IR at Times of Global Financial Distress: Reflections and Assessment of Future Options

A constructive way to evaluate the role of IR during the crisis is to apply the perspective of insurance mitigating exposure to risky activities. The self insurance benefits associated with IR can be understood using two benchmarks: no self-insurance, and full self-insurance. To illustrate, Korea in the early 1990s refrained from hoarding IR for self insurance against sudden stops. Korea's IR:GDP ratio was at a low level, of about 5%, comparable of the level of OECD countries at that time. This reflected the presumption that Korea was not exposed to sudden stop events, both by virtue of its limited financial integration, and its history of high growth and an impressive record of adjustments to adverse shocks. The 1997–8 crisis however vividly illustrated that Korea and all emerging markets embarking on financial integration were exposed to sudden stop events. The Asian crisis induced a regime switch wherein IR:GDP ratio in Korea more than quadrupled in less that ten years, reducing thereby the expected costs of possible sudden stops.

With most insurance schemes agents rarely get full insurance against the relevant hazard because a typical insurance is associated with loading factors, deductibles, moral hazard, and other such constraining features. Thus full insurance is frequently too costly to attain, and rarely observed. This applies to personal hazard like health and car insurance, as well as to the macro self insurance services provided by hoarding IR. Thus with partial insurance one should expect that the insurance would mitigate but would not eliminate the adverse effects of the hazardous event. In the context of financial integration, fully insuring against deleveraging may entail excessively costly hoarding. At the limit, the portfolio investment of foreign agents and the external borrowing of domestic agents should be matched by equivalent level of international reserves. Such a scheme implies that the country is fully insured at too high a cost, as pointed out by Park (2009). Yet, this argument does not negate the beneficial effects of self insurance, as the alternative of no self insurance would be too costly (see the costs of the East Asian crisis). Thus, the question facing the central bank is to find the optimal level of self insurance.

The theory of optimal insurance suggests that with hazards impacted by agents' behavior, optimality calls for a mixture of partial insurance and preventive methods reducing the frequency and intensity of the calamity (installing fire alarm and external lights in a house, driving a car at a lower speed, equipping a car with air-bags, etc.). This logic applies equally well to emerging markets' exposure to sudden stops and deleveraging shocks wherein a country may supplement hoarding IR with policies that would reduce its exposure to sudden stop events. As was pointed out by Rodrik (2006), such policies may include proactive steps to reduce exposure to external debt. Similarly, deleveraging foreign equity position in an emerging market tends to induce real depreciation, increasing thereby the country's vulnerability to a crisis due to worsening balance sheet exposure.

Aizenman (2009) outlines the case of supplementing hoarding IR with a Pigovian tax-cum-subsidy scheme. The logic of the scheme follows from the negative fire-sale externalities associated with large inflows of capital. Specifically, Eichengreen, Hausmann, and Panizza (2003), and the related balance sheet literature showed that external debt associated with maturity and currency mismatches increases the downside risk of costly sudden stops crises. Greater balance sheet exposure frequently entails higher real depreciation triggered by deleveraging, inducing greater distress of the domestic banking system, and ultimately higher expected forgone output costs of a sudden stop and deleveraging crisis. If most foreign and domestic agents are price takers, each ignores its marginal impact on increasing the expected cost of such a crisis. This in turn entails an externality akin to “congestion”, calling for a Pigovian tax-cum-subsidy scheme.

I construct a minimal model to explain the optimal self insurance offered by international reserves in mitigating the output effects of liquidity shocks. The structure of the model is akin to Diamond and Dybvig (1983)—investment in a long-term project should be undertaken prior to the realization of liquidity shocks.⁷ Hence, the liquidity shock may force costly liquidation of the earlier investment, reducing second period output. As our focus is on developing countries, I assume that all financial intermediation is done by banks, relying on a debt contract. I simplify further by assuming that there is no separation between the bank and the entrepreneur—the entrepreneur is the bank owner, using it to finance the investment. At the beginning of period 1 entrepreneurs fund investment by external borrowing to finance planned second period capital, K_2,p, and banks' reserves, R; K_2,p= D-R. At the end of period one, after the commitment of investment capital, a deleveraging liquidity shock Z materializes. A fraction z of foreign lenders demands their deposits back, Z = zD. Assuming away sovereign risk and bankruptcy constraints, the deleveraging shock is first met by selling reserves. Any excess of the liquidity shock zD above reserves R is met by pre-mature costly liquidation of MAX{0,Z-R}. The liquidation reduces the actual second period capital from K_2,p to K₂, at a rate that depends on the adjustment cost, θ: K₂ = K_2,p - (1 + θ) MAX{Z-R, 0}. Premature liquidation implies that the impatient depositors get their money back without any interest payment. Only patient depositors are paid interest rate ?upon the realization of the investment. Final output is produced at period 2. The second period output finances the repayment of outstanding debt left to maturity, D(1-z)(1+ρ). Unused reserves hoarded in period 1, MAX{R-Z, 0}, provide the bank with a risk free return in the second period, (1+r_f)MAX{R-Z, 0}.

In this economy, bank intermediation exposes the economy to the risk of sudden stop and a deleveraging crisis that may induce costly premature liquidation of tangible investment. Hoarding IR mitigates this risk. I show that the optimal allocation involves a tax on external borrowing, and a subsidy on hoarding IR. The logic of this Pigovian tax-cum-subsidy scheme follows from the negative externalities associated with large inflows of capital. If reserves are not plentiful, a deleveraging crisis induces a large number of banks to liquidate investments at the same time. This would depress the selling price of tangible capital, increasing the cost of deleveraging—the fire-sale effect. Large deleveraging in emerging markets increases the demand for foreign currency, needed in order to meet the deleveraging. If foreign currency reserves are limited, the deleveraging pressure would bid up the price of foreign currency, requiring each bank to liquidate more of its investment to fund a given deleveraging pressure. While each bank takes potential fire-sale prices as given, as a group, they induce the fire sale prices. This leads to a fire-sale externality, akin to congestion (see Krugman [2000] on the experience of Korea in the 1997-8 crisis.)⁸ I show that 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 tax-cum-subsidy scheme reduces the distorted activity (external borrowing), inducing the borrowers to co-finance the precautionary hoarding of IR by means of the borrowing tax. Such a scheme may mitigate some of the recent concerns dealing with the costs of hoarding and using IR for self insurance purposes.

Figure 5 [ PDF 23.8KB | 1 page ] summarizes this discussion. It plots the expected marginal productivity of investment funded by external borrowing, drawn for a given level of international reserves. Curve EMP^PR_D corresponds to the conditions facing the atomistic entrepreneur, in the absence of borrowing taxes. The debt threshold level D is the lowest external debt that induces liquidation [defined by D = IR / τ]. A further increase in external debt increases the expected cost of liquidation. In the absence of tax-subsidy policies, external borrowing is given by D₀. Curve EMP^SO_D is the expected social marginal benefit of borrowed funds. It coincides with EMP^PR_D as long as the probability of costly liquidation is zero (for D<D). For D<D, the planner's curve EMP^SO_D is below the entrepreneur's curve, (EMP^PR_D >EMP^SO_D), because it takes into account the negative fire-sale externality associated with marginal borrowing. For the given initial IR, the optimal external borrowing is D, well below D₀. The fire sale externality is given by the dotted line, CE. The optimal borrowing tax is defined by that externality, shifting curve EMP^PR_D downwards. Note that Figure 5 is a partial equilibrium treatment, drawn for a given level of international reserves. A similar figure can be drawn for the bank's and the planner's demands for IR. In comparison to the initial, no borrowing tax equilibrium, the impact of policies is to reduce the distorted activity [external borrowing], co-financing the precautionary hoarding of international reserves by means of the borrowing tax.^{9 10}

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