Economic Management in a Volatile Environment

China is the world’s largest international holder, having amassed about US$ 2 trillion of international reserves by the end of 2008 (Figure 1.1), rising to US$ 3 trillion by 2010.¹ The rapid accumulation of reserves by China has generated several controversies. One concern is whether this continuing balance of payments (BOP) surplus signals the need for a substantial revaluation or appreciation of the Chinese Yuan (CNY) to protect China both from the inflationary consequences of the liquidity buildup and a misallocation of resources² as well as to help ease global imbalances. An alternative view, particularly associated with McKinnon and Schnabl (2003a,b; 2004), argues that a fixed exchange rate is an optimal policy for China and the larger Asian region both on the grounds of macroeconomic stability and rapid economic development. The global monetarist approach of McKinnon is based on the assumption of little or no sterilisation of reserve accumulation, so that any BOP imbalance is temporary. However, many other commentators have suggested that the Chinese government’s concern with inflation has led the People’s Bank of China (PBC) to heavily sterilise these reserve inflows.³

The real exchange rate (RER) is one of the most important price variables in macroeconomics as changes in it have implications for both external competitiveness as well as internal sectoral resource allocation. Accordingly, a great deal of attention has been paid to the causes of real exchange rate volatility. Broadly, there are four sets of literature in this area. The first focusses on linking RER volatility to the exchange rate regime and, in particular, the rise in volatility as a country shifts from fixed to flexible regimes — so-called “Mussa puzzle” (Stockman, 1983; Mussa, 1986). The second set of literature employs Vector Auto Regression (VAR) methods and variance decomposition techniques to estimate the relative contributions of real and nominal shocks to RER fluctuations (for example, see Clarida and Gali, 1994; Enders and Lee, 1997; Lastrapes, 1992; and Rogers, 1999). The third deals with the fundamental determinants of the long-run equilibrium RER (such as productivity, government spending, net foreign asset position, etc.) (for instance, see MacDonald, 2000; Ricci et al., 2008). A closely related literature attempts to determine the drivers of long-run deviations from purchasing power parity (PPP) and focusses on the reasons behind the well-known “PPP puzzle” Froot and Rogoff (1995) and Rogoff (1996) offer authoritative surveys. This literature also recognises the time-varying nature of the long-run RER which could evolve over time based on a set of economic and financial fundamentals.

There is a burgeoning literature on the role and efficacy of capital controls. At the risk of generalising, most of the literature has found that controls on capital inflows are more effective than on outflows, and they are also more effective at altering the composition of inflows rather than the magnitude of inflow surges per se. In particular, controls seem to play a role in raising the average maturity structure of capital inflows (Binici et al., 2010 and references cited within), presumably making the country somewhat less susceptible to sudden stops and accompanying adjustment costs. However, this advantage comes with a cost, namely, there is evidence that capital controls on inflows tend to raise the cost of capital especially to small and medium sized enterprises (SMEs) (Forbes, 2007). However, most of the cross-country macro literature on the subject tends to be somewhat aggregated in nature, focussing only on the extent of capital flows, often failing to distinguish between the composition of capital flows and, more importantly, not differentiating between gross versus net flows.¹

Developing countries are caught in a dilemma in terms of exchange rate policy. When macroeconomic policies are inconsistent with an exchange rate peg, and domestic prices and costs are sticky, real exchange rates will become misaligned, allowing currencies to be vulnerable to speculative attacks. However, eradicating misalignments by devaluation can itself create problems. Not only are there political constraints, as devaluation is seen as a badge of failure, but also devaluation can spark off an inflationary impulse as well as cause additional speculation that pushes the currency into free fall. It may then prove difficult to engineer a “soft landing”.¹

International reserves were an important subject of the international finance literature in the 1960s and the 1970s, but interest dwindled with the collapse of the Bretton Woods system. The issue received renewed attention after the Asian Financial Crisis (AFC) in 1997 when developing and emerging market economies (EMEs) in Asia (and later the oil producers) started accumulating large stockpiles of reserves. This interest was further augmented by the global financial crisis (GFC) of 2008–2009 wherein some authors pointed to the fact that countries which held more reserves did better than those with lower levels of reserve holdings (Aizenman, 2009a; IMF, 2011). They suggested that the GFC led to a short period of reserve depletion toward the end of 2008 and early 2009, after which there has been a renewed acceleration in reserve accumulation in many of the EMEs.

The Eurozone crisis, that began in 2009, most badly affected the Southern Eurozone countries consisting of Greece, Ireland, Italy, Portugal and Spain (GIIPS). A combination of extremely sluggish growth and harsh fiscal consolidation forced these economies to undergo a painful process of deleveraging to reduce their high public and private debts. Also, facing a rapidly ageing population that is likely to add to greater stress to their future fiscal burdens, there is a growing need for these countries to undertake painful structural reforms (“internal devaluation”) to restore their lost competitiveness and get back on a fiscally sustainable growth path.

Over the last two decades, several developing and emerging market economies (EMEs) have embraced domestic as well as international financial liberalisation. While there is considerable heterogeneity in the details of the policy mixtures adopted by individual countries, the broad contours have remained constant across the board, with most countries opening up their economies to cross-border flows of private capital and their financial systems to both domestic and foreign entrants.

Several EMEs have eased the regulatory norms for the entry of foreign banks over the last two decades as an integral component of their financial sector liberalisation policies (see Chapter 7). One of the important reasons why they allowed foreign banks into their economies was because of the much needed funds foreign banks could help bring in to recapitalise their domestic banking systems. While the immediate motivation was related to the financing issues, foreign bank entry impacts the domestic banking system of the host economy in numerous other ways. For instance, foreign banks could facilitate reductions in cost structures, contribute to improvements in operational efficiency through introduction and application of new technologies and banking products, enhance marketing skills and management, as well as strengthen corporate governance structures (Claessens et al., 2001). In relation to this, as some studies note, foreign banks could enhance the quality of human capital in the domestic banking system by importing highly skilled personnel to work in the local host subsidiary, as well as via knowledge spillovers to local employees which may in turn benefit the customers in terms of access to new financial services (See among others, Levine, 1996; Claessens and Glaessner, 1998).

In Chapter 8, we examined how foreign bank entry in EMEs has generally been associated with fostering greater operational efficiency in the domestic banking system mainly through the introduction of new technologies and banking products as well as facilitating a reduction in cost structures. In general, there is evidence to show that foreign banks contribute to reduced costs of financial intermediation resulting in greater credit availability facilitating overall financial development (Claessens et al., 2001). But at the same time, there is greater ambiguity about the relationship between foreign bank entry and firms’ access to credit in EMEs (Clarke et al, 2006).

As we saw in previous chapters, one of the important characteristics of deepening financial integration that has occurred in several emerging market economies (EMEs) over the last two decades has been the increasing importance of foreign bank entry in domestic banking systems. As noted in Chapter 7, even though there exists considerable variation among countries and regions, over the period 1995 to 2009, the average share of foreign banks (in terms of numbers) has increased from 20 per cent to 34 per cent while in terms of assets, the share has grown from 22 per cent in 1996 to about 44 per cent in 2009 (Claessens and Van Horen, 2011).¹