Introduction

In this paper I discuss the implications of the ongoing global liquidity crisis on developing countries' use of precautionary measures aimed at mitigating their exposure to financial crises. The global liquidity crisis raises questions about the degree to which large hoarding of international reserves (IR) suffices to deal with the financial exposure of emerging markets (EMs) in an efficient way. The crisis also renews the debate about the desirability of unfettered financial integration of developing countries. I provide an overview of this debate, and assess possible future options.

Over the last two decades, emerging countries have opted for increasing financial integration. Mundell-Fleming's "trilemma” implies that they must either forego exchange-rate stability (if they wish to preserve a degree of monetary independence) or forego monetary independence (if they wish to preserve exchange rate stability). Aizenman, Chinn, and Ito (2008) found that emerging countries have moved towards greater exchange-rate flexibility and deeper financial integration buffered with sizable reserve holdings. Both trends are more pronounced for the EMs than for the non-emerging developing countries. The data also points to differential trends among emerging Asia and emerging Latin America (LATAM). Figure 1 [ PDF 33.1KB | 1 page ] applies “Diamond charts” for emerging Asia and emerging LATAM, tracing the changing patterns of the trilemma configurations. Each of the charts shows the levels of the three trilemma policy goals and IR (as a ratio to GDP). The origin in the charts is normalized so as to represent zero monetary independence, pure float, zero international reserves, and financial autarky. The trilemma variables are normalized to a range of zero to one, where one corresponds to achieving the desired policy goal. A comparison of the regions reveals that emerging LATAM moved much more rapidly towards financial integration than emerging Asia. Emerging Asia opted to hoard more IR than emerging LATAM. Both blocks moved towards greater exchange rate flexibility. These trends have enabled them to retain a fair degree of monetary autonomy without hampering financial integration— a sort of “middle-ground Trilemma's configuration.”

Indeed, the response of many EMs to the current crisis fits the “middle ground” trend—allowing real exchange rate depreciation mitigated by selling IR to take the first brunt of the adjustment. The absence of deeper adjustment in EMs (so far) as compared to the severe impact of the crisis in industrialized economies, testifies to the degree to which proper management of the trilemma's middle ground enables a softer landing in the aftermath of major external events. The combination of hoarding large stockpiles of IR and the growing exchange rate flexibility facilitated adjustment to deleveraging pressure induced by the crisis.

In Section 1 I outline the debate about desirable adjustment of EMs during the first phase of the on-going crisis. I start by discussing the experience of the Republic of Korea (hereafter Korea)—a prime example of a country that opted for deeper financial integration in aftermath of the 1997-8 crisis, buffered with large hoarding of IR. The limited ability of the large initial stockpile of Korean IR (about US$250 billion) to stabilize domestic financial markets in the aftermath of the current crisis, renewed discussion about the desirability of financial integration. Provision of self insurance to deal with growing exposure to sudden stop and deleveraging crises may require large and perhaps inefficient levels of IR hoarding. Looking at the experience of all EMs, their adjustments during the current crisis reveal a switch from “fear of floating” during 1970s–1980s toward “fear of losing IR.” Intriguingly, only half of the EMs used their IR during first phase of the current crisis as a shock absorber, depleting not more than one-third of their initial IR. The other half of the EMs opted to adjust to the crisis mostly through exchange rate depreciations. I end the section with an overview of the use of provisional swap lines during the crisis.

In Section 2 I reflect upon and assess future policy options. A way to alleviate sudden stops and deleveraging pressure may be a Pigovian tax-cum-subsidy scheme. Specifically, I consider an economy where domestic entrepreneurs borrow externally to fund long-term projects, exposing the economy to balance sheet fragility. Premature liquidation of long-term investment is associated with deadweight loses due to fire-sale congestion externalities. Under such circumstances, competitive laissez-faire equilibrium is inefficient. Each entrepreneur ignores the marginal impact of his borrowing on increasing expected costs of a deleveraging crisis, and the impact of higher hoarding of IR on reducing the expected cost of a crisis. The fire-sale externality reduces the marginal social benefit of borrowing below the private benefit, and increases the marginal social benefit of hoarding IR above the private one. The optimal policy calls for taxing external borrowing, and subsidizing hoarding reserves. If such a tax-cum-subsidy policy is implemented before foreign capital flows in, then the policy would limit exposure of the recipient country to possible deleveraging. The scheme induces domestic agents to internalize the externality associated with external borrowing and deleveraging crisis. A virtue of the tax-cum-subsidy scheme is that the optimal borrowing tax funds the optimal subsidy on hoarding IR. This scheme may mitigate concerns about costly hoarding of large stockpiles of IR needed to self-insure against a deleveraging crisis.

In Section 3 I discuss the case for deepening regional pooling arrangements, and the possibility of the emergence of a yuan (CNY) anchored currency block in the future.

1.1 IR as Self Insurance During a Crisis: the Crisis Experience of EMs

The experience of Korea during the last fifteen years outlines the contours of the debate about self insurance by means of hoarding reserves. To recall, following the 1997–8 East Asian crisis, Korea embraced financial integration, buffered with large hoarding of IR. The large stockpiles of IR provided Korean authorities with precautionary savings to cushion against sudden stops and deleveraging. Figure 2 [ PDF 88.7KB | 1 page ] overviews these trends (1992–2008), tracing the short and long-run external debt to gross domestic product (GDP) ratio, share of foreign ownership of stock market, and IR to GDP ratio in Korea. The financial integration led to rapid increase in the foreign ownership share of the Korean stock market, from less than 5% in 1992 to more than 40% in 2004. This was also a time when the ratio of the valuation of Korean stocks held by foreigners to Korean GDP reached about 30%. While IR:GDP hovered around 5% before the 1997–8 crisis, the financial upheaval triggered by the crisis induced major change in the hoarding of IR. IR accounted for more than 25% of the GDP by 2004. By that time, Korea's IR exceeded the short term external debt by more than 2.5 times, and in 2004 Korean's IR exceeded its total external debt.²

Less than ten years after the 1997–8 East Asian crisis, by conventional yardsticks Korea's IR:GDP ratio seemed more than adequate, with IR that exceeded short-term external debt and allowed financing of several quarters of imports. Indeed, observers raised questions about the growing costs of stockpiling these reserves, asserting that their level in EMs, including Korea, potentially exceeded the social optimum (see Jeanne and Ranciere [2005]). Yet, the onset of the current global liquidity crisis and the ensued deleveraging changed the above-mentioned perception. During the first stage of the 2008–9 global liquidity crisis, Korea's reserves dropped by roughly US$60 billion in half a year, a decline of about 25%. Indeed, reserves were key to the bailout package the Korean government unveiled in second half of 2008. The principal element of the package was a US$100 billion, three-year government guarantee for banks' debt raised abroad before July 2009. This sum was more than sufficient to cover Korean banks' foreign debt maturing by June 2009. The latter has been estimated by the Korean Ministry of Strategy and Finance to be about US$80 billion. Yet, observes noted that, despite the large hoarding of IR used to finance the bailout package, market concerns were not abated.

“Similar guarantees had failed to allay fears of financial meltdown at the beginning of the Asian crisis in 1997 and they failed again. As in 1997, the market reactions were indifferent. Only when Korea secured a swap line amounting to $30 billion from the Fed on October 30 the foreign exchange market settled down somewhat, but not very long. The foreign exchange rate shot up to 1,509 won per dollar three weeks after the swap had been announced, which was apparently not enough to remove uncertainties surrounding Korea's ability to service its foreign debt. Korea also managed to arrange won-local currency swaps with the central banks of both China and Japan, each amounting to an equivalent of $30 billion on December 13. Only when it was made clear that the Fed would renew the swap agreement, foreign investors' confidence in the Korean economy improved and stability in the foreign exchange market returned toward the end of the first quarter of 2009.” Park (2009: p.16).

Looking beyond Korea, other EMs cushioned their adjustment to the global financial crisis by a combination of exchange rate depreciation and partial depletion of their IR.³ Yet, after the first phase of adjustment, central banks have been reluctant to further draw down their reserves. This reluctance possibly reflected the fear that further depletion of IR may signal growing vulnerability—a potential adverse externality arising from “keeping up with the Joneses' IR”. Figure 3 [ PDF 20.1KB | 1 page ] portrays the IR dynamics during the first year of crisis in Korea, India, Russia, Poland and Malaysia, July 08-March 09, reporting the ratio of IR (US dollar) relative to their level in July 08. The inverted S curve is consistent with the “fear of losing IR.” Central banks used a share of their IR in first quarters of the crisis to finance deleveraging pressures, thereby mitigating currency depreciation. Yet, after losing not more than third of their initial reserves, countries became more averse to further drawing down their stocks of IR. Choice of the speed of drawing-down accumulated IR is a delicate one. It hinges on the anticipated future course of the global economy, the domestic adjustment capacity and the degree of financial integration of the country in question. The trade-offs for a country like India differs from those of Chile. India is less integrated with the global financial system and Indian government has less room for fiscal adjustment due to its significant and growing fiscal deficits. Brazil, Chile and other EMs have preferred to adjust to the current crisis mostly through exchange rate depreciation. It is possible that the latter group of EMs have been saving their IRs for leaner years to self-insure against potential prolonged period of weakness in their terms of trade.

Further insight about the “fear of losing IR” can be gained by looking at the differential patterns of using IR during the crisis across all EMs. To recall, investigating the patterns of exchange rates, interest rates, and IR during 1970–1999, Calvo and Reinhart (2002) inferred the prevalence of the “fear of floating.” Countries that claim they allow their exchange rate to float, mostly do not. Instead, the authorities frequently attempt to stabilize the exchange rate through direct intervention in foreign exchange market and through open market operations. The fear of floating may also provide an interpretation for the massive hoarding of IR during the last ten years by EMs and other developing countries. Alternative explanations of IR hoarding however include the precautionary and/or mercantilist motives (Aizenman and Lee [2007, 2008]), as well as the reincarnation of the Bretton Woods system (Dooley et al. [2009]). The present crisis imposes daunting challenges to EMs. The “flight to quality,” deleveraging, and the rapid reduction of international trade affected EMs from mid-2008, thereby testing their adjustment capabilities. While in several earlier crises episodes, EMs were forced to adjust mostly through a rapid exchange rate depreciation, the sizable hoarding of IR during the late 1990s and early 2000s provided the same countries with a richer menu of choices.

Aizenman and Yi (2009) looked at the degree to which the large hoarding of IR “paid off,” during the current crisis in terms of allowing EMs to adjust by drawing down their IR. Their study follows the adjustment of 21 EMs during the window of the crisis and reveals a mixed and complex picture.⁴ Figure 4 [ PDF 28.6KB | 1 page ] presents the countries' monthly IR measured relative to the highest IR level from January 2008 until February 2009. Regression analysis shows that EMs with large primary commodity exports, especially oil exports, tended to experience large IR losses in the current global crisis. Countries with a medium level of financial openness and a large short-term external debt ratio also on average lost more of their initial IR holdings. Most of the countries that suffered large IR losses began depleting their IR during the second half of 2008, and many of them still have not recovered their precrisis level of IR holdings. Intriguingly, only about half of the EMs relied on significant depletion of their IR as part of the adjustment mechanism. The study proceeded by dividing the sample of EMs into two groups: countries that have sizable IR losses and countries that have either not lost IR or quickly recovered from their IR losses. The first group is defined as countries that lost at least 10% of their IR during the period of July 2008 to February 2009 relative to their highest IR level. Among the 21 EMs, nine countries belong to the first group. ⁵

To gain further insight, the study compared precrisis demand for IR:GDP of countries that experienced sizable depletion of their IR, to that of countries that didn't, and found different patterns between the two groups. Trade related factors (trade openness, primary goods export ratio, especially large oil exports) seem to be more significant in accounting for the precrisis IR:GDP level of countries that experienced a sizable depletion of their IR in the first phase of the crisis. These findings suggest that countries that internalized their large exposure to trade shocks before the crisis used their IR as a buffer stock in the first phase of the crisis. Their reserves losses followed an inverted logistical curve. After a rapid initial depletion of reverses, within seven months these countries reached a markedly declining rate of IR depletion, losing not more than one-third of their precrisis IR. In contrast, for countries that refrained from a sizable depletion of their IR during the first crisis phase, financial factors account more than trade factors in explaining their initial level of IR:GDP.

The patterns of using reserves by the first group, and refraining from using reserves by the second group, are consistent with the ”fear of losing reserves” Such a fear may reflect a country's concern that dwindling IR may signal greater vulnerability, triggering a run on its remaining reserves. This fear is probably related to a country's apprehension that, as the duration of the crisis in unknown, depleting IR too fast may be suboptimal . Rapid depletion exposes the country to the risk of abrupt adjustment in the event that the crisis turns out to be deeper and more enduring than its initial intensity.

These findings suggest that there exists a clear structural difference in the precrisis demand for IR between EMs that were willing versus those that were unwilling to spend a sizable share of their IR during the first phase of the 2008–9 crisis. Trade related factors are more significant in accounting for the precrisis IR level of the countries that experienced a sizable depletion of their IR in the first phase of the crisis, in line with the buffer stock interpretation of the demand for IR. Countries that depleted their reserves in the first phase of the crisis, refrained from drawing their IR below one-third of the precrisis level. The majority of these EMs used less than a one-fourth of their pre crisis IR. Countries whose pre crisis demand for IR was more sensitive to financial factors, refrained from using IR altogether, preferring to adjust through larger depreciations. My results suggest that the adjustment of EMs during the ongoing global liquidity crisis has been constrained more by their fear of losing IR than by their fear of floating.

These observations raise new questions. More work is needed to understand why countries differ in the weight assigned to financial versus commercial factors, in accounting for their demand for IR. Intriguingly, the average exchange rate depreciation rate for the period from August 2008 to February 2009 was about 30% in both EMs that depleted and those that refrained from depleting their IR. A possible explanation could be that the shocks affecting EMs that opted to deplete their IR, were larger than the shocks impacting EMs that refrained from using their IR. Testing this hypothesis requires more data, not available presently, including information on the deleveraging pressures and balance sheet positions during the crisis. Moreover, this hypothesis, if valid, implies that countries prefer to adjust to bad shocks first through exchange rate depreciation, and then supplementing it with partial depletion of their IR when the shocks are deemed to be too large to be dealt only with exchange rate adjustments.

The fear of using IR also suggests that some countries opt to revisit the gains from financial globalization. Earlier research suggests that EMs that increased their financial integration during the 1990s to the mid-2000s, hoarded IR due to precautionary motives, as self-insurance against sudden stops and deleveraging crises. Yet, the crisis suggests that for this self insurance to work, it may require levels of IR comparable to a country's external financial gross exposure (see Park [2009] analyzing Korea's challenges during the crisis). In these circumstances, countries may benefit by supplementing hoarding with Pigovian tax-cum-subsidy policies (Aizenman [2009]). A possible interpretation for the fear of losing IR is the “keeping with the Joneses' IR” motive—the apprehension of a country that reduction of its IR:GDP ratio below the average of its reference group, might increase its vulnerability to deleveraging and sudden stops (see Cheung and Qian [2009] for evidence on “keeping up with the Joneses' IR” in East Asia). These factors suggest a greater demand for regional pooling arrangements and swap lines (see Rajan et al. [2005]), as well as possible new roles for IFI (World Bank, the International Monetary Fund [IMF], etc.). A better understanding of these issues is left for future research.

1.2 The Crisis and the Provision of Swap Lines

An example of alternative means of adjustment is the use of swap lines. A most intriguing development took place at the end of October 2008, when the US Federal Reserve (FED), the central banks of Brazil, Mexico, Korea, and the Monetary Authority of Singapore announced the establishment of temporary reciprocal currency arrangements or swap-lines, worth US$ 30 Billion each. These facilities were designed to help improve liquidity conditions in global financial markets and to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies. The practical meaning of it was the unprecedented provision of US$120 billion in swap lines to four EMs by the US FED. It provided welcome relief and also sent an important signal. In the case of Korea, observers including Park (2009) credited this development with stopping the run on Korean reserves. While the FED extended such swaps lines to numerous Organisation for Economic Co-operation and Development (OECD) countries, these arrangements were extended by the FED to only four emerging markets.⁶ This raises questions regarding the selection criteria behind the “chosen four EMs,” and the degree to which these selective swap-lines accomplished the goals spelled out in the FED's press release.

While final evaluation of the impact of these swap-lines requires much more data and a longer time horizon, Aizenman and Pasricha (2009) found that the exposure of US banks to EMs is the most important selection criterion. Inclusion of US trade exposure, capital account openness, and credit history of countries, along with the US banks' exposure in the estimations, provides statistically accurate interpretation of the selected four swap-lines. Their result is consistent with a Diamond and Dybvig (1983) model of an open economy. In circumstances of unanticipated deleveraging, emergency swap-lines prevent or mitigate costly liquidation today, thereby allowing investment projects to reach maturity. Emergency swap-lines may provide valuable services in circumstances where the realized liquidity shock turns out to be much larger than the one expected ex-ante. The impetus for “a larger than anticipated” liquidity shock may come from ”financial contagion,“ or from an adverse real shock reducing the expected productivity of the investment. The first scenario is exemplified by deleveraging shocks due to a credit crunch and “flight to quality,” affecting creditors that co-financed investment in EMs. The second scenario may correspond to news about unfolding deep global recession—a recession that may cause further deterioration of EMs' terms of trade. The recent challenges facing various EMs reflect a mixture of both scenarios. Swap-lines may also provide valuable positive option value. By averting massive liquidation today, if things improve by end of the investment gestation period, the higher surplus would support higher profits and will reduce the ultimate cost of the capital flight. This in turn would possibly enhance the welfare of both the source and the recipient countries (i.e., the US and the four EMs).

Their analysis suggests that swap-lines had relatively large short-run impact on the exchange rates of the selected EMs, but much smaller effect on the spreads (measured relative to that of other EMs that were not the recipients of swap-lines). Specifically, non-swap countries experiences an average depreciation of 0.15% on the day after the swap announcement, whereas swap countries witnessed their exchange rate appreciate, on average, by about 4%. Yet, all the swap countries faced a subsequent depreciation of their exchange rate to a level lower than the pre-swap rate, thereby calling into question the long-run impact of the arrangements. A note of caution is in order here—as the selective swap-lines targeted countries with large US exposure, it potentially prevented even a deeper exchange rate depreciation of the four, as apparently was the case in Korea. Furthermore, only with the benefit of time would one be able to appreciate the fuller welfare implications of these arrangements.

The limited efficacy of the large stockpile of IR in preventing a run on reserves of countries such as Korea during a crisis calls into question the desirability of unfettered capital mobility.

While hoarding IR prevented a replay of the 1997–8 crisis dynamics in Korea, the large depreciation of the Korean won renewed concerns about the residual exposure to balance sheet effects associated with depreciation. At the limit, eliminating the balance sheet exposure may require hoarding dollar liquidity per dollar external liability, practically nullifying the gains from financial integration (Park [2009]). I turn now to evaluate possible future developments of policies and financial mechanisms to deal with the concerns discussed above.

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