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«WP/06/280 Financial Versus Monetary Mercantilism: Long-Run View of Large International Reserves Hoarding Joshua Aizenman and Jaewoo Lee © 2006 ...»

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WP/06/280

Financial Versus Monetary Mercantilism:

Long-Run View of Large International

Reserves Hoarding

Joshua Aizenman and Jaewoo Lee

© 2006 International Monetary Fund WP/06/280

IMF Working Paper

Research Department

Financial Versus Monetary Mercantilism: Long-Run View of Large International

Reserves Hoarding

Prepared by Joshua Aizenman and Jaewoo Lee 1

Authorized for distribution by Gian Maria Milesi-Ferretti December 2006 Abstract This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

The sizable hoarding of international reserves by several East Asian countries has been frequently attributed to a modern version of monetary mercantilism—hoarding international reserves in order to improve competitiveness. From a long-run perspective, manufacturing exporters in East Asia adopted financial mercantilism—subsidizing the cost of capital— during decades of high growth. They switched to hoarding large international reserves when growth faltered, making it harder to disentangle the monetary mercantilism from a precautionary response to the heritage of past financial mercantilism. Monetary mercantilism also lowers the cost of hoarding through its short-term boost to external competitiveness, but may be associated with negative externalities leading to competitive hoarding.

JEL Classification Numbers: F15, F31, F43 Keywords: Mercantilism, cost of capital, competitive real depreciations, self insurance, precautionary hoarding Authors’ E-Mail Addresses: jaizen@ucsc.edu; jlee3@imf.org We appreciate comments by Gian Maria Milesi-Ferretti, Charles Wyplosz, and Alessandro Zanello, but are solely responsible for all errors and misinterpretations.

Contents Page I. Overview

II. Financial Versus Monetary Mercantilism over the Decades: 1970–2005

III. The Hazard of Competitive Hoarding

A. A “Mercantilist” Case for Pooling Reserves in East Asia

B. Do Financial Mercantilists Beggar Their Neighbors?

IV. Bank Fragility: On the Observation Equivalence of Monetary Mercantilism and Self-Insurance

V. Conclusion

References

Figures

1. Japan and Korea: Foreign Exchange Reserves and Economic Growth

2. Competitive Hoarding

3. History of Current Account Balances in East Asia

4 China: Foreign Exchange Reserves and Economic Growth

I. OVERVIEW

The growing stockpiles of international reserves held by emerging markets have prompted a considerable debate. Among the explanations advanced, Dooley, Folkerts-Landau, and Garber (2005) took the perspective of modern mercantilism—hoarding international reserves as part of a deliberate development strategy, which facilitates growth by maintaining an undervalued real exchange rate. They also opined that international reserves potentially served as “collateral” for encouraging foreign direct investment. This interpretation takes for granted the advantages of an outward-oriented growth strategy, viewing hoarding reserves as an integral part of it.

An alternative interpretation for the sizable hoarding of international reserves is the selfinsurance/precautionary demand, as described in Ben-Bassat and Gottlieb (1992) that viewed international reserves as output stabilizers. International reserves can reduce the probability of an output drop induced by capital flight and/or the depth of the output collapse when the sudden stop materializes. Aizenman and Marion (2003) attributed the large increase in international reserves in Korea and other East Asian countries to the aftermath of financial crises during the 1990s. Similar views have been voiced by researchers who used more elaborate models (see Lee, 2004; Garcia and Soto, 2004; Aizenman and Lee, 2005; and Jeanne and Ranciere, 2005). These authors concluded that part of the large increase in reserves is consistent with self-insurance motives in the presence of sudden-stop risks.2 Rodrik (2005) also pointed out that increasing the ratio of international reserves to short-term debt can be achieved by combining reserve accumulation with a reduction in short-term debt exposure.3 In Aizenman and Lee (2005), we evaluate the relative importance of these approaches by augmenting the conventional econometric specifications for international reserves with new variables associated with the mercantilism and selfinsurance/precautionary demand approaches. While variables associated with both approaches are statistically significant, the self-insurance variables play a greater economic role in accounting for recent trends.

Another self-insurance interpretation deals with precautionary hoarding of international reserves needed to stabilize fiscal expenditure in developing countries in the context of Barro’s distortion smoothing (see Aizenman and Marion, 2004). Specifically, a country characterized by volatile output, inelastic demand for fiscal outlays, high tax collection costs, and sovereign risk may want to accumulate both international reserves and external debt. External debt allows the country to smooth consumption when output is volatile.





International reserves that are beyond the reach of creditors would allow such a country to smooth consumption in the event that adverse shocks trigger a default on foreign debt. Political instability, by taxing the effective return on reserves, can reduce desired current reserve holdings. The tests reported by Aizenman and Marion (2004) are consistent with this interpretation.

Hence, Rodrik (2005) suggests that emerging markets over invested in the costly strategy of reserve accumulation and underinvested in capital-account management policies to reduce their short-term foreign liabilities.

The purpose of the present paper is to infer the association between mercantilism, economic growth, and hoarding reserves by looking at the development strategies of East Asian countries during recent decades. Taking a long-run perspective is useful because the outward growth orientation of East Asia goes back more than four decades, whereas the sizable hoarding of international reserves started in the early 1990s. The history of the region suggests the prevalence of export promotion by preferential financing, which effectively subsidized investment in targeted sectors. This was achieved in several ways, including direct subsidies funded by state banks, or by means of financial repression where favored sectors enjoyed preferential access to cheaper external borrowing, or via “moral suasion” where private banks were encouraged to provide favorable financing. We refer to this policy as financial mercantilism, and contrast it with monetary mercantilism, a policy that hinges on hoarding international reserves.4 These two mercantilist approaches differ both in terms of transparency and the economic channels at work. Financial mercantilism is frequently less transparent and may promote exports in the long run independently of the nature of the monetary regime. In contrast, monetary mercantilism is directly linked to hoarding reserves, thereby having direct monetary implications, and its efficacy is bounded by the flexibility of price and wage adjustment in response to monetary policy. Yet, both forms of mercantilism are associated with economic costs and may lead to unintended adverse consequences.

The history of Japan and Korea suggests the (near) absence of monetary mercantilism during the phase of fast growth. Abounding anecdotal evidence, occasionally supported by more Wyplosz (2002) used the expression in a similar context: “…financial mercantilism, i.e., the desire to keep domestic savings home in order to finance domestic investment and growth.” Favorable financing [what we dub financial mercantilism] and favorable treatment of successful producers as a means of encouraging exports was

part of the classical mercantilism:

“Most of the mercantilist policies were the outgrowth of the relationship between the governments of the nationstates and their mercantile classes…These policies took many forms. Domestically, governments would provide capital to new industries, exempt new industries from guild rules and taxes, establish monopolies over local and colonial markets, and grant titles and pensions to successful producers.” (The Concise Encyclopedia of Economics, 2006, Mercantilism, by L. LaHaye.) “As conventionally pictured, mercantilism was a long chapter of simple coherence in the history of European economic thought and national economic policy, extending from roughly 1500 to 1800. With diverse expositors and practitioners scattered far over space as well as time, it was intended to promote production and commerce of private entrepreneurs who benefited from and contributed to the consolidation, prosperity and power of nation-states, with foreign trade being the most strategic variable.

......The precepts and proposals of mercantilism were the economic component of state-building, providing much of the rationale and suggesting some of the procedures of national unification, seen especially in England, France and Spain. Men of trade sought the protection and the order essential for expansion of their activity, as well as monopolistic subsidization of their ventures from the crown.” (The New Palgrave: A Dictionary of Economics, 1987, Mercantilism, by William R. Allen.) detailed analysis, suggests that financial mercantilism had been vigorously applied during the phase of rapid growth. In both countries, the switch to large hoarding of international reserves happened at times of collapsing growth. Thus, if monetary mercantilism played any significant role in these countries, it was adopted in periods of disappointing growth.

We discuss in detail the implications of these regularities. The legacy of financial mercantilism led to deteriorating balance sheets of affected banks. The resultant financial fragility is more sustainable in times of rapid growth, but it may induce banking crises when growth flounders. As the switch to large hoarding of reserves coincides frequently with the collapse of growth, it is difficult to disentangle monetary mercantilism from precautionary hoarding that is intended to mitigate the growing risk of currency crises induced by financial fragility. Moreover, monetary mercantilism and precautionary hoarding may be mutually complementary: the competitiveness benefit may reduce the effective cost of hoarding reserves and induce governments to prefer reserve-hoarding over alternative precautionary means.5 Furthermore, monetary mercantilism is associated with negative externalities akin to competitive devaluation. Hoarding international reserves motivated by short-run competitiveness concerns of one country may trigger other countries to adopt a similar policy, to preempt any competitive advantage gained by the first country. These circumstances may lead to competitive hoarding of reserves, which in turn would dissipate any competitiveness gains. We provide a simple framework illustrating the welfare losses associated with competitive hoarding. These losses may provide a novel argument in favor of regional funds, viewed as a mechanism to cope with regional negative externalities.

It is not our intention in this paper to offer a normative statement on the pros and cons of what we call financial and monetary mercantilism. The normative question can be answered only by carefully quantifying all costs and benefits of the two varieties of mercantilism, and then by comparing the welfare of diverse agents who are differently affected by them.

Instead, we offer a positive long-run interpretation of the forces behind the phenomenal hoarding of international reserves by several countries.

The rest of the paper is organized as follows. Section II discusses the phases of financial and monetary mercantilism for Korea and Japan. Section III discusses their economic implications both domestically and internationally, including the logic of competitive hoarding and a case for regional pooling. Section IV discusses the near observational equivalence between monetary mercantilism and the precautionary hoarding, and Section V concludes.

For the discussion of efficiency of reserves as means of precaution, see Caballero and Panageas (2004), and Lee (2004). Rodrik (2005) offered a similar critique, by calling for simultaneous reduction of reserves and short-term external debt.

II. FINANCIAL VERSUS MONETARY MERCANTILISM OVER THE DECADES: 1970–2005 We start with a case study of Japan and Korea during the last 35 years. Figure 1 traces the International reserves/GDP (along the left scale) and the GDP per capita growth rate (along the right scale) in both countries, where the horizontal dotted line corresponds to zero growth rate. We center the time line at the 1997 financial crisis for Korea and the beginning of the relative stagnation in Japan, around1992. Intriguingly, in both countries international reserves were almost flat at a low level during the years of rapid growth and “took off” during periods of relatively sluggish growth, from the early 1990s in Japan and from 1998 in Korea. Compared to the average over the decade prior to crisis, the foreign exchange reserves in percent of GDP rose by nearly fivefold after 8-10 years since the crisis.

There is a significant body of evidence that financial mercantilism played an important role during the phases of rapid growth of Japan and Korea (see Amsden, 1989; Kim and Leipziger, 1993; Noland, 2005; Rodrik, 1995; Noland and Pack, 2003; and Doi and Hoshi, 2002). Financial mercantilism operated at the background of financial repression and considerable involvement of the government in the allocation of credit. Because financial mercantilism operated under conditions of limited transparency, quantifying the magnitude of these subsidies remains a challenge. The better documented experience of Japan, however, indicates that the order of magnitude of these subsidies has been staggering. For example,

Doi and Hoshi (2002) reported:



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