Financial Markets and Institutions (2-downloads)

How Did China Accumulate Over 

$2 Trillion of International Reserves?

By the end of 2010, China had accumulated more than $2 trillion of international

reserves, and its international reserves are expected to keep growing in the near

future. How did the Chinese get their hands on this vast amount of foreign assets?

After all, China is not yet a rich country.

The answer is that China pegged its exchange rate to the U.S. dollar at a fixed

rate of 8.28 yuan (also called renminbi) to the dollar in 1994. Because of China’s

rapidly growing productivity and an inflation rate that is lower than in the United

States, the long-run value of the yuan has increased, leading to a higher relative

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expected return for yuan assets and a rightward shift of the demand for yuan assets.

As a result, the Chinese have found themselves in the situation depicted in 

panel (b) of Figure 16.2, in which the yuan is undervalued. To keep the yuan from

appreciating above E

par

to E

1

in the figure, the Chinese central bank has been engag-

ing in massive purchases of U.S. dollar assets. Today the Chinese government is one

of the largest holders of U.S. government bonds in the world.

The pegging of the yuan to the U.S. dollar has created several problems for

Chinese authorities. First, the Chinese now own a lot of U.S. assets, particularly

U.S. Treasury securities, which have very low returns. Second, the undervaluation

of the yuan has meant that Chinese goods are so cheap abroad that many countries

have threatened to erect trade barriers against these goods if the Chinese govern-

ment does not allow an upward revaluation of the yuan. Third, the Chinese pur-

chase of dollar assets has resulted in a substantial increase in the Chinese monetary

base and money supply, which has the potential to produce high inflation in the

future. Because the Chinese authorities have created substantial roadblocks to cap-

ital mobility, they have been able to sterilize most of their exchange rate interven-

tions while maintaining the exchange rate peg. Nevertheless, they still worry about

inflationary pressures. In July 2005, China finally made its peg somewhat more flex-

ible by letting the value of the yuan rise 2.1%. The central bank also indicated that

it would no longer fix the yuan to the U.S. dollar, but would instead maintain its value

relative to a basket of currencies. However, in 2008 during the global financial cri-

sis, China reimposed the peg, but then dropped it in June of 2010.

Why have the Chinese authorities maintained this exchange rate peg for so long

despite the problems? One answer is that they want to keep their export sector hum-

ming by keeping the prices of their export goods low. A second answer might be

that they want to accumulate a large amount of international reserves as a “war chest”

that could be sold to buy yuan in the event of a speculative attack against the yuan

at some future date. Given the pressure on the Chinese government to further revalue

its currency from government officials in the United States and Europe, there are

likely to be further adjustments in China’s exchange rate policy in the future.

Managed Float

Although most exchange rates are currently allowed to change daily in response to

market forces, many central banks have not been willing to give up their option of

intervening in the foreign exchange market. Preventing large changes in exchange

rates makes it easier for firms and individuals purchasing or selling goods abroad

to plan into the future. Furthermore, countries with surpluses in their balance of pay-

ments frequently do not want to see their currencies appreciate, because it makes

their goods more expensive abroad and foreign goods cheaper in their country.

Because an appreciation might hurt sales for domestic businesses and increase unem-

ployment, surplus countries have often sold their currency in the foreign exchange

market and acquired international reserves.

Countries with balance-of-payments deficits do not want to see their currency

lose value, because it makes foreign goods more expensive for domestic consumers

and can stimulate inflation. To keep the value of the domestic currency high, deficit

countries have often bought their own currency in the foreign exchange market and

given up international reserves.

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Chapter 16 The International Financial System

391

The current international financial system is a hybrid of a fixed and a flexible

exchange rate system. Rates fluctuate in response to market forces but are not deter-

mined solely by them. Furthermore, many countries continue to keep the value of

their currency fixed against other currencies.

Capital Controls

Because capital flows were an important element in the currency crises in Mexico

and East Asia, politicians and some economists have advocated that emerging mar-

ket countries avoid financial instability by restricting capital mobility. Are capital con-

trols a good idea?

Controls on Capital Outflows

Capital outflows can promote financial instability in emerging market countries,

because when domestic residents and foreigners pull their capital out of a country,

the resulting capital outflow forces a country to devalue its currency. This is why some

politicians in emerging market countries have recently found capital controls par-

ticularly attractive. For example, Prime Minister Mahathir of Malaysia instituted cap-

ital controls in 1998 to restrict outflows in the aftermath of the East Asian crisis.

Although these controls sound like a good idea, they suffer from several disad-

vantages. First, empirical evidence indicates that controls on capital outflows are sel-

dom effective during a crisis because the private sector finds ingenious ways to evade

them and has little difficulty moving funds out of the country.

6

Second, the evidence

suggests that capital flight may even increase after controls are put into place,

because confidence in the government is weakened. Third, controls on capital out-

flows often lead to corruption, as government officials get bribed to look the other

way when domestic residents are trying to move funds abroad. Fourth, controls on

capital outflows may lull governments into thinking they do not have to take the steps

to reform their financial systems to deal with the crisis, with the result that oppor-

tunities to improve the functioning of the economy are lost.

Controls on Capital Inflows

Although most economists find the arguments against controls on capital outflows per-

suasive, controls on capital inflows receive more support. Supporters reason that if

speculative capital cannot come in, then it cannot go out suddenly and create a cri-

sis. Our analysis of the financial crises in East Asia in Chapter 8 provides support

for this view by suggesting that capital inflows can lead to a lending boom and exces-

sive risk taking on the part of banks, which then helps trigger a financial crisis.

However, controls on capital inflows have the undesirable feature that they may

block funds from entering a country that would be used for productive investment

opportunities. Although such controls may limit the fuel supplied to lending booms

through capital flows, over time they produce substantial distortions and misalloca-

tion of resources as households and businesses try to get around them. Indeed, just

as with controls on capital outflows, controls on capital inflows can lead to corrup-

tion. There are serious doubts whether capital controls can be effective in today’s

6

See Sebastian Edwards, “How Effective Are Capital Controls?,” Journal of Economic Perspectives

13, (Winter 2000): 65–84.

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environment, in which trade is open and where there are many financial instru-

ments that make it easier to get around these controls.

On the other hand, there is a strong case for improving bank regulation and super-

vision so that capital inflows are less likely to produce a lending boom and encour-

age excessive risk taking by banking institutions. For example, restricting banks in

how fast their borrowing can grow might substantially limit capital inflows. Supervisory

controls that focus on the sources of financial fragility, rather than the symptoms,

can enhance the efficiency of the financial system rather than hampering it.

The Role of the IMF

The International Monetary Fund was originally set up under the Bretton Woods sys-

tem to help countries deal with balance-of-payments problems and stay with the fixed

exchange rates by lending to deficit countries. When the Bretton Woods system of

fixed exchange rates collapsed in 1971, the IMF took on new roles.

Although the IMF no longer attempts to encourage fixed exchange rates, its role

as an international lender has become more important recently. This role first came to

the fore in the 1980s during the Third World debt crisis, in which the IMF assisted devel-

oping countries in repaying their loans. The financial crises in Mexico in 1994–1995

and in East Asia in 1997–1998 led to huge loans by the IMF to these and other affected

countries to help them recover from their financial crises and to prevent the spread of

these crises to other countries. This role, in which the IMF acts like an international

lender of last resort to cope with financial instability, is indeed highly controversial.

Should the IMF Be an International Lender 

of Last Resort?

As we saw in Chapter 8, in industrialized countries when a financial crisis occurs

and the financial system threatens to seize up, domestic central banks can address

matters with a lender-of-last-resort operation to limit the degree of instability in the

banking system. In emerging market countries, however, where the credibility of

the central bank as an inflation fighter may be in doubt and debt contracts are typ-

ically short-term and denominated in foreign currencies, a lender-of-last-resort oper-

ation becomes a double-edged sword—as likely to exacerbate the financial crisis as

to alleviate it. For example, when the U.S. Federal Reserve engaged in a lender-of-

last-resort operation during the 1987 stock market crash (Chapter 10), there was

almost no sentiment in the markets that there would be substantially higher inflation.

However, for a central bank with less inflation-fighting credibility than the Fed, cen-

tral bank lending to the financial system in the wake of a financial crisis—even under

the lender-of-last-resort rhetoric—may well arouse fears of inflation spiraling out

of control, causing an even greater currency depreciation and still greater deterio-

ration of balance sheets. The resulting increase in moral hazard and adverse selec-

tion problems in financial markets would only worsen the financial crisis.

Central banks in emerging market countries therefore have only a very limited

ability to successfully engage in a lender-of-last-resort operation. However, liquid-

ity provided by an international lender of last resort does not have these undesir-

able consequences, and in helping to stabilize the value of the domestic currency,

it strengthens domestic balance sheets. Moreover, an international lender of last

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Chapter 16 The International Financial System

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7

See International Financial Institution Advisory Commission, Report (IFIAC: Washington, DC, 2000).

resort may be able to prevent contagion, the situation in which a successful specu-

lative attack on one emerging market currency leads to attacks on other emerging

market currencies, spreading financial and economic disruption as it goes. Because

a lender of last resort for emerging market countries is needed at times, and because

it cannot be provided domestically, there is a strong rationale for an international

institution to fill this role. Indeed, since Mexico’s financial crisis in 1994, the

International Monetary Fund and other international agencies have stepped into

the lender-of-last-resort role and provided emergency lending to countries threat-

ened by financial instability.

However, support from an international lender of last resort brings risks of its

own, especially the risk that the perception it is standing ready to bail out irrespon-

sible financial institutions may lead to excessive risk taking of the sort that makes

financial crises more likely. In the Mexican and East Asian crises, governments in the

crisis countries used IMF support to protect depositors and other creditors of bank-

ing institutions from losses. This safety net creates a well-known moral hazard prob-

lem because the depositors and other creditors have less incentive to monitor these

banking institutions and withdraw their deposits if the institutions are taking on too

much risk. The result is that these institutions are encouraged to take on excessive

risks. Indeed, critics of the IMF—most prominently, the Congressional Commission

headed by Professor Alan Meltzer of Carnegie-Mellon University—contend that IMF

lending in the Mexican crisis, which was used to bail out foreign lenders, set the stage

for the East Asian crisis, because these lenders expected to be bailed out if things

went wrong, and thus provided funds that were used to fuel excessive risk taking.

7

An international lender of last resort must find ways to limit this moral hazard

problem, or it can actually make the situation worse. The international lender of

last resort can make it clear that it will extend liquidity only to governments that

put the proper measures in place to prevent excessive risk taking. In addition, it

can reduce the incentives for risk taking by restricting the ability of governments

to bail out stockholders and large uninsured creditors of domestic financial institu-

tions. Some critics of the IMF believe that the IMF has not put enough pressure on

the governments to which it lends to contain the moral hazard problem.

One problem that arises for international organizations like the IMF engaged in

lender-of-last-resort operations is that they know that if they don’t come to the res-

cue, the emerging market country will suffer extreme hardship and possible politi-

cal instability. Politicians in the crisis country may exploit these concerns and engage

in a game of chicken with the international lender of last resort: They resist neces-

sary reforms, hoping that the IMF will cave in. Elements of this game were present

in the Mexican crisis of 1994 and were also a particularly important feature of the

negotiations between the IMF and Indonesia during the Asian crisis.

How Should the IMF Operate?

The IMF would produce better outcomes if it made clear that it will not play this game.

Just as giving in to ill-behaved children may be the easy way out in the short run,

but supports a pattern of poor behavior in the long run, some critics worry that the

IMF may not be tough enough when confronted by short-run humanitarian concerns.

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For example, these critics have been particularly critical of the IMF’s lending to the

Russian government, which resisted adopting appropriate reforms to stabilize its finan-

cial system.

The IMF has also been criticized for imposing on the East Asian countries 

so-called austerity programs that focus on tight macroeconomic policies rather than

on microeconomic policies to fix the crisis-causing problems in the financial sector.

Such programs are likely to increase resistance to IMF recommendations, particu-

larly in emerging market countries. Austerity programs allow politicians in these

countries to label institutions such as the IMF as being antigrowth, rhetoric that helps

them mobilize the public against the IMF and avoid doing what they really need to do

to reform the financial system in their country. IMF programs focused instead on

reforms of the financial sector would increase the likelihood that the IMF will be seen

as a helping hand in the creation of a more efficient financial system.

An important historical feature of successful lender-of-last-resort operations is

that the faster the lending is done, the lower the amount that actually has to be

lent. An excellent example involving the Federal Reserve occurred in the aftermath

of the stock market crash on October 19, 1987 (Chapter 10). At the end of that day,

to service their customers’ accounts, securities firms needed to borrow several bil-

lion dollars to maintain orderly trading. However, given the unprecedented devel-

opments, banks were nervous about extending further loans to these firms. Upon

learning this, the Federal Reserve engaged in an immediate lender-of-last-resort oper-

ation, making it clear that it would provide liquidity to banks making loans to the secu-

rities industry. What is striking about this episode is that the extremely quick

intervention of the Fed not only resulted in a negligible impact of the stock market

crash on the economy, but also meant that the amount of liquidity that the Fed

needed to supply to the economy was not very large.

The ability of the Fed to engage in a lender-of-last-resort operation within a day

of a substantial shock to the financial system stands in sharp contrast to the amount

of time it has taken the IMF to supply liquidity during the recent crises in emerg-

ing market countries. Because IMF lending facilities were originally designed to pro-

vide funds after a country was experiencing a balance-of-payments crisis and because

the conditions for the loan had to be negotiated, it took several months before the

IMF made funds available. By this time, the crises had gotten much worse—and much

larger sums of funds were needed to cope with the crisis, often stretching the

resources of the IMF. One reason central banks can lend so much more quickly than

the IMF is that they have set up procedures in advance to provide loans, with the

terms and conditions for this lending agreed upon beforehand. The need for quick

provision of liquidity, to keep the loan amount manageable, argues for similar credit

facilities at the international lender of last resort, so that funds can be provided

quickly as long as the borrower meets conditions such as properly supervising its

banks or keeping budget deficits low. A step in this direction was made in 1999

when the IMF set up a new lending facility, the Contingent Credit Line, so that it

can provide liquidity faster during a crisis.

The debate on whether the world will be better off with the IMF operating as

an international lender of last resort is currently a hot one. Much attention is being

focused on making the IMF more effective in performing this role, and redesign of

the IMF is at the center of proposals for a new international financial architecture

to help reduce international financial instability.

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Chapter 16 The International Financial System