Rising Forex reserves and capital flows

This is one of the hot topics being discussed all around the world (others are sub-prime, global imbalances, sovereign wealth funds etc).

For a recent summary of the capital inflows read chapter 3of IMF’s recent global financial stability report. It has some good summary of how each country has responded to the increasing capital flows. The idea is the same – improve domestic financial systems so that they could absorb capital flows.

I have read number of papers and explanations on the relation between rising capital inflows and forex reserves but this one by Joshua Aizenman is quite good.

The general idea is that these countries are shoring upon their reserves to safeguard themselves from future crisis. He says:

While not a panacea, international reserves help by providing self insurance against sudden stops; mitigating REER effects of TOT shocks; smoothing overtime the adjustment to shocks by allowing more persistent current account patterns; and possibly even export promotion, though this mercantilist use of reserves remains debatable due to possible coordination issues. Countries following an export oriented growth strategy may end up with competitive hoarding, akin to competitive devaluations. The sheer size of China, and its lower sterilization costs suggests that China may be the winner of a hoarding game. Hoarding international reserves may also be motivated by a desire to deal with vulnerability to internal and external instability, which is magnified by exposure of the banking system to non performing loans. Testing the self insurance and precautionary motives in the context of China may be challenged by a version of the ‘peso problem.’ Hoarding international reserves and sterilization have been complementing each other during the last ten years, as developing countries have increased the intensity of both margins.

It has lots of insights on rising forex reserves in asian economies. Read on.

Primer on Value at Risk

I had posteda while ago on IMF’s recent report on Global Financial Markets.  I just read this chapter on risk management techniques.

It is a pretty useful primer on risk management, Value at Risk in particular. It asks a basic question- DO risk management techniques (VAR) amplify risk?

Well as usual, it is a typical economist answer- not really. Risk management system do show that firms take on more risk when times are good and reverse it when times are bad. This leads to everybody becoming risk sensitive when bad times strike furthering the crisis (like what has happened in subprime crisis.) But still, the risk management techniques have helped understand firm’s risk position and are improving by the day.

A nice revision of risk management.

Assorted Links

1. Ajay Shah on recent events.

2. TTR has 2 interesting posts. One onirrational exuberance in Indian stock markets and two, on tough corporate governance norms in Norway.

3. MR has a guest blogger- Justin Wolfers. He saysdivorce rates are falling in US.  Analysing divorces in US is more difficult than subprime mess.

4. MR points to inequality and unhappiness. I agree, people should be given more economic opportunities.

5. Behavioral Economics is now finding favour in macroeconomics and monetary policy. Mankiw says Boston Fed is taking the lead in this initiative.

6. Mankiw has a terrifc post on academics advising politicians.

7. Mankiw pointsto an interesting article on Harry Markowitz. I also liked his humor in this post- when he says:

James, incidentally, once coauthored work on financial crises with some guy named Ben Bernanke

8. Rodrik has some interesting ideas (as usual). One on whether rising food prices are good or bad? Two, on the role of IMF. Three, he takes a nice dig at Clinton’s mini-Davos meet.

9. PSD Blog points to where next financial crisis may arise from- Eastern Europe.  

10. Fin Prof points to an excellent article on EMH. Fama’s student learnt it the best way- by investing in the markets himself.