«Role Reversal in Global Finance Eswar S. Prasad I. Introduction The global financial crisis has sparked a reconsideration of the role of unfettered ...»
These figures paint a sobering picture of worsening public debt dynamics and a sharply rising public debt burden in advanced economies, along with a high level of dependence on foreign investors in search of a safe haven, especially in the case of the United States. The major reserve currency economies—especially the United States and Japan—face daunting trajectories of public debt and weak growth prospects. These economies have had the benefit of being able to issue sovereign debt in their own currencies, allowing them to essentially transfer currency risk to the foreign purchasers of their sovereign debt.
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Notes: Each bar denotes increases in net debt—total level and the level accounted for by foreign investors— calculated as the year to year change in end-of-year debt stocks (as reported in series (3) and (11) in Table OFS-2 on p. 41 of data source).
Source: Treasury Bulletin, June 2011 Issue, U.S. Treasury Advanced economies have not been subject to original sin but their accumulated sins will eventually catch up with them. Indeed, with low levels of population growth, rapidly aging populations and rising costs of health care and other entitlement programs, advanced economies could be in far worse shape beyond the medium-term horizon discussed in this section if they do not bring their public finances under control.14 As demonstrated by recent events in the eurozone, bond investors—both domestic and foreign—can quickly turn against a vulnerable country with high debt levels, leaving the country little breathing room on fiscal tightening and eventually precipitating a crisis.
The United States is large, special and central to global finance but the tolerance of bond investors may have its limits.
In advanced economies, rising public debt levels imply significant crowding-out effects that will affect productivity growth and could generate a persistent productivity growth gap relative to emerging markets. Balance sheets of households and the financial sector in advanced economies were severely damaged by the financial crisis 366 Eswar S. Prasad and are only now beginning to recover, putting a further crimp on these economies’ growth prospects. All of this implies that emerging markets’ currencies will in the long run tend to appreciate relative to those of the major advanced economies, implying a large wealth transfer from poorer to richer economies.
If one looks at the overall level of foreign exchange reserves and the fact that nearly all of these reserves are held in dollars, euros and yen, the implications in terms of a capital loss in domestic currency terms for emerging markets are quite significant. For instance, for China, a 10 percent decline in nominal exchange rates against each of the major reserve currencies would imply a capital loss of about $300 billion just from currency valuation effects.15 These issues raise serious questions about what it means for emerging markets to hold government bonds of advanced economies as safe assets.
With these unfavorable debt dynamics, why is the United States still in the position of being a liquidity provider of last resort? The same question can be asked of the other major reserve currency economies. The answer must lie in the quality of public institutions as well as financial market depth, which means that at least investments in those countries’ bonds are liquid and easily tradable. The rush into U.S. Treasury bonds in the presence of global financial turmoil is then more a flight to liquidity and depth than a flight to safety.
How can emerging market countries protect themselves against external crises precipitated by global shocks? How can they do this without incurring huge insurance costs? Are there any alternatives that emerging markets can count on in the absence of really safe and liquid assets? I now sketch a proposal that attempts to tackle these issues.
V. Global Liquidity Insurance To begin with, consider why countries accumulate reserves. Some countries like China have built up reserves in the process of keeping their currency undervalued, thereby increasing their export competitiveness but at the cost of less balanced growth. Another objective is to accumulate reserves as insurance against volatile capital flows and to smooth associated fluctuations in aggregate consumption.
Role Reversal in Global Finance 367 Reserves can also be used to fend off attacks on the domestic currency, although this is less of a concern for countries with flexible exchange rates. It is difficult to evaluate the extent of reserve accumulation that is attributable to precautionary motives as opposed to mercantilist policies. If an alternative to self-insurance were available, one would have a more straightforward answer to this question.
How much insurance is enough? Conventional criteria suggest a level sufficient to cover six months of imports or the stock of short-term external debt maturing over the next year (the Greenspan-Guidotti rule). By these criteria, most major emerging markets had accumulated more than sufficient reserves by the early 2000s. Other criteria, related to measures of financial stability and financial openness, do a better job of explaining the incentives behind the sharp run-up in reserves during the past decade. But even with this set of augmented criteria it is difficult to fully rationalize the continued increase in reserves after the mid-2000s, especially among Asian economies.16 In any event, all such notions of reserve adequacy took a beating during the crisis. India lost about $66 billion of its stock of $305 billion of foreign exchange reserves in a matter of six months. Russia’s reserves fell by a third over a seven-month period starting from July
2008. Table 5 shows that, in a selected group of 13 emerging markets that experienced significant reserve losses, the median reserve loss was 27 percent of peak reserves over a seven-month period. Some emerging markets did not lose much of their stock of reserves; China even continued to accumulate reserves through the crisis period.
Nevertheless, with rising financial integration and ever larger positions of gross flows and stocks, in the aftermath of the crisis emerging markets face stronger incentives to obtain higher levels of insurance through the accumulation of massive stocks of reserves. Indeed, virtually all emerging markets have been rebuilding or continuing to increase their reserve stocks after 2009. The last column of Table 5 shows that, by April 2011, most of the countries that experienced major reserve losses during the crisis had rebuilt their reserve positions and were approaching or had already exceeded their pre-crisis levels of reserves.
368 Eswar S. Prasad Self-insurance tends to be costly for emerging markets that have to tie up resources in advanced economy government bonds rather than using them to meet their own physical capital investment needs.
Another cost involves the higher yields paid on domestic government bonds used to sterilize the liquidity effects of foreign inflows relative to the low yields earned on reserves held in advanced economy bonds. Some economies limit their sterilization costs through financial repression. In China, bank deposit rates are capped, allowing state-owned banks to buy central bank bonds for relatively low yields while still making a profit. Financial repression, in addition to impeding the efficient operation of financial markets, has direct costs to households.17 Such insurance may also prove expensive in the long run in terms of an eventual capital loss from the anticipated depreciation of advanced economy currencies relative to those of emerging markets or if advanced economy governments drive down the real value of their bonds through inflation.
Moreover, there is a collective action problem associated with reserve accumulation by emerging markets as it provides cheap financing for the fiscal profligacy of advanced economies while increasing the risks of future crises. During the financial crisis, the concern prevailed that if a number of emerging markets simultaneously tried to liquidate their holdings of U.S. government securities, financial markets could be further destabilized. Thus, in many ways, massive reserve accumulation makes those reserves less valuable at a time of global crisis and in fact reduces the value of insurance as it heightens global risks. Regional insurance pools can alleviate some of these problems but are likely to prove inadequate if a number of countries in a region are subject to the same shock.
How then can we obviate the motives for self-insurance by emerging markets, along with the costs and risks that the associated policies imply?
A Proposal for Global Insurance My proposal falls out in a straightforward manner from the previous discussion. The obvious answer is an insurance pool for the world’s major economies—mainly but not necessarily just for the emerging markets. Each country would pay a modest entry fee Role Reversal in Global Finance 369
Notes: This table shows the recent peak and trough of a country’s stock of foreign exchange reserves during the financial crisis. Absolute levels of reserves are in billions of U.S. dollars. The economies selected for this table are relatively large emerging markets (along with South Korea) that experienced significant reserve losses.
Sources: IMF’s International Financial Statistics, CEIC
between $1 billion and $10 billion, depending on its size as measured by GDP, to provide an initial capital base. It would then pay an annual premium for buying insurance that it could call upon in the event of a crisis.
The premium would depend on the level of insurance desired and could on average be about 5 percent of the face value of the insurance policy ($5 billion in annual premiums for $100 billion of insurance).
This premium level would be of roughly the same order of magnitude as the quasi-fiscal cost of reserve accumulation through sterilized intervention and the implied cost of a 2-3 percent annual depreciation of the reserve currencies’ values against emerging market currencies over the long term, based on productivity growth differentials.
370 Eswar S. Prasad The level of the premium in a particular year would depend not only on the level of insurance desired but also the quality of a country’s policies. There would be higher premiums for a country that chose to run large budget deficits or that accumulated large amounts of debt, thereby increasing its vulnerability to crises. The principle is analogous to car insurance, where owners of more expensive cars and riskier drivers (based on verifiable characteristics such as age and gender) face higher premiums. There would be discounts from the base level for countries that have demonstrated policy discipline.
Premiums would have to be based on simple and transparent rules.
For instance, a current account deficit larger than 2 percent of a country’s GDP triggers a higher premium. Other criteria that affect premia could be based on variables such as fiscal deficits, public debt and external debt (all relative to GDP). To keep things simple, there would be no country-specific adjustments—such as adjusting the budget deficit for business cycle conditions—that would be contentious and also difficult to deal with in real time.
The premiums would increase in a nonlinear fashion with the persistence and levels of policies that contributed to an economy’s vulnerability. A country running large budget deficits or continuing to accumulate large stocks of external debt in successive years would pay rising premiums in each of those years. In this way, the country’s contributions to rising global risks would be accounted for. Likewise there would be a nonlinear premium schedule for countries requiring larger levels of insurance relative to their economic size. As the premiums and the size of the insurance pool increased, the premiums could gradually be scaled down for all countries.
This is a transparent rules-based mechanism to strengthen the power of moral suasion to get a country to at least partially internalize the effects of its own policies on global risks. There is no stigma or signaling effect associated with the premium levels as they are based on country variables that are all public knowledge.18 The premiums could be tweaked with a novel feature—charge higher premiums of countries with policies that might serve them well individually but could drive up global risks. A country may well Role Reversal in Global Finance 371 decide that accumulating a large stock of reserves by preventing currency appreciation is in its own interest. There is not much the world could do about this other than retaliating by blocking trade from that country, which could start a trade war that hurts everyone.
So why not just charge that country a higher premium based on the size of its stock of reserves relative to GDP. Extending the automobile insurance analogy, this would be like charging a higher premium of drivers who insist on driving at a speed that is only half the posted speed limit, thereby raising the risks for other drivers who have to get around them. The premiums would not be large enough to deter a country that had legitimate needs for some self-insurance but it would be an effective tool of moral suasion against bad policies (from a global perspective) if a country had to pay higher premiums when its economy was doing well.
Operation of the Insurance System The premiums would be invested in a portfolio consisting of government bonds of the United States, euro area and Japan. In return, the Federal Reserve, European Central Bank (ECB) and Bank of Japan would be obliged to backstop the pool’s lines of credit in the event of a global crisis. This would simply institutionalize ex-ante swap arrangements of the sort that the G-3 central banks opened up ex-post during the crisis to provide liquidity to other central banks.
The insurance payout would be in the form of a credit line open for a year rather than an outright grant. The interest rate would be nonpunitive and based on the yields on short-term government securities in the countries backing up the insurance pool.