Explaining rising forex reserves

I had posted about this topic earlier as well where I featured a paper from Joshua Aizenamn.

I read another paper from him and Jaewoo Lee which looks at rising forex reserves from a different angle.

The sizable hoarding of international reserves by several East Asian countries has been frequently attributed to a modern version of monetary mercantilism – hoarding international reserves in order to improve competitiveness. From a long-run perspective, manufacturing exporters in East Asia adopted financial mercantilism—subsidizing the cost of capital—during decades of high growth. They switched to hoarding large international reserves when growth faltered, making it harder to disentangle the monetary mercantilism from precautionary response to the heritage of past financial mercantilism. Monetary mercantilism also lowers the cost of hoarding, but may be associated with negative externalities leading to competitive hoarding.

The broad idea is that East Asian economies have focused on exports to drive their growth. Earlier, they did this by providing export subsidies, easy credit to exporters etc which the authors term as financial mercantilism. When the South east Asian crisis happened this was exposed and an attempt was made to create more competition and do away with providing implicit help to exporters.

However, most East Asian economies still rely on exports for their growth. They do this by keeping their currencies undervalued compared to their peers. The currencies are kept undervalued by intervening in forex markets and buying foreign currencies and not letting the currencies appreciate. This they call as Monetary Mercantilism.

The authors then discuss the positives and negatives of each.

The two forms of mercantilism differ considerably. Financial mercantilism operates though the direct cost of investment, and may increase investment in enduring ways. In its incarnation as export-oriented growth strategy in East Asia, financial mercantilism can improve long-run economic efficiency when there are strong dynamic externalities in the economy, such as learning by doing and knowledge spillovers.

In contrast, for monetary mercantilism to be potent, prices and wages should adjust in an extremely sluggish manner, and trade rivals should refrain from adopting similar policies. If other countries adopt similar mercantilist policies, they can undermine the exchange rate effect of the mercantilist attempt by the home country and lead to a competitive real depreciation.

The costs- FM increases financial fragility and MM leads to costly sterilization. If other countries also hoard, then problems become more acute as it leads to competitive hoarding.

Read the paper for more insights.

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4 Responses to “Explaining rising forex reserves”

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  2. Dictionary Says:

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