Capital Inflows and Reserve Accumulation

[A]uthorities seem reluctant to be bound by the iron triangle of international finance that holds only two of the following three can be achieved: freely mobile capital, fixed exchange rates, and monetary autonomy.

As global capital flows have intensified over the past decade, many emerging market nations have tried to keep their currencies from appreciating against the U.S. dollar. They use a wide variety of tools to accomplish that feat. By trying to maintain autonomy over their exchange rates, these countries’ monetary officials appear to want to “have their cake and eat it, too,” according to Carmen Reinhart and Vincent Reinhart in Capital Inflows and Reserve Accumulation: the Recent Evidence (NBER Working Paper No. 13842). “[A]uthorities seem reluctant to be bound by the iron triangle of international finance that holds only two of the following three can be achieved: freely mobile capital, fixed exchange rates, and monetary autonomy,” the authors write.

For this study, the Reinharts examined the major policy initiatives in more than 100 emerging market countries. Often, these nations ended up accumulating foreign reserves, many times causing them to raise reserve requirements in order to blunt the economic effects of holding so much foreign money. When the authors looked at the monthly changes in the exchange rate and foreign-currency reserves for 97 developing countries from 1990 to 2006, they found that most of the countries’ exchange rates varied less than the currency swings of the developed nations they were benchmarking: Australia, Japan, and the United States. And, the developing nations’ foreign exchange reserves generally varied more than those of the benchmark countries.

For example, seven of every ten emerging nations studied had more muted swings in their exchange rates and more pronounced swings in their reserves than Australia. Only 4 percent of the emerging nations allowed the opposite phenomenon – more variable exchange rates and less variable reserves than their benchmark.

One of the emerging nations’ chief concerns is a rapid inflow of foreign capital, which can distort local markets, expose and increase weaknesses in the domestic banking and investment industries, or fuel an asset-price bubble. But monetary authorities have various tools to discourage such inflows, or at least to dampen their effects. In theory, the simplest mechanism is to tie local interest rates to those of the United States or another benchmark country, so that foreign investors never see a comparative advantage in investing in the developing country rather than the benchmark. In practice, that can be difficult to do, because that advantage hinges not just on interest rates but also on investor perceptions of risk in both countries, the authors explain. “Thus, the domestic rate may have to change with changes in the perceived default rate and the risk premium, two variables that must be inferred, not observed.” Another way to discourage capital inflows is to raise taxes on the assets that foreign investors might buy. But some research suggests that investors could perceive those taxes as a way to keep assets for local investors, meaning that the government sees the assets as even more valuable. “If that is the case, then foreign investors may just pile more capital into the country,” the authors write.

If governments can’t stop capital inflows, then at least they can try to balance them by encouraging their citizens to export their capital. They can do this by lowering the tax on foreign assets, but only if one exists in the first place. A fourth option is to sterilize the inflows ¬– in effect, mopping up all the foreign money coming in by selling government bonds. That keeps the domestic money supply from becoming bloated. But in many cases, countries appear not to sterilize the inflows and to instead raise reserve requirements (in reality, this is another form of sterilization) on banks that take excess money and lend it out. Raising the percentage that banks have to hold as reserves on loans acts as a tax on the banking system, as long as reserves don’t accrue interest at a competitive rate, the authors write. “Changes in that tax can have real effects, including on the exchange rate, depending on the incidence of the tax.”

Indeed, developing nations have been accumulating massive amounts of reserves. The International Monetary Fund projects that as a group their reserves will grow by $3-4 trillion in each of the next few years. To see whether those reserves were growing through sterilized or unsterilized means, the authors looked at international reserves and the domestic money stock for 30 non-industrial economies from 2000 to 2006. “Quite clearly, international reserves did not leave a material imprint on the domestic money stock in the early years of this decade…. In the most recent years, though, authorities apparently have found it difficult to offset their massive purchases,” the authors write, and the rate of increase in money supply drifted up. This study looked at official actions related to exchange rates in more than 100 nations over the past decade. The authors found a wide variety of actions, suggesting that there is no single policy tool. For example, Croatia, South Korea, and Vietnam boosted their reserve requirements in the past few years. The People's Bank of China did it six times in the first seven months of 2007 alone. Others, including Australia, Denmark, El Salvador, Hong Kong, Sweden, and Switzerland, did not. A handful of countries have given up completely on having an independent monetary policy, including Brunei, Hong Kong, and Ecuador, which has adopted the U.S. dollar as its own currency.

-- Laurent Belsie

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