Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Mercantilism Ceyhun Bora Durdu Enrique G. Mendoza Marco E. Terrones Board of Governors of the University of Maryland International Monetary Fund Federal Reserve & NBER The views presented in this paper are those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal Reserve or the IMF.
Stylized facts & the New Mercantilism 1. Gradual financial globalization since late 1980s 2. 18 Sudden Stops since Mexico 1994 3. Foreign reserves have surged since Sudden Stops 8% of GDP in median SS country, 13% in Asia! New Mercantilism: a) Reserves are a war chest for defense against Sudden Stops b) Current account surpluses & undervalued currencies
Financial globalization in Sudden Stop countries (average of country indexes) 0.8 80 0.6 Edwards right axis 0.4 70 0.2 0.0-0.2 Chinn-Ito left axis 60 50-0.4-0.6 1970 1975 1980 1985 1990 1995 2000 40
Surge in reserves in Sudden Stop Countries (difference of averages for SS year to 2005 minus 1985 to SS year) Country Year of Sudden Stop Change in reserves Hong Kong 1998 34.69 Korea 1997 16.23 Malaysia 1997 14.36 Thailand 1997 13.17 Uruguay 2002 12.87 Indonesia 1997 12.17 Philippines 1997 10.65 Russia 1998 9.41 Turkey 2001 7.90 Peru 1998 7.41 Pakistan 1998 6.61 Argentina II 2001 6.51 Argentina I 1994 5.42 Chile 1998 3.57 Brazil 1998 3.30 Colombia 1998 2.97 Mexico 1994 2.65 Ecuador 1999-3.46 Median 7.66 Median Asian Countries 13.17
Our analysis Is the New Mercantilism consistent with quantitative predictions of an optimal self-insurance framework? Three determinants of precautionary asset demand: 1. Business cycle volatility Increases in variability & persistence of output fluctuations 2. Financial globalization Lower tax on NFP or lower transactions costs 3. Endogenous Sudden Stop risk Credit constraints and liability dollarization trigger Fisherian deflation
Main findings 1. Volatility cannot explain surge in reserves because it has not increased post-globalization 2. Financial globalization and Sudden Stop risk produce surge in foreign assets Larger globalization effects at high financial integration Self insurance reduces sharply long-run prob. of Sudden Stops 3. Slow adjustment with protracted surpluses and undervalued real exchange rates 4. Implicit hedge in two-sector model lowers prec. savings 5. Results robust to specification of preferences
Optimal self-insurance framework Preferences 1 1 UE t γ c ρ ln(1 + c) w. UE setup t E 0 exp v( cτ ), v( c ) = 0 0 1 BAH t = τ = γ ln(1 + ρ ) wbahsetup. Budget constraint μ ( ) ( ) T N T N cc ( t, ct ) = a ct (1 a) c + t, a> 0, μ 1. μ 1 μ T N N T T N t t t t t t+ 1 t t t+ 1 t c + p c = ε y + π b + b [ 1 + r(1 τ) ] + T ( ψ/2)( b b ) T N N t + ( A + p A ) 2
Elasticity of savings under BAH & UE preferences Mean foreign assets: BAH preferences Mean foreign assets: UE preferences
Measures of foreign asset holdings Precautionary savings: Mean net foreign assets: Eb [ ] Sss Deterministic SS of bonds differs in BAH and UE setups In BAH setup: (independent of τ) Dss b = φ In UE setup: (depends on τ ) Dss Eb [ ] Sss Dss b exp( vb ( )) = (1 + r(1 τ))
Strategy for the quantitative analysis 1. Calibrate 1S model to Mexican aggregate data 2. Use 1S model to examine effects of volatility and financial globalization 3. Calibrate 2S model to Mexican sectoral & agg. data 4. Revisit effects of volatility and financial globalization 5. Examine the effects of endogenous Sudden Stop risk
50% 40% Precautionary demand for foreign assets & output volatility: One-sector Model (percent of GDP) A. Variability 30% 20% 10% 0% 1 2 3 4 5 6 7 8 Standard deviation of output (%) Uzawa-Epstein Bewley-Aiyagari-Hugget
Evolution of GDP volatility in Sudden Stop Countries (20-year rolling std. devs. of HP-filtered GDP) 8 8 Mean and Median Volatility Median Volatility By Regions 7 7 6 6 5 5 Latin American Countries 4 Mean 4 SS countries Median 3 3 Asian Countries 2 2 1 1 0 1980 1985 1990 1995 2000 2005 0 1980 1985 1990 1995 2000 2005
Financial globalization effects: One-sector model (shares of GDP) Mean foreign assets Precautionary savings 2.0 12.0 0.10 0.0-2.0-4.0 10.0 8.0 0.08 0.06-6.0-8.0 6.0 4.0 Right Axis 0.04-10.0 2.0 0.02-12.0 0 5 10 15 20 25 30 Tax on capital flows (Percent) 0.0 0 5 10 15 20 25 30 Tax on capital flows (in percent) 0.00 Bewley-Aiyagari-Hugget: NDL Bewley-Aiyagari-Hugget: ADL=-2 Bewley-Aiyagari-Hugget:ADL=-1.0 Uzawa-Epstein
Effects of lower transactions costs 10% A. Foreign Assets 60% B. Precautionary Savings 0% 50% Percent of GDP -10% -20% -30% Percent of GDP 40% 30% 20% -40% 10% -50% 0 2 4 6 8 Transactions costs coefficient 0% 0.0 2.0 4.0 6.0 8.0 Transactions Costs coefficient Bewley-Aiyagari-Hugget Uzawa-Epstein
Effects of globalization on precautionary savings (one- & two-sector models, shares of GDP) 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Right Axis 0 5 10 15 20 25 30 Tax on capital flows (in percent) 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 BAH two sectors:adl=-1.0 UE two sectors BAH one sector:adl=-1 UE one sector
Endogenous Sudden Stops Business cycles lead to binding borrowing constraint Long-run business cycle moments unchanged Countercyclical current account Fisherian deflation amplifies effects of shocks causing Sudden Stops: T T N bt+ 1 = κ εt y + pt (1 α) ztzmt α c T p N t ( 1 ) T a c t = a c N t 1+μ m p N N α 1 t α t t = p z Zm p Extra incentive for precautionary savings Excessive SSs ruled out from stochastic steady state Long-run probabilities of Sudden Stops: 3.9% (BAH), 7.9% (UE) m
Impact amplification effects in Sudden Stop region 100 80 60 (excess responses to 1 s.d. shocks) BAH long run prob. border UE long run prob. border 40 20 long-run Sudden Stop region 0-20 -40-60 -80-100 -0.578-0.566-0.554-0.542-0.530-0.518-0.506-0.494-0.482-0.470 Foreign assets as a percent of long-run GDP Price of Nontradables: UE setup Price of Nontradables: BAH setup Current account-gdp ratio: UE setup Current account-gdp ratio: BAH setup
4 Sudden Stop dynamics at a 49% debt ratio (excess responses to 1 s.d. shocks) Current Account-Output Ratio 2 Price of Nontradables 3 0 2-2 -4 1-6 0-8 -1 5 10 15 20 25 30 35 40 45 50-10 5 10 15 20 25 30 35 40 45 50 1 0-1 -2-3 -4-5 -6-7 CES Consumption 1 0-1 -2-3 -4-5 -6-7 -8 5 10 15 20 25 30 35 40 45 50 Bewley-Aiyagari-Hugget Preferences Total Output in Units of Tradables 5 10 15 20 25 30 35 40 45 50 Uzawa-Epstein Preferences
Transitional distributions in Sudden Stop economies (foreign assets in percent of mean GDP) 1.00 UE setup 1.00 BAH setup 0.80 0.80 0.60 0.60 0.40 0.40 0.20 0.20 0.00-0.70-0.59-0.48-0.37-0.26-0.14-0.03 0.08 0.19 0.30 0.41 0.52 0.63 0.74 0.00-0.70-0.59-0.48-0.37-0.26-0.14-0.03 0.08 0.19 0.30 0.41 0.52 0.63 0.74 2 years 5 years 10 years 15 years Long-run distribution
The magic of precautionary savings Mean foreign assets and probability of a Sudden Stop at a -48.7% debt ratio BAH setup UE setup Prob. of Mean Prob. of Mean Sudden Stop foreign assets Sudden Stop foreign assets Economy with credit constraints year 0 100.0% -48.7% 100.0% -48.7% year 2 40.0% -48.2% 21.0% -48.2% year 15 4.7% -41.7% 3.4% -42.9% long run 0.9% -24.3% 1.1% -37.8% Frictionless economy long run 0.0% -44.7% 0.0% -42.4% Change in mean foreign assets 20.4% 4.6%
Conclusions New Mercantilism is only partially right: Volatility explanation fails Sudden Stop risk explains some of the surge in reserves but so does financial globalization even without Sudden Stops Slow transition after Sudden Stops or fin. globalization Persistent surpluses and undervalued exchange rates (not necessarily due to exchange rate management) Normative implications pose challenges Precautionary savings are suboptimal, but how suboptimal? and what feasible second-best arrangement can dominate? Financial globalization without financial development reduces welfare because of adverse distributional effects of prec. savings