Capital account opening, international reserves, and development: evidence and some policy controversies.

• Author: Aizenman, Joshua
• Position: Research Summaries

One salient feature of the global economy over the last 20 years has been the embrace by developing countries of financial reforms, leading to growing opening of capital accounts. The adjustment process to financial integration has been rocky: growing financial opening frequently has been associated with financial crises. Literature on the subject has led to a spirited debate concerning the wisdom of unrestricted capital mobility between the OECD and emerging markets. (1) Notwithstanding this debate, the strongest argument for financial opening may be a pragmatic one. Like it or not, greater trade integration erodes the effectiveness of restrictions on capital mobility. Hence, for successful emerging markets that engage in trade integration, financial opening is not a question of if, but rather of when and how. Consequently, the pragmatic approach to the problem should recognize that there is no quick fix to exposure to financial crises induced by financial opening. Instead, the challenge is to reduce the depth and frequency of the crises. This report reviews some of my recent research on these issues.

Limited Access to International Financial Markets and the Precautionary Demand for International Reserves by Developing Countries

One frequent by-product of financial opening has been financial crises. A possible mechanism that explains these crises is the inflow of short-term capital in the aftermath of financial opening (inflows dubbed as "hot money"). These short-term flows are "footloose," subject to abrupt reversal, exposing the developing country to greater hazard of a liquidity squeeze, occasionally leading to full-blown financial crises. Nancy Marion and I show that hoarding foreign exchange reserves may serve a useful role in dealing with exposure to such crises. (2) These findings are consistent with the observation that since the 1997-8 Asian financial crises, monetary authorities in emerging markets in East Asia have more than doubled their stockpiles of foreign exchange reserves.

Marion and I start by conducting statistical analyses to explain the holdings of international reserves by developing countries, using the conventional variables employed in the literature. We extend these analyses by adding two political measures that may lower the demand for reserves. We confirm that an increase in an index of political corruption significantly reduces reserve holdings, as does an increase in the probability, of a change in government leadership. Our research leads us to conclude that the recent large buildup of international reserve holdings in East Asia is motivated by the experience of the recent Asian financial crisis. (3) Therefore, we examine the possibility that the buildup may represent "precautionary" holdings, and find two situations that can give rise to increased demand for such holdings. (4)

The first is the government's desire to "smooth consumption"--that is, to spread over time the costs of shocks. When countries' access to capital markets is diminished, and when it is costly to either raise taxes or cut government spending, then countries will find it desirable to hold large precautionary reserve balances. The model also helps us to understand why some developing countries have chosen not to hold large precautionary reserve balances. Specifically, countries that strongly favor current consumption, that experience political instability, or that suffer from political corruption face a lower effective return on holding reserves and will accumulate more modest stockpiles.

The second situation leading to a buildup of reserves is "loss aversion" after the 1997-8 Asian financial crises. Loss aversion is the tendency to be more sensitive to reductions than to increases in consumption. (5) We show...