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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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What about the side effect of financial mercantilism, namely the cost of replenishing the weak balance sheet of the banking and financial sector? This side effect would impose a negative externality on trading partners to the extent that the cost of restructuring or provision is borne by trading partners. In practice, the foreigners’ share of the restructuring cost is typically very small, and the bulk of the cost is borne by current and future taxpayers of the country whose financial sector is restructured.

The following question can arise, considering the gigantic amount of the U.S. government securities held as international reserves (McCauley, 2005). Don’t foreigners pay for the cost, if the mercantilist country holds a large amount of foreign government securities as its international reserves? The answer to this is negative. Foreign (e.g., U.S.) government securities were purchased at market prices and represent financial transactions between a lender and a borrower. If the lender liquidates the asset in the market or transfers it to commercial banks to bolster their balance sheets, the transaction involves no transfer from the borrower to the lender, in contrast to the transfer from current and future taxpayers to the financial sector that goes on among domestic agents.

The absence or weakness of negative externality in financial mercantilism—unlike monetary mercantilism—does not imply that financial mercantilism is a highly desirable development strategy which every developing country should consider. The almost certain cost of it, namely the deepening fragility of the financial sector, suggests that it is at best a high-risk strategy, which is worth trying only when the associated return is high enough to compensate for the risk. In the case of Japan and Korea and with the benefit of hindsight, it appears to have delivered a high return during the take-off period, which may have compensated for the apparently high cost, while saddling the present policymaker with the legacy of financial fragility.

The importance of prudent macroeconomic policies should also be noted. Considering the likely burden on the financial sector over the long haul, fiscal and monetary policies should be run in a such way that minimizes the likely burden on the financial sector. Otherwise, the combination of macroeconomic and structural/mercantilist pressures on the financial sector may easily prevent the realization of dynamic externality that is the benefit of financial mercantilism. The sustained prudence of macroeconomic (especially fiscal) policies appears to have been an important contributing factor to the working of financial mercantilism in Japan and Korea.13



Circumstances where floundering growth leads to the switch from financial mercantilism to large hoarding of reserves are associated with growing fragility of the banking system. This reflects both the legacy of past borrowing, as well as the deteriorating balance sheet induced by the deterioration of the borrower’s growth prospects. The research triggered by Kaminsky and Reinhart (1999) points out that greater financial fragility increases the odds of currency crisis. Hutchison and Noy (2005) report that “… the onsets of 31% of banking crises were accompanied by currency turmoil. Furthermore, there is a statistically significant correlation between lagged banking crises and contemporaneous currency crises but not vice versa.” This observation is consistent with the insight of models of financial fragility, exemplified by Chang and Velasco (1999).

In these circumstances, precautionary motives may lead countries to hoard international reserves in order to mitigate the possible transmission of a banking crisis to currency crisis.

With limited data, such a response may be observationally equivalent to the one predicted by monetary mercantilism. Having good data about international reserves but spotty data on non- performing loans, it is hard to disentangle the precautionary hoarding from the monetary mercantilism.14 Given the sheer size of China and its reserve hoarding, however, other See Wyplosz (1996) for the discussion of the postwar French experience with government intervention in credit allocation, which is viewed to have had a limited success. Nor is the French experience viewed to have been characterized by very prudent macroeconomic policies.

In the case of China, the ratio of banks’ non-performing loans/international reserves is estimated to be in the range of about 20% (according to the Bank of China) to more than 90% (see Jim Peterson’s report at the International Herald Tribune, 9-11-2006). In Barnett (2004), non-performing loans were estimated to be 23 percent of GDP on average for 2002-03, more than 90 percent of the international reserves in 2002-03.

(continued) countries in the region may be tempted to engage in competitive hoarding in order to mitigate the competitiveness loss in third markets. These interpretations, the merit of which was discussed in Section III.A, are consistent with growing regional interest in the formation of Asian fund (for further discussion on regional funds see Eichengreen, 2006).

China’s hoarding of reserves picked up sharply after the Asian crisis. Its foreign exchange rate reserves rose from $105 billion at the end of 1996 to $820 billion at the end of 2005 (and to $950 billion in July 2006). In percent of GDP terms, this amounts to a fivefold increase, similar to that of the Japan and Korea after their respective financial crises. Unlike them, China is accumulating reserves without having gone through a sharp slowdown in economic growth. It can be viewed to be accumulating reserves in anticipation of possible deterioration in the strength of the financial sector. We conjecture that the recent history of Japan and Korea provided evidence encouraging China to adopt a dual strategy of financial mercantilism and rapid hoarding of international reserves (Figure 4). This dual strategy is reinforced by the speed of the Chinese transition from a sleepy giant to a highly open economy (by now its trade openness is more than three times that of Japan). Arguably, as much as China is growing even faster than Korea and Japan in their early years and is going through its take-off process in the era of a highly integrated global financial market, China faces much greater downside risk of social and political instability associated with a crisis than the risk that confronted Korea or Japan. This greater downside risk of recession and financial crisis may explain the Chinese eagerness both to push financial mercantilism and to buffer the downside risk of the growing financial fragility with aggressive reserve hoarding.

The prominence of financial mercantilism is supported by Aizenman and Lee (2005) and by Cheung, Chinn, and Fujii (2006). As discussed earlier, Aizenman and Lee (2005) find that reserves accumulation is more closely associated with precautionary variables—which relate to financial mercantilism—than with variables that capture monetary mercantilism. Nor do we find evidence that China’s reserve accumulation was exceptionally larger than those of other countries until 2003 or so, once the effects of standard determinants (population, GDP/capita, trade openness, etc.) are taken into account. After a detailed examination of the price level data for a panel of more than 100 countries, Cheung, Chinn, and Fujii (2006) find that China’s currency got substantially undervalued by 2004, in terms of the deviation of the price level from the international trend. However, the measured undervaluation still falls within the two standard-deviation band of the international trend, leading the authors to conclude that there is little evidence of statistically significant real undervaluation of China’s currency. Considering the difficulty with statistical inference in these issues, these results do not constitute an irrefutable proof that monetary mercantilism is absent in China, but strongly Restructuring of non-performing loans would reduce the ratio from the banks’ balance sheet, but would not eliminate the economy-wide burden of them. These numbers indicate a large uncertainty associated with estimating the economy-wide burden of financial weakness, which itself would add to the demand for precautionary hoarding.

suggest that there is more than monetary mercantilism at work behind the rapid accumulation of reserves in China.

As an interpretation of mercantilist tendencies, financial mercantilism is consistent with the apparently slow development of the financial sector in Japan and Korea, as well as in China.

When credit is channeled to export sectors with mercantilist intentions, the overall development of the financial sector is in the primary interest of neither the government nor the market. If any, weak development of the arm’s-length financial market will leave the savings in the banking system, making it easy for the government to direct credits to targeted sectors. Nor is there an immediate need to improve the credit allocation of the banking system. Financial underdevelopment is not just an unintended outcome of unbalanced development, but also a convenient coincidence which the government and market have no pressing desire to escape.

Moreover, the mercantilist push may lead to “status quo” bias: financial repression would be supported by the key players running the show as long as growth continues. The opposition to financial repression reflects mostly the interests of smaller producers, which tend to be less organized due to the free rider problem, and the inability to identify ex ante the losers from the missing activities that were not financed due to financial repression. This bias may be an example of the incumbent bias against financial development, espoused by Rajan and Zingales (2003).


International reserves held by three East Asian countries of China, Japan, and Korea have exceeded 2 trillion dollars by the summer of 2006. The sheer amount of their reserves, combined with their relentless increase, has aroused a strong suspicion of mercantilist intervention. This interpretation, however, harbors its share of difficulty. It would have been no small feat to keep the real exchange rate undervalued by monetary means for the span of a decade. Nor has it been easy to produce conclusive evidence of massive and persistent undervaluation in the real exchange rate of China, which is the prime target of the suspicion.

Drawing on existing studies, we provided a heuristic argument for an alternative understanding of the accumulation of reserves in these countries. If the mercantilist push refers to the growth strategy based on export orientation, Japan and Korea may be viewed to have relied on mercantilist push for much of the years of rapid growth. However, the means of decades-long mercantilist push are better sought in the financial-sector-based instruments, rather than the monetary instruments whose real effects are unlikely to stretch over decades.

Financial mercantilism carries a cost, in the form of heightening fragility in the financial sector, which needs to be reckoned with at some stage. The reckoning appears to have come through financial crises, of a purely domestic variety for Japan and of an international variety for Korea. Subsequent to that, the precautionary motive provides a strong impetus for reserve accumulation.

Additional stimulus to reserve accumulation could have been provided by the possible competitiveness gain of monetary mercantilism, which reduces the perceived cost of precautionary hoarding of international reserves. Monetary mercantilism, when pursued simultaneously by countries with interdependent trade structures, could result in competitive hoarding. The negative externality can push the reserve hoarding beyond the desired precautionary level. Regional pooling of reserves can be one method to internalize the negative externality of competitive hoarding.

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-2 10 -4



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The lower panel presents the reserves-to-GDP ratios divided again by the ten-year averages of the reserves-toGDP ratios themselves (1987-1996 for Korea and 1982-1991 for Japan).

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HH and FF are the home and foreign reaction functions, respectively.

Point S is the non-cooperative equilibrium. Point O corresponds to the cooperative outcome.

The above plot corresponds to the reaction functions in a symmetric world, g = 2, b = 10.

In percent of GDP


-5 China

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Aizenman, Joshua, and Nancy P. Marion, 2003, “The High Demand for International Reserves in the Far East: What’s Going On?” Journal of the Japanese and International Economies, Vol. 17, pp. 370–400.

———, 2004, “International Reserves Holdings with Sovereign Risk and Costly Tax Collection,” Economic Journal, Vol. 114, pp. 569–91.

Aizenman, Joshua, and Jaewoo Lee, 2005, “International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence,” NBER Working Paper No. 11366 (Cambridge, Massachusetts: National Bureau of Economics Research).

Amsden, Alice H., 1989, Asia’s Next Giant: South Korea and Late Industrialization, (New York: Oxford University Press).

Barnett, Steven, 2004, “Banking Sector Developments,” in China’s Growth and Intergration into the World Economy, edited by Eswar Prasad, IMF Occasional Paper No. 232 (Washington: International Monetary Fund), pp. 43–50.

Ben-Bassat, Avraham, and Daniel Gottlieb, 1992, “Optimal International Reserves and Sovereign Risk,” Journal of International Economics, Vol. 33, pp. 345–62.

Caballero, Ricardo, and Stavros Panageas, 2004, “A Quantitative Model of Sudden Stops and Liquidity Management,” (unpublished; Cambridge, Massachusetts: MIT).

Caballero, Ricardo, Emmanuel Farhi, and Pierre-Olivier Gourinchas, 2005, “An Equilibrium Model of Global Imbalances and Low Interest Rates,” (unpublished; Cambridge, Massachusetts: MIT).

Chang, Roberto, and Andres Velasco, 1999, “Liquidity Crisis in Emerging Markets: Theory and Policy,” NBER/Macroeconomics Annual, pp. 11-57.

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