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«Role Reversal in Global Finance Eswar S. Prasad I. Introduction The global financial crisis has sparked a reconsideration of the role of unfettered ...»

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in dollars. This argument assumes that the high U.S. debt levels will not have major inflationary consequences in the United States. Another issue is that, in the process of sterilizing inflows, the People’s Bank of China (PBOC) has issued central bank bonds that are effectively liabilities denominated in renminbi and match a significant proportion of the dollar assets. Even if the capital loss on the dollar-denominated assets nets out within the government as the PBOC bonds are held by state-owned banks, the real cost is the massive financial repression needed to maintain the tightly-managed exchange rate regime.

A speech by Jose De Gregorio (2011), Chile’s central bank governor, explicitly references reserve accumulation for precautionary purposes. Obstfeld, Shambaugh and Taylor (2010) estimate a model of reserve stocks that includes M2, financial openness, ability to access foreign currency through debt markets, and exchange rate policy. These variables do better at explaining emerging markets’ reserve accumulation during the 2000s than traditional models that only include imports and external short-term debt. For other analyses of accumulation motives and criteria for reserve adequacy, see Aizenman and Lee (2007), Jeanne (2007) and Dominguez, Hashimoto and Ito (2011).

See Prasad (2009a) for a discussion of this issue in the context of China. Lardy (2010) estimates the cost to households of financial repression in China—as captured by the low or negative real interest rates paid on households’ bank deposits— at about 4 percent of GDP per annum.

Some commentators have suggested that these premiums could be linked to market-based measures of country risk as captured by debt or CDS spreads. However, policymakers will be reluctant to participate in an insurance scheme where premiums are subject to shifts in market sentiments that may or may not be based on economic fundamentals.

There is some evidence that signing up for the FCL reduced spreads on these countries’ debt, but that evidence has apparently not been sufficient to overcome the stigma effect as there have been no additional takers for the FCL. The poor cousin of the FCL is the Precautionary Credit Line (PCL), designed to “meet the needs of countries that, despite having sound policies and fundamentals, have some remaining vulnerabilities that preclude them from using the FCL.” Shockingly, only one country—Macedonia—has so far volunteered to have its policies rated as being good but not quite good enough for the PCL.

Obstfeld (2011) makes this point and discusses other impediments to the SDR becoming a global reserve currency.

Even though the insurance premiums would be invested in advanced economy

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There are of course exceptions. One is Turkey, which is in a vulnerable position as it has a large current account deficit and relies mainly on volatile portfolio equity inflows to finance that deficit.

Kose and Prasad (2010), Frankel and Saravelos (2011) and Gourinchas and Obstfeld (2011) identify rapid expansion of domestic credit in the run-up to the recent crisis as a factor that led to worse outcomes for some emerging markets, particularly those in emerging Europe.

Ye (2011) reports preliminary evidence that greater financial openness is associated with greater wage inequality among emerging market economies. Rajan (2010) discusses how, even in the United States, inequality and a feeble safety net led to distorted government policies that ultimately led to an unraveling of the financial system.

See, for instance, Krueger and Yoo (2002).

For more discussion of the potential collateral benefits of financial globalization and why they may be more important than the direct financing effects of foreign capital, see Kose, Prasad, Rogoff and Wei (2009).

See, for instance, Magud, Reinhart and Rogoff (2010). Kose, Prasad, Rogoff

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References Aizenman, Joshua, and Jaewoo Lee (2007). “International Reserves: Precautionary versus Mercantilist Views: Theory and Evidence.” Open Economies Review, Vol.

18, pp. 191-214.

Aizenman, Joshua, Menzie D. Chinn, and Hiro Ito (2010). “The Emerging Global Financial Architecture: Tracing and Evaluating the New Patterns of the Trilemma’s Configurations.” Journal of International Money and Finance, Vol. 29, No. 4, pp.


Burger, John D., Francis E. Warnock, and Veronica Cacdac Warnock (2010).

“Investing in Local Currency Bond Markets.” NBER Working Paper No. 16249.

Caballero, Ricardo J., Emmanuel Farhi and Pierre-Olivier Gourinchas (2008a).

“Financial Crash, Commodity Prices, and Global Imbalances.” Brookings Papers on Economic Activity, Fall, pp. 1-55.

Caballero, Ricardo J., Emmanuel Farhi and Pierre-Olivier Gourinchas (2008b).

“An Equilibrium Model of ‘Global Imbalances’ and Low Interest Rates.” American Economic Review, Vol. 98:1, pp. 358-393.

Cecchetti, Stephen G., M.S. Mohanty, and Fabrizio Zampolli (2010). “The Future of Public Debt: Prospects and Implications.” BIS Working Paper No. 300.

De Gregorio, Jose (2011). “Chile: Policy Responses to the Global Crisis.” Presented at Monetary Policy and Central Banking in the Post Crisis Environment. Central Bank of Chile and Global Interdependence Center, January 17, Santiago, Chile.

De Gregorio, Jose (2011). “International Reserve Hoarding in Emerging Economies.” Economic Policy Papers Central Bank of Chile, No. 40.

Dominguez, Kathryn, Yuko Hashimoto and Takatoshi Ito (2011). “International Reserves and the Global Financial Crisis.” Presented at the NBER Global Financial Crisis Conference, Bretton Woods, N.H., June.

Eichengreen, Barry, and Ricardo Hausmann (1999). “Exchange Rates and Financial Fragility.” In New Challenges for Monetary Policy. Jackson Hole Symposium, Federal Reserve Bank of Kansas City.

Eichengreen, Barry (2011). Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, Oxford University Press.

Forbes, Kristin J. and Francis E. Warnock (2011). “Capital Flow Waves: Surges, Stops, Flight and Retrenchment.” Presented at the NBER Global Financial Crisis Conference, Bretton Woods, N.H., June.

388 Eswar S. Prasad Frankel, Jeffrey, and George Saravelos (2011). “Can Leading Indicators Assess Country Vulnerability? Evidence from the 2008-09 Global Financial Crisis.” Manuscript, Kennedy School of Government, Harvard University.

Gourinchas, Pierre-Olivier, and Olivier Jeanne (2009). “Capital Flows to Developing Countries: The Allocation Puzzle.” Manuscript, University of California, Berkeley and Johns Hopkins University.

Gourinchas, Pierre-Olivier, and Maurice Obstfeld (2011). “Stories of the Twentieth Century for the Twenty-First.” Prepared for the American Economic Journal:

Macroeconomics session on Financial Crises and Macroeconomics at the American Economic Association annual meeting, Denver, Colo., January 8.

Gourinchas, Pierre-Olivier, Helene Rey and Kai Truempler (2011). “The Financial Crisis and the Geography of Wealth Transfers.” Presented at the NBER Global Financial Crisis Conference, Bretton Woods, N.H., June.

International Monetary Fund (2010). “The Fund’s Role Regarding Cross-Border Capital Flows.” November.

International Monetary Fund (2011). “Assessing Reserve Adequacy.” February.

International Monetary Fund, Fiscal Monitor (2011). “Shifting Gears Tackling Challenges on the Road to Fiscal Adjustment.” April.

International Monetary Fund, Fiscal Monitor (2011). “Staying the Course on Fiscal Adjustment.” June.

Jeanne, Olivier (2007). “International Reserves in Emerging Market Countries:

Too Much of a Good Thing?” Brookings Papers on Economic Activity 1, W.C.

Brainard and G.L. Perry, eds., pp. 1-55. Brookings Institution: Washington, D.C.

Kose, M. Ayhan, and Eswar S. Prasad (2010). Emerging Markets: Resilience and Growth Amid Global Turmoil, Brookings Institution Press.

Kose, M. Ayhan, Eswar S. Prasad and Marco E. Terrones (2009). “Does Financial Globalization Promote Risk Sharing?” Journal of Development Economics, Vol.

89:2, pp. 258-270.

Kose, M. Ayhan, Eswar S. Prasad, Kenneth Rogoff, and Shang-Jin Wei (2009).

“Financial Globalization: A Reappraisal.” IMF Staff Papers, Vol. 56, pp. 8-62.

Krueger, Anne O., and Jungho Yoo (2002). “Chaebol Capitalism and the Currency-Financial Crisis in Korea.” In Sebastian Edwards and Jeffrey Frankel, eds., Preventing Currency Crises in Emerging Markets, Cambridge, Mass.: NBER, pp.


Role Reversal in Global Finance 389 Lane, Philip R., and Gian Maria Milesi-Ferretti (2007). “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004.” Journal of International Economics, Vol. 73:2, pp. 223-250.

Lane, Philip R., and Gian Maria Milesi-Ferretti (2008). “The Drivers of Financial Globalization.” American Economic Review (Papers and Proceedings), Vol. 98:2, pp. 327-332.

Lardy, Nicholas R. (2008). “Financial Repression in China.” Policy Brief 08-8, Peterson Institute for International Economics.

Magud, Nicholas E., Carmen Reinhart, and Kenneth Rogoff (2011). “Capital Controls: Myth and Reality – A Portfolio Balance Approach.” Peterson Institute for International Economics Working Paper 11-7.

Mendoza, Enrique G., Vincenzo Quadrini, and José-Víctor Ríos-Rull (2009).

“Financial Integration, Financial Development, and Global Imbalances.” Journal of Political Economy, Vol. 117, No. 3, pp. 371-416.

Milesi-Ferretti, Gian Maria, Francesco Strobbe and Natalia Tamirisa (2010).

“Bilateral Financial Linkages and Global Imbalances: A View on the Eve of the Financial Crisis.” IMF Working Paper 10/257.

Obstfeld, Maurice (2010), “Expanding Gross Asset Positions and the International Monetary System.” 2010 Jackson Hole Symposium, Federal Reserve Bank of Kansas City.

Obstfeld, Maurice (2011). “The SDR as an International Reserve Asset: What Future?” Manuscript, University of California, Berkeley.

Obstfeld, Maurice, and Kenneth Rogoff (2009). “Global Imbalances and the Financial Crisis: Products of Common Causes.” Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Santa Barbara, Calif., October 18-20.

Obstfeld, Maurice, Jay C. Shambaugh, and Alan M. Taylor (2010). “Financial

Stability, the Trilemma, and International Reserves.” American Economic Journal:

Macroeconomics, Vol. 2, No. 2, pp. 57-94.

Prasad, Eswar S., Raghuram G. Rajan and Arvind Subramanian (2007). “Foreign Capital and Economic Growth.” Brookings Papers on Economic Activity, No. 1, pp. 153-230.

Prasad, Eswar S., and Raghuram Rajan (2008). “A Pragmatic Approach to Capital Account Liberalization.” Journal of Economic Perspectives, Vol. 22:3, pp. 149-172.

Prasad, Eswar S. (2009a). “Is China’s Growth Miracle Built to Last?” China Economic Review, Vol. 20, pp. 103-123.

Prasad, Eswar S. (2009b). “The Insurance Solution.” Wall Street Journal Asia, March 11.

390 Eswar S. Prasad Prasad, Eswar S., and Mengjie Ding (2011). “Debt Burden in Advanced Economies Now a Global Threat.” Financial Times, July 31.

Rajan, Raghuram G. (2010). Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton University Press.

Reinhart, Carmen M., and Kenneth Rogoff (2009). This Time is Different: Eight Centuries of Financial Folly, Princeton University Press.

Ye, Lei (2011). “Financial Integration and Wage Inequality.” Manuscript in

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