Will emerging economies stop maintaining forex reserves?

This is a super speech from Adam Posen of BoE.

Some background first. Economic Historians/Historians have pointed how the recent globalization phase is similar to the one seen in 1870-1910. The previous one was interrupted by world wars and in the middle due to Great Depression. After that we had these tight controls which began to be relaxed around 1970s and again a new wave of globalization emerged. The players  changed. As in previous, UK was the supplier of funds and US was the receiver (Adam Posen disputes this in this recent speech). This time China (and other middle ease etc) are the suppliers and US the receiver. US should have been the supplier of funds this time as it is the leading economy as UK was then. However, as highlighted by Lucas in 1990s capital flows have not flown to developing but developed economies. Subsequent research shows even amidst developing economies, it goes to economies which are better off.

So just as this recession was taking place, some said perhaps globalization will at best not increase as much as countries become more protective.

Posen curiously titles the speech as  – What the return of 19th century economics means for 21st century geopolitics? According to him, we are likely to see the trends of 19th century globalization now. As emerging economies have gained immensely from globalization barring some issues here and there, they are unlikely to undo glob.

He covers following themes:

  • Globalization in the form of integration of national economies and markets across borders will continue, with increasing support from important constituencies in emerging markets;
  • As US hegemony, that is relative economic dominance, recedes into multipolarity, the international economic system will have less strict rule enforcement and be subject to greater economic volatility;
  • The erosion of (intellectual and other) property right enforcement will have significant effects on the global division of labor, which will reinforce this multipolarity and income convergence;
  • Price stability will prevail, with sharper fluctuations around low average inflation driven by real (relative price) shocks, and deflation will occur from time to time;
  • More than one currency will play a global or reserve role, and the benefits in terms of lower interest rates from having such a role will diminish;
  • International diversification of investment will increase, and so will the gross flows of capital, with capital accounts in the major emerging markets moving more towards balance if not deficit;

Hmm…interesting. Read the speech for comparisons with 19th century.

I was particularly interested in two thoughts:

  • deflation will occur from time to time
  • Instead of piling on forex reserves, there will be diversification of international investment

With central banks sticking onto 2% inflation targets, mild deflations are likely to occur as you only have so much room.

On forex reserves he says:

My last assumption or assertion regarding capital mobility may sound particularly suspect. Many observers of recent economic crises have argued with good reason that large capital flows and their reversals are a source of international economic instability. This is one explanation for the self-insurance against financial crisis by governments through the accumulation of official foreign reserves (and thus through undervaluation of their currencies) that has proliferated in East Asia and elsewhere following the 1997-98 crisis and China’s lead. Yet, I believe that period of reserve accumulation is coming to an end, and that we will move instead to a time of increased private investment diversification across borders.

Fundamentally, the incentives for investor diversification are increasing. The relative attractiveness of US and other advanced country government bonds versus those from emerging markets and from selected multinational corporations is markedly declining. Macroeconomic cycles and long-run growth trends are increasingly diverging if not decoupling between the West and the rest. The rise of sizable and politically influential middle classes in the emerging markets increases the pressures on those economies’ governments to be more accountable with their pots of money (such as official reserves) withheld from their people and to allow purchasing power to rise. 

Hmmm..Superb thoughts.

History is always wonderful to read..

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