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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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“When the FILP (Fiscal Investment and Loan Program) started in the 1950s, financing the economic recovery was the most important goal for the government. Hence, the FILP heavily targeted the industrial financing through the Japan Development Bank (predecessor of the present Development Bank of Japan) and other government financial institutions.

… The Fiscal Investment and Loan Program (FILP) in Japan collects funds through government financial institutions (most notably postal savings) and use the funds to finance public projects undertaken by government-affiliated corporations or to finance government loans to borrowers in targeted areas (targeted industries, small firms, mortgage borrowers, etc.). Many countries have government sponsored loan programs. The Japanese program is distinguished in its size. As of the end of fiscal 2000 (March 2001), for example, the outstanding amount of the FILP stood at more than 80% of GDP. The postal savings, which is the most important source of funds for the FILP, is the world’s largest financial institution, accepting 35% of total household deposits as of the end of fiscal 2000.” The legacy of this strategy is the growing fragility of the banking system, an issue that becomes more transparent when growth flounders, as has been the Japanese experience.6 Doi and Hoshi (2002) report that “Our estimates suggest as much as 75% of the FILP loans are bad. The expected losses are likely be 16% of GDP, or higher.” Figure 1 suggests that floundering growth may have provided the impetus towards both precautionary hoarding and monetary mercantilism, augmenting or replacing the credit subsidy with hoarding reserves. This switch may be triggered by budgetary/precautionary concerns related to the growing weight of bad loans, or/and as a “last resort” attempt to revitalize declining growth. Moreover, the two motives can reinforce each other. When the financial sector is saddled with non-performing loans, the government would want to make provisions against these loans (see Krueger, 2002, for a discussion of prevailing standards for provisions). The mercantilist benefit of maintaining a competitive exchange rate reinforces the attraction of hoarding reserves as a means of making provisions for financial fragility, compared to other means that do not help to maintain a competitive exchange rate— including structural reforms that strengthen the financial sector.

The two forms of mercantilism differ considerably. Financial mercantilism operates through the direct cost of investment, and may increase investment in enduring ways. In its incarnation as an export-oriented growth strategy in East Asia, financial mercantilism can improve long-run economic efficiency when there are strong dynamic externalities in the economy, such as learning by doing and knowledge spillovers. In general, the case for financial mercantilism remains debatable, and may hinge on government ability to precommit and the nature of the strategic interaction among competitors.7 Dynamic externalities have often been postulated in models of economic growth in the name of knowledge accumulation or learning by doing, exemplified by Romer (1990) and the followup literature.8 While we don’t argue that the case for export subsidies is watertight and universal, the revealed preferences of policymakers in Japan and Korea indicate their presumption that the gains from such subsidies in the early development stages warranted It is difficult to disentangle the historically cumulated fragility from that which might have been generated by the property boom during the pre-crisis decade. However, suggestive evidence is provided by Iwamoto (2002) who reports that the FILP loans averaged 5 percent of GDP since the mid-1950s, buttressing the possibility that a large part of the bad FILP loans originated during the earlier decades.

For example, Leahy and Neary (1999) show conditions under which optimal export subsidy is increasing the rate of learning with government precommitment but decreasing it without. See Fundenberg and Tirole (1983) for study of learning by doing in a closed economy, and Spencer and Brender (1983) for a model of international R&D rivalry and industrial policy.

The often cited “Dutch disease” also postulates a variant of dynamic externality, though applied to the detriment of an economy in which the activity in the sector with dynamic externality declines in response to a favorable external shock, often in commodity exports [Krugman (1987)]. For financial development, Lee (1996) discusses financial underdevelopment trap that hinders the accumulation of information through learning by doing.

financial mercantilism. Indeed, some observers made the case that, with proper implementation, such policy worked well for these countries.9 In contrast, for monetary mercantilism to be potent, prices and wages should adjust in an extremely sluggish manner, and trade rivals should refrain from adopting similar policies. If other countries adopt similar mercantilist policies, they can undermine the exchange rate effect of the mercantilist attempt by the home country and lead to a competitive real depreciation. In addition, the speed of price adjustment determines the time frame over which monetary mercantilism can remain effective. Monetary mercantilism would have sizable effects usually as long as monetary policy has real effects—typically the duration of a business cycle. Little evidence exists that monetary policy can have long-run effects beyond that, and certainly not over the duration of economic growth for a whole generation. Even if monetary mercantilism succeeds in keeping the nominal exchange rate at a desired level, inflationary pressures will erode competitiveness by appreciating the real exchange rate.

Both types of mercantilism come with a cost, too. Financial mercantilism increases financial fragility, and may lead to abuse and overinvestment in inefficient activities. Cumulated over time, the cost may turn into a significant macroeconomic hazard, either culminating in a macroeconomic crisis or calling for a sizable precautionary undertaking ahead of a fullblown crisis. Monetary mercantilism is frequently associated with costly sterilization, which may be outweighed by short-term competitiveness gains if other countries do not follow similar policies. If they do, monetary mercantilism may lead to a competitive hoarding described below, which renders even its short-lived mercantilist benefit ineffectual.


Monetary mercantilism is subject to negative externalities, akin to competitive devaluation.

Countries that compete in similar third-market destinations may end up following a policy of competitive hoarding, which in the symmetric case would not alter their competitiveness but would lead to large hoarding. To exemplify this concern, we focus on a simple example of two symmetric countries, H and F, in a one-shot game. Both counties start with international * reserves at levels R0 ; R0, respectively. For notational simplicity, we assume a symmetric initial hoarding, R0 = R0 = 1. The initial international reserve stocks may reflect selfinsurance/precautionary demand and other, nonmercantilist motives. 10 Hoarding more reserves by H is assumed to depreciate H’s real exchange rate, thereby improving H’s shortrun competitiveness vis-à-vis country F. We model this situation assuming that H’s net exports depend positively on the relative hoarding of international reserves of the two countries, NE = X 0 [1 + g log(1 + R − R*)], where R and R* are the actual international See World Bank (1993).

Alternatively, these levels can be viewed as the optimal levels of reserves, which have been approached from a variety of viewpoints in aforementioned papers.

reserve levels of country H and F, respectively. Hoarding international reserves comes at a quadratic cost, reflecting costly sterilization and other indirect costs. The policymaker in

country H maximizes the following reduced form “utility”:

–  –  –

The parameter g reflects net export’s responsiveness to hoarding international reserves, and b reflects the costs of sterilization. A similar situation confronts country F. Assuming X 0 = 1,

the reaction functions in a symmetric world are:

–  –  –

In contrast, the cooperative equilibrium yields R = R* = 1. Figure 2 plots the reaction functions, where the symmetric Nash equilibrium is at point S, whereas the cooperative outcome is at point O. Consequently, competitive hoarding is associated with welfare cost of

0.5 g 2 / b = 0.5 gχ. Greater substitutability between the exports of two countries and lower sterilization costs would magnify the externality associated with hoarding international reserves. Both conditions are more likely to be met in countries exporting manufacturing goods, subject to financial repression.

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

An unintended consequence of competitive hoarding is excessive reserves, where the competitive gains are dissipated. The inefficiency associated with competitive hoarding may provide the impetus for the formation of institutions that would allow coordination. For example, an “Asian International Reserve Fund” may provide an umbrella institution that would commit the countries to refrain from competitive hoarding.11 The greater importance This is an example of the usefulness of institutions in dealing with competitive externalities. Melitz (1996)

points out that these concerns in the context of the EMU project:

–  –  –

of manufacturing in East Asia relative to Latin America, and the deeper financial repression in some East Asian countries suggests that the case for an Asian fund is stronger than that for a similar regional fund among Latin American countries.12 While financial mercantilism does not necessarily impose a negative externality on trading partners (Section III.B), monetary mercantilism impacting the real exchange rate does and can even lead to a Pareto-inferior equilibrium among monetary mercantilists themselves. The observational near-equivalence between monetary mercantilism and precautionary hoarding (to be discussed in Section IV) makes it difficult to infer the extent of competitive hoarding driven by monetary mercantilism. Regional pooling arrangement, can alleviate the pressure of competitive hoarding and enable countries to focus better on precautionary hoarding.

This rationale for regional pooling is independent of the risk-sharing argument, which in fact militates against regional pooling. If the risks facing countries in the region are more positively correlated among themselves than with those facing countries outside the region, risk sharing outside the region will dominate the risk sharing that can be attained within a region. And there is ample evidence for a strong regional correlation of risks. Be it due to trade links or to pure sentiments, financial contagion has been much stronger among countries in the same region. Overall macroeconomic risks have also been found to provide a much greater scope of risk sharing among countries beyond than inside a regional boundary (Imbs and Mauro, (2006).

Once monetary mercantilism is out of the way, the desirable magnitude of precautionary hoarding may decline. Pooling reserves would also provide a side benefit of reducing the scope of unwarranted contagion, potentially reducing the optimal self-insurance of countries in a region with significant overlap of the trade vector across countries. The future course of financial mercantilism will be partly determined by the opportunity for dynamic externality.

Once the expectable dynamic efficiency gain falls below the cost of static distortion, the efficiency rationale for financial mercantilism will lose validity.

B. Do Financial Mercantilists Beggar Their Neighbors?

Financial mercantilism differs from monetary mercantilism in the extent of negative externalities for trading partners. What we call financial mercantilism (an outward-oriented growth strategy by means of financial support), can in principle proceed with no beggar-thyneighbor trade externality. Financial mercantilism promotes the export sector, which results in the shift of comparative advantage as the dynamic efficiency gains are realized. The avoiding competitive devaluations in the initial phase of EMU when there will be both "ins" and "outs." One of the benefits of EMU that its proponents often have in mind is a certain degree of cooperation in the formation of policy.” The presumption is that the real exchange rate has greater consequences on the competitiveness of manufacturing exporters than on countries specializing in exporting commodities and raw materials.

benefit of efficiency gains improves the welfare of both home and foreign consumers, and has the potential to compensate for the static efficiency losses that may arise in the subsidy phase.

Static efficiency losses that fall on trading partners are the excessive promotion of exports and the consequent job losses in the importing countries. The resulting costs are difficult to quantify, because sector-level transition—involving job destruction in some sectors and job creation in others—is the other side of the coin to the benefit of international trade.

Nevertheless, the suspicion of a beggar-thy-neighbor effect runs high when a large current account surplus is realized. Financial mercantilism, however, can proceed with any level of current account balance, namely surplus, zero balance, or even a deficit. Indeed, over the course of rapid growth during the past several decades, Korea and Japan did not always run large current account surpluses (Figure 3).

The negative externality of the two varieties of mercantilism can be compared by considering the relative prices that are targeted by them. Monetary mercantilism purports to alter the relative price between home and foreign exports, and can work only by undermining the competitiveness of foreign exports. Financial mercantilism, on the other hand, purports to alter the relative price of capital, in order to facilitate expansion of the sector with dynamic externalities. Pushed beyond a threshold, the lower cost of capital can also end up having a similar effect on the relative competitiveness of foreign exports as the monetary mercantilism, but it is one possible consequence rather than being the only consequence or the objective.

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