contradicts the supposed assumption, that Brazil might follow the path of a mercantilist approach.
Even though this approach is by far more existent in Asian countries, “it also applies to other countries, like some Latin American countries and oil producers, where the desire to limit exchange rate appreciations is evident.” In this case “magnitude and persistence of the current process suggest that the mercantilist motives may be increasingly relevant” [Alberola/Serena 2007: 6].
To a certain degree, the reason for that is the “export-led growth strategy that, by maintaining the exchange rate depreciated with respect to the rate that would emerge had the central bank not act in the markets, generates current account and financial account surpluses, thanks to trade balance surplus and expectations of appreciation of the exchange rate. If a central bank wants to maintain the exchange rate at the desired level, it has to act in financial markets, consequently accumulating reserves” [Alberola/Serena 2007: 6]. Nonetheless, this effect cannot be observed sufficiently in the case of Brazil. As Figure 2 clearly shows, except for an inflationary peak 2002, where the real reached its weakest level, the real appreciated ever since and therefore deteriorates Brazils export capability on the world market.
Concluding the presented numbers and tables it can clearly be observed that Brazil did pretty well with its way of overcoming their own and multiple other crises since the end of the 90s. This conclusion is supported by Figure 4 and 5, where the absolute and relative increase in GDP is extremely impressive compared to other Latin American countries. Owing the circumstances, Brazil was successful in keeping their exchange rate volatility relatively low (Figure 2)
Based on the economic literature that was discussed above, there are three clear approaches to aim for reserve accumulation. While the first approach considers the precautionary motive to assure the country against financial shocks, the second approach lays stress on the mercantilist view to undervalue the own currency and therefore to remain or establish competitiveness on the world export market, as you can see in the case of China. The third approach thereby stresses the idea of extending the financial latitude before lending money becomes impossible.
Having the findings in mind that were elaborated throughout this paper, Brazil's strategy of reserve accumulation is clearly focused on the first and third approach, the precautionary motive and the protection of financial agility.
The presented data and the work of several mentioned economists stated that in the aftermath of Brazil's currency crisis in 1999 the government accumulated reserves in order to maintain financial stability once the currency began free floating. With the help of the president Ignacio Lula da Silva in 2002, Brazil was able to fend overwhelming recession and inflation and therefore to avoid the collapse of the financial sector. His work enabled Brazil to preserve “access to international credit markets. Economic growth has been healthy and President Lula was re-elected in October 2006” [Krugman/Obstfeld 2009: 636].
Nonetheless, there is still a risk of an inadequate accumulation of reserves. The European Central Bank stated in its report in 2007 that Brazil has already in 2006 reached a level of reserves that is above the appropriate level, as you can see in Table 2. Important to know in this case is what happened in the aftermath of the global crisis started in the US subprime market from 2007 on. The reserve accumulation worldwide accelerated even at a higher pace. Apparently, compared with the rest of the world, the Latin America countries were really modest in accumulating reserves. For the present global crisis it is observable that Brazil will have to use their accumulated reserves in order to protect itself sustainably against upcoming threats. Considering the presented numbers, the outlook for Brazil is rather gloomy with huge current account deficits (Figure 11) and the lately plunging merchandise trade balance (Figure 14) as well as increasing external debt. Hereby Brazil remains a net debtor country (Table 3 and Figure 13).
At the very moment, the global economy is facing huge problems that unfortunately were caused by themselves. The people in charge and we all have to learn from the past knowing that with great powers comes great responsibility and little mistakes can cause huge damage for all of us, even for those who did not do anything. We need to be capable of doing the right things at the right time, even though there simply cannot be perfect assurance that these problems are not replicated every now and then, as the history teaches us.
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