I’ll be honest, I’m jealous of Joshua Aizenman. Not only does he write some very sensible things on foreign reserves and SWFs, but he gets to live in Santa Cruz, CA while doing it. Can you think of a better life? I can’t. Anyway, Aizenman has just released two new papers that are definitely worth a read:
1) “Macro prudential supervision in the open economy, and the role of central banks in Emerging Markets.” This paper uses the recent liquidity crisis to evaluate the prudential supervision role of central banks. I learned a lot reading this paper, but one specific insight is worth repeating here:
“Diversification by means of Sovereign Wealth Funds exposes the economy to the risk that value of the fund may collapse precisely at the time when hard currency is needed to fund deleveraging as has been the case during the 2008-9 global liquidity-crisis.
It’s a good point, which is why SWFs should only be comprised of “excess reserves” (i.e. those not needed for precautionary purposes).
2) “International reserves and swap lines: substitutes or complements?” with Yothin Jinjarak and Donghyun Park. This paper examines whether “swap lines” between central banks of larger economies and their counterparts in smaller economies can reduce the need for reserve accumulation. Again, I learned quite a bit from this paper; here is an excerpt:
“One way to reduce such costs is to use reserves more productively via sovereign funds and more generally, by active reserve management. Although the global financial crisis has inflicted heavy losses on Asian sovereign funds and temporarily dampened their risk appetite, they provide an important channel for more productive use of reserves in the medium- and long-term. There are already signs that the funds are returning to the financial markets, and there are indications that China may inject up to US$250 billion of fresh capital into CIC. However, investing surplus reserves more efficiently after they have already been accumulated is a second-best solution. The first-best solution is to avoid building up such large reserves in the first place. Furthermore, if we view reserves as insurance against unexpected shortage of international liquidity and financial crisis, pooling risks is more efficient than individual risk bearing. That is, collective insurance is always less costly than self insurance. The seemingly irrational behavior of reserve hoarding can partly be explained by the region’s loss of confidence in the IMF during the Asian crisis. In principle, the IMF pools the risks of all countries and thus offers the most efficient collective insurance. In practice, a region wide perception that the IMF has mishandled the Asian crisis, compounded by a broader region wide perception that the IMF does not serve the interests of Asian countries, has eroded the region’s confidence in IMF. Regardless of the validity of the perceptions, the perceptions themselves have contributed to a marked preference of self-insurance over collective insurance.”
I totally agree. As such, this paper explores innovative mechanisms that would reduce countries’ demand for precautionary reserves in the first place, such as swap agreements. It’s worth reading in its entirety.
(Photo by Jim Whitehead)
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