CAPITAL FLOWS, SUDDEN STOPS, AND INTERNATIONAL RESERVES

 

International financial flows can bring substantial economic benefits to both lending and borrowing countries. However, they have proved too often be unstable, with capital flow surges being followed by sudden stops. Both phases of this instability can impose high costs on the receiving countries. In the inflow stages such flows can generate unwanted pressures for currency appreciation and/or domestic inflation and on the outflow stage they can contribute to currency and financial crises that impose great economic costs. Only a portion of this instability can be explained by changing economic conditions. Thus we need to look beyond the popular economic models based on far sighted rational expectations. Our studies of financial contagion during crises find, on the other hand, that irrational panic does not provide a full explanation either. 

Thus one major focus of our research in this area is to develop a better understanding of international capital flows based on such factors as rational herding where information is limited and costly, the role of popular mental models, moral hazard, internal incentive structures, and the various explanations being developed in the literature on behavioral and neuro finance. The latter literature has focused primarily on domestic finance while we have been one of the leading research groups looking at their implications for international financial flows. 

Of course we are also concerned with the adoption of policies to reduce the problems generated by capital flow surges and sudden stops by researching the development of better early warning systems, policies to deal with capital flow surges, and to limit the frequency and costs of sudden stops. 

One of the most important policies with respect to the latter objectives is the buildup of adequate levels of international reserves. It is clear that the levels of international reserves in relation to their short term external debt was a major determinant of how hard different Asian countries were hit during the crisis of 1997-98 and while initial studies have reached conflicting results we expect that this will also prove to be a significant factor with respect to how hard countries were hit during the recent global financial crisis. 

One of the results of the Asian crisis was the dramatic increase in international reserves held by the Asian countries. The initial phase of this build up is easily explained by the need to acquire adequate levels of international reserves. This in turn has led to a major surge in research on the determinants of optimal reserve levels. The traditional approaches to this issue had been developed in a world of limited capital mobility and needed to be rethought for today's world where we have moved to a substantial degree from current account to capital account crises. In this new world large capital inflows instead of being a sure indicator of a crisis proof economy are sometimes a precursor of a currency crisis. In such a world which economist now often analyze with what are called second generation crisis models adequate international reserve levels can not only help finance balance of payments deficits but also reduce the probability of crises. Furthermore the size of reserves needed to cushion adequately such crises can no longer be predicted from the previous variability of the balance of payments as was done in the original models. This has led us to develop new models based on estimates of the size of potential capital outflows during a crisis. We have also developed arguments that for policy purposes the old types of measures of capital flow volatility based on standard deviations or coefficients of variation need to be replaced with measures of the size of capital flow reversals. We have also applied such concepts to the study of whether some types of capital flows are more prone to reversals than others. 

While there as yet not general agreement on the best ways to measure reserve adequacy in today's world it became clear that by the middle of the first decade of this century that countries such as China had accumulated far more internal reserves than called for by any of the models of reserve adequacy. This has led to frequent charges that China and a number of other countries have reverted to old style mercantilism where maintaining a large current account surplus has become a major objective of policy and this in turn has led to popular discussions of the threat of emerging currency wars. We have offered an alternative explanation that if correct suggests that international economic conflicts will be less severe than implied by the mercantilist view. In our interpretation countries like China are not striving to keep large surpluses but rather a limiting the appreciation of their currencies and thus continuing to accumulate more reserves in order to reduce the domestic political pressure that would be generated by influential groups such as exporters that would be hurt in the short run by substantial currency appreciation. 

SELECTED PUBLICATIONS 

Chiu, E. and Willett, T.D. (2010), “Capital Controls and Currency Crises: A More Disaggregated Political Economy Analysis”, presented at the annual meetings of the International Political Economy Society, Harvard University, November 12-13, 2010. 

Clark, W., Hallerberg, M, Keil, M. and Willett, T.D. (2012), “Measures of Financial Openness and Interdependence,” Journal of Financial Economic Policy Vol. 4, Issue 1 

Kim, J.S., Li, J., Rajan, R. Sula O. and Willett, T.D. (2004), “Reserve Adequacy in Asia”, Korea Institute of International Economic Policy Conference proceedings, edited by Oh, Y., Willett, T.D. and Yoon, D.R.  

Li, J. Sula, O. and Willett, T.D. (2009), “A New Framework for Analyzing Adequate and Excessive Reserve Levels Under High Capital Mobility”, China and Asia: Economic and Financial Interactions, Cheung, Y.W. and Wong, K.Y. (Eds.). 2009, Routledge, New York, NY, pp. 230-245. 

Li, J. Sula, O. and Willett, T.D. (2008), “Optimal International Reserves”, presented at the UCSC Conference on International Liquidity, spring 2008 

Ouyang, A.Y. Rajan, R.S. and Willett, T.D. (2008), “Managing the Monetary Consequences of Reserve Accumulation in Emerging Asia”, Global Economic Review June 2008, pp. 171-199. 

Ouyang, Y.F. Rajan, R. and Willett, T.D. (2010), “China as a Reserve Sink”, Journal of International Money and Finance, Volume 29, Issue 5, September 2010, Pages 951-972. 

Sula, O. and Willett, T.D. (2009), “The Reversibility of Different Types of Capital Flows to Emerging Markets”, Emerging Markets Review, Vol. 10, Issue 4, December 2009, pp.296-310. 

Willett, T.D. (2005), “The IMF and Capital Account Crisis: The Case for Separate Lender of Last Resort and Conditionality Functions,” in Ranis, G., Vreeland, J and Kosak, S. (Eds). The IMF and World Bank, Routledge, 2005, pp. 351 – 371. 

Willett, T.D. and Liang, P. (2008), “Testing Four Strong Behavioral Hypotheses About the Effects of Asian and Russian Crises on Asian Financial Markets”, Journal of Applied Business Economics, 2008, Volume 8, No.3, pp. 11-30. 

Willett, T.D., Liang, P. and Ouyang, A. (2009), “The RMB Debate and International Influences on China’s Money and Financial Markets”, inBarth, J. and Tatom, J. (Eds.), China’s Emerging Financial Markets: Challenges and Opportunities, Milken Institute, 2009, pp. 267-301

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