Free Economics Essays - Management Reserves Foreign
Management Reserves Foreign
Empirical Specification and Finding
In this Chapter, we are going to perform empirical assessment to rethink the management of international reserves by the Chinese monetary authority. We first employ methodologies to illustrate the mainly factors which are behind the large accumulation of international reserves in the last decade. By taking a retest on foreign reserves and other related macroeconomic variables, we attempt to give a comprehensive cognition of the optimal level of hoarding and how to manage such massive foreign reserves in China.
Section 1 Data and Methodologies
In this paper, we design to employ two methodologies which based on the development theories of foreign reserve adequacy suggested by the economists mentioned in the Chapter 2. In order to estimate whether the current foreign reserves of China is in a suitable level which adapt to balance of payment and exchange rate regime, the ratios as the most obvious tools of analysis will be demonstrated in the empirical evaluation. We are going to look at three indicators for this assessment based on the prevailing theories of reserves from 1960s to 1970s which are reserves to imports; reserves to M2 and reserves to net external balance.
Meanwhile, the assessment period will be focus on the last ten years from 1995 to 2007. That is because during the last decade, China has experienced a tough economic environment in the aftermath of Asian financial crisis and entered a rapid development era, hence, this time series data and ratios may be useful and characteristic to well present the economic features.
The original estimated data such as China's foreign reserves, import, export and M2 figures are sourced from the Datastream database and some statistics are gathered from the NBSC (2007). The compare and contrast will be given in the result analysis section. As a significant indicator, although it has the weakness, ratios is still an irreplaceable tool to give a general image of the reserves adequacy of one country.
The second tool of analysis is to use econometric formula to estimate optimal holding according to the models on reserves adequacy. As can be seen in the literature review, there are a number of well developed models that demonstrate different situations of reserves holding. Considering of advantages and shortcomings among these models and the direction of assessment, we intent to employ two mature models suggested by Frenkel and Jovanovic (1981) and Aizenmean and lee (2005) in the empirically evaluation s of reserve management in China.
Frenkel-Jovanovic mode as a buffer stock or inventory model has remarkably successful in explaining foreign reserves holding in the 1980s. It has performed empirically and proceed to useful outline of optimal reserves. This model hypothesises that the reserves authority will choose an initial level of reserve holding that minimizes its total expected costs which consist of macroeconomic adjustment costs and opportunity costs of holding foreign reserves. In the working paper from Flood and Marion (2002), it points out that the two costs are interrelated due to a higher stock of reserves.
The optimal reserve management is to find the cost-minimizing level of reserves to acquire once reserves have reached their lower bound. That is to say, a reasonable level of reserves holding is to optimise the trade-off among the costs produced from the hoarding. Furthermore, Frenkel and Jovanovic (1981) assumed that reserve movements between the occasional re-stockings are generated by an exogenous Wiener process1, where the incremental change in reserves in a small time interval is distributed normally.
Based on the previous FJ formal modelling formulations (3) and (4) shown in chapter 2, a new derivation of the optimal reserves holding developed by Frenkel and Jovanovic (1981) can be presented as followed: 2
Where R* is the optimal reserve; C is a fixed cost per adjustment, related to the capacity to adjust expenditures to income; r is the cost of holding reserves per unit of time, representing the cost of forgone earnings. Finally, σ is standard deviation of the Wiener increment in the reserve time-series process operating between stock adjustments
In the equation (11), optimal reserve holding increase with the volatility of reserves (), and higher volatility equals that reserves hit the lower bound more frequently. Therefore, the money authority prefers to restock a large amount of reserves and tolerate greater opportunity costs so as to incur the adjustment costs less frequently. It can be also seen that a bigger adjustment cost lead to a larger optimal reserve holdings while a higher opportunity cost shrink them. In a word, it reveals optimal reserve holdings to be a positive function of volatility and a negative function of the opportunity costs of maintaining reserves.
To be more straightforward, the expression (11) can be transformed into the log form which is a successful estimating equation:
For the purpose of empirical test, this estimating equation finally becomes a convenient econometric formulation like below: 3
It is quite straightforward to use the econometric formulation to estimate the variables. Because FJ realise that obtaining a variability measure was free of scale, thus, to make it feasible and simple, they divided the standard deviation by the value of imports and the opportunity cost, r, was approximated by a country's government bond yield. They also define that the component estimating coefficients b0, b1 and b2 are namely fixed cost, adjustment cost and opportunity cost. In particularly, the constant b0 is interpreted to be country specific and regime specific.
In the empirical work from FJ, they estimated the models by using ordinary least squares on various cross-section and panel data sets. They once estimated across 22 developed countries during the 1971 to 1975 period. The result can be seen as below:
R2= .97, n=110, S.E= 0.234
Their empirical evidence is closely consistent with their previous theoretical finding since the estimated coefficients of reserve holdings with respect to and r is very close to the predictions of the theoretical model given by equation (12).
After explaining the methodology, we attempt to replicate the FJ regression equation in China's foreign reserves analysis by using PcGive program. The data sets are in time series which come from Datastream and NBSC as well. It is noticeable that the estimation may not be accurate due to technique issue and scaling issue. But we will try to make the process clear and integral. We now commence our effort to retest this model in China's foreign reserves and discuss the findings in detail in the next part. The output of the estimation can be shown on the Table 4 in appendix.
On the other hand, we will go further to estimate the China's foreign reserves via new theoretical model suggested by Aizenman and Marion (2004). Unlike the general framework, there are some limitations of FJ model which lead to under perform in emerging market. The first limitation is using fewer factors as scaling variable for determining reserve adequacy. Crises during the 1990s and beyond have predominantly been crises of the capital account. Reserve adequacy benchmarks accordingly need to be modified to allow more variables influenced on reserves (Bird and Rajan, 2002).
The other limitation is that FJ model does not explicitly capture changes in loss aversion. According to the precautionary motive on demand for reserve adequacy, holding reserves may be considered a form of insurance premium, which means that reserves hoarding has the functions to avoid future crises and reduce the probability of an output drop induced by a sudden stop of foreign capital and so on. It can be thought as an approach to stabilise fiscal expenditure in developing countries (Aizenman and Marion, 2004).
That is to say, in emerging market, the political factors may have a great impact on reserve holding rather than developed countries. China is the most important developing counties in Asia and we should consider various factors in the management of foreign reserves. Thus, we commence to retest the reserves holding in China on the basis of the extension of theoretical model generalised by Aizeman and Marion (2004).
The estimating equation is as followed:
where: R is actual holding of reserves minus gold; pop is the total population of specific country; gpc is real GDP per capita; exa is the volatility of real export receipts; imy is the share of imports of good and services in GDP; neer is the volatility of the nominal effective exchange rate.
Regarding to the study of Aizenman and Marion, (2003), they point out that the real holdings should increase with the size of international transactions; hence, they expect reserves holding to be positively correlated with the country's population and standard of living. Moreover, reserves holding should increase with the volatility of international receipts and payments which would make it positively correlate with the volatility of export receipts; and it is also expected to increase with the vulnerability to external shocks which means be positive with import. And finally, since the severe fluctuation of exchange rate will reduce the demand for reserves thus, reserves should be negative with the exchange rate. Aizenman and Marion explain the choice of variables in detail in order to construct a structural model.
In the case of China, making the test simply and clear, we intend to apply reduced-form of the model and use a few of significant variables instead of complication. It is remarkable the sample data is during the period from 1998 to 2007. We expect to find out the change of management of reserves holding in the aftermath of Asian financial crisis.
The model we estimate involves variations of the following equation:
where: Rt is the actual reserves holding; ca is the capital account balance; ed is the net external debt; imy is the ratios of import to GDP; RM2 is the ratios of reserve to M2; neer is the volatility of the nominal exchange rate(standard deviation of exchange rate movement).
The estimation output is reported in the table 5. The discussion of the finding will be presented in the next part as well.
Section 2 Result Presentation and Analysis
3.2.1 Ratios Indicators
The four key ratios indicators will be introduced in this part to outline the structure of foreign reserves in China. Although ratios indicator can not tell the full condition of the reserves holding, they still play an important role on the analysis of reserves level and reflect the significant problems.
i. Reserves-to-GDP(R/GDP)
The first principle ratio presented here is Reserves to GDP. Table 2 shows the actual data and the R/GDP ratio from 1995 to 2007. In the half end of 1990s, reserves holding in China were in a stable growth level. Consisting with the development of economy, R/GDP has been growing fast, especially after 1998. In 1999, China's foreign reserves accounted for 14.5 percent of its GDP. In the next 2 year, until 2000, the ratio seems maintain in the similar level. However, it has been increased again in 2001 and was reach more than 60 percent of GDP by then end of 2007 (see table 2), which made China become the largest foreign reserve holder in the world. Obviously, the reserves holding follow the development of economy.
ii. Reserve-to-M2(R/M2)
Another indicator is R/M2 is considered as a predictor of financial crisis (Kaminsky et al., 1997). A higher level of this ratio will reduce the probability of crisis. Figure 3 reflects there is a gradual increase of the ratio after 2000, it shows evidence that china has strengthen the management of reserves holding after Asian financial crisis. The R/M2 can be a useful indicator of the potential impact of capital flight, but, further discussion needs to be supplemented by analysis of other possible sources.
iii. Reserves-to-IMPORT(R/IM) and Reserves-to-EXPERNAL DEBT(R/STED)
The most common ratio in previous foreign reserves literatures, R/M ratio reflects how sufficient of reserves on the foreign import. But Bird and Rajan, (2003) find out it lacks a linear relationship between the occurrences of deficit and value of imports which may fail to reflect the actual condition. However, we still consider it as a main measurement. It can be seen from table 3 that the R/IM ratios are very high in China and Korea and Malaysia are less than 3 before the Crisis. It is remarkable that Korea has boosted the ratio from 2.9 up to 8 after the crisis which implies a great adjustment in trade policy.
The last indicator which is considered most relevant for emerging markets (Wijnholds and Kapteyn, 2001) is R/STED. It indicates that countries with low value were most likely to be affected by the financial crisis (Dadush et al., 2000). Table 3 summarizes the reserve adequacy indicator: R/IM and R/STED in five main east-Asia countries from 1995 to 2000. They implies that Korea, Malaysia, Hong Kong have all been linked to financial crisis and related to a weak R/STED. China was able to manage a stable exchange rate during the Asian financial crisis due to its comfortable R/STED.
3.2.2. Regression technique
On the basis of FJ model formulation, we retest China's foreign reserve during the period from 1995 to 2007. In this regression, we apply the traditional determinants of the demand for international reserves such as GDP, IMPORT, and EXTERNAL DEBT. It should be noticed that when scale R by these factors, the right-hand side variables have to do the same procedure. In the table 4, it reports the results using the three scaling variables mentioned above.
As can be seen from the output, we interpret our result is consistent with those FJ model equation (12) since the estimating coefficients is approximately close to the theoretical prediction. Our approach differs from the primarily because we use others scaling factors. In the estimation, reserve volatility still positively influences reserve holdings. It can be seen that the reserve volatility in benchmark regression (a) of table 2 has a closest elasticity of 0.58 without scale factor. Meanwhile, the interest rate has a negative and significant coefficient in all regressions as well. Moreover, the value of R2 in first regression also reflect a
The estimating coefficients in other three regressions with scaling variables have the similar values which are around 0.4. It is clear that reserve holding mainly depend on GDP factor since the elasticity of reserve volatility in regression (b) shows the highest value among others. Further, IMPORT has a great impact on reserve holding as well. As the opportunity cost, the coefficients of interest rate have a wide range of value although they are all in negative. In sum, the result of the FJ model in China's foreign reserves is receivable although parts of the parameters are not perfect.
Although FJ model has a good empirical support in reserves holding under certain assumptions, it is noteworthy that it can only predict for developed countries and fail to explain the recent reserves hoarding in emerging market, especially after the Asian financial crisis. Therefore, in the following part, the regression result of the new model (16) introduced in section 1 will be discussed to find out what factors influence on China reserves holding after crisis.
We reconstruct the original model (15) from Aizenman and Marion, (2004) by adding five variables that assume to affect the reserves holding.
In order to assess the responsiveness of international reserves, we run a new form regression which relates change in international reserves to current account, net external debt, import ratios, money supply and exchange rate movement.
By regressing the new form model (16) in PcGive, we find out that the criteria of adjusted R square and DW test both show a perfect goodness of fit of the model. When our adjusted R square is very close to 1 and DW is around 2, it means our regression line is perfectly fit the data offered. From the test result, it can be concluded that the factors of import ratio (LIMY) and M2 money supply ratio (LRM2) have a higher value of coefficients which imply a positive correlation with reserves holding.
Although current account balance (LCA) and outstanding external debt (LED) have small value, it still indicates they are positive with reserves holding. Moreover, it is suggested that the volatility of exchange rate has a negative correlation with foreign reserves. In general, the empirical result above is consistent with the suggestion from Aizenman and Marion, (2003).
It can be realised from the result that political factors such as fiscal M2 supply, external debt and import volume play an important role to determine reserves hoarding in China. Like Aizenman and Marion suggestion, hoarding of foreign reserves can be viewed as a precautionary adjustment, reflecting the desire for self-insurance against exposure to future sudden stop of foreign capital inflows or economic crisis loss. From the test, we are aware of that political factors may be the dominate determinants to affect the management of foreign reserve in China rather than opportunity cost and adjustment cost.
Chapter 4 Extension and Suggestion
Section 1 Sufficient Vs. Excessive
The debate on the issue whether China's foreign reserve is in a suitable level has been triggered severely these years. Li (2006) believes that China's foreign reserves are not excessive and in a suitable level since it needs sufficient reserves to maintain the stability of the yuan and to maintain the confidence of international investors. As can be seen in the Asian financial crisis, the mainly reason that China can survive among other countries should attributes to the massive foreign reserve which prevent yuan from depreciation. He also argues that China's foreign reserves have been rewarded by sufficient returns.
Nevertheless, China's spectacular economic development has presented China with a dilemma. Although foreign reserves could earn credibility and maintain stability of the Chinese currency, the accumulation of huge reserves has created pressure for the yuan to appreciate, and its further appreciation would result in financial losses and instability of the currency. Therefore, the issue whether China foreign reserves are excessive has been explored again. Some analysts suggest it would be reasonable to reduce them until an optimal level is reached.
Frankel (2004) has emphasized the opportunity cost of massive foreign reserves and believe that China was presumably paying foreign investors on their inward investment a higher return than it was earning from its investment in foreign reserves. Another argument from Xia (2006) points out that approximately 22 percent of foreign reserves accumulated in 2005 were induced by expectations of the Chinese currency's appreciation, mostly in terms of short-term capital inflows. He maintained that US$700bn in foreign exchange reserves should be sufficient. He believes China foreign reserves are fiercely large in light of the adequate level.
To identify China foreign reserve whether is excessive or not, we need to analyse the essential causes hidden in the rapid growth of holding. In terms of our study, it can be explained by a few points.
I. Exchange rate maintenance
For a long time, China has been blamed for manipulating exchange rates regime to maintain international competitiveness. It intervenes in the foreign exchange market to prevent real appreciation of the yuan. However, from July of 2005, China reformed the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. RMB has no longer been pegged to the US dollar. After the reform, the RMB exchange rate has become more flexible.
It is noteworthy that since 2005, the expectation for renminbi appreciation has been growing continually and a large amount of speculative capital has swarmed in. Therefore, the Central Bank has adopted a compulsory foreign exchange settlement policy to maintain the relative stability of the renminbi exchange rate, which is an important factor behind expanding foreign exchange reserves.
II. Financial stability
As we know, China did not face financial shock during the 1997-1998 Asian financial crisis due to the strong capital controls. Witnessing the damage inflicted on the financial and corporate sector of its neighbours it took measure to tighten the strict foreign debt management as well. At the end of 1997, its foreign debt was 373 US$ billion. Its capacity to service foreign debt, as measured by the growth of foreign reserves, has kept pace with the growth of foreign liabilities.
Consequently, the key debt ratios have been kept well with the generally accepted safety limits. In particular, the foreign reserves at that time are four times larger than short-term foreign debt which protects China from economic meltdown. That is why china favors having sizeable reserves holding because it insists that large foreign reserves help to maintain the foreign confidence deeded for attracting foreign direct investment and securing foreign loans at good terms (Ford and Huang, 1994).
It is worthy to rethink the reasons behind such huge foreign reserves in China. For the precaution functions of reserves holding, it is difficult to tell what level should be optimal or adequacy to reach a safety protection. On the other hand, if consider the economic effect, we need to have a standard for foreign reserves to minimise the cost induced by holding. In the special case of China, it is more complicate to confirm a optimal level of reserves because its has a complex economic and political environment. In this paper, we suggest to focus on the management of its reserves holidng.
Section 2 Implications on management China foreign reserves
Rregarding huge China's foreign reserves, there are theoretical misconceptions that magnifying the function of reserves holding and the more reserves the safety economics are. Under this the view of passive precautionary motive, it is suggested that reserves should not be used until the critical moment. Consequently, foreign reserves have in reality not been effectively utilized although there has been a large pool of them. Reflecting such a view, in the management of foreign reserves, factors such as the economic benefit, social benefit, risk control, efficiency of operation have been ignored. This has led to the management of reserves rigid and inflexible.
As mentioned before, foreign reserves are the important part of a country's monetary policy. Change in reserves is a tool for balancing international payments, and it is usually a result of intervention in the foreign exchange market by the central banks.
However, management of the foreign reserve is not only a policy objective, but also a protection of the export competitiveness of domestic enterprises. This is related to measures to boost economic growth and to ensure full employment, both of which are key internal factors in maintaining the balance of development. Therefore, the rapid expansion of reserve should be considered not only for political motives but also the economic motives. It should be worthy to rethink the reserves management measures comprehensively and feasibly.
The present condition of foreign reserves in China has been concerned broadly. There is a worry about the potential danger in massive reserves holding which may result in excess load for China. Therefore, it is necessary to adjust measure so as to reduce the risk and even gain profit from the large reserves. For purpose of that, controls the scale of foreign reserves and strengthen monitoring are the key principle of the management.
In the present situation, it is more important for China to implement feasible management and make good use of them.
China has long implemented the traditional trade strategy which led to sustained trade surplus and rapid expansion of foreign exchange reserves. It would not only exacerbate the pressure for renminbi appreciation, but also carries great risk. Moreover, reforming and maintaining stable renminbi exchange rate regime will be good to the foreign exchange markets which can slowdown the rapid growth in foreign exchange reserves.
Apart from reducing its adverse impacts on the macroeconomic, another task is to boost economic growth and establish a new mechanism to transform and use reserves. Further, risk management of foreign reserves should be strengthened and a risk management framework should be established and improved as well. More broadly, the efficiency of reserve operation should be lift. Finally, the capital structures of foreign reserves should be considered in a rational way.
According to these directions, we propose some available measures: a) spending and investing foreign reserves; b) gradual liberalization of the capital account; c) reserves hoarding diversification.
Since foreign reserves can be regarded as indirect debts of the government against companies and individuals, large foreign reserves could be used to import petroleum and other essential raw materials, high technology, even to invest in key sectors abroad. However, expending and investing reserves would increase liquidity risks problems. Thus, policy decisions on expenditure and investment should be carefully considered based on asset risks.
With regarding to capital liberalization, China government always keeps eyes on hot money. It allows efficient capital inflows and reasonable capital outflows through a strictly monitoring system. However, it is difficult to distinguish hot money inflows from normal short-term inflows. Moreover, RMB appreciation and net capital inflows could easily reverse if the government lifts control on capital outflows immediately. In case it happens, foreign reserves holding would still not be sufficient to satisfy the extremely high demand for foreign exchange and this could lead to a financial crisis. Therefore, capital account needs to be monitored before such thing happen.
Among the options, diversification would allow China to diversify reserves out of US dollar securities and switch into others countries bonds, given concerns over a weakening US currency. However, US dollar is still the main currency to be used in international payment. No other currency has the similar high level of liquidity as US dollar. Therefore, diversification of reserves asset may add volatility of foreign exchange markets and can catalyze abrupt exchange rate movement. As the result, we suggest the policymakers in China adopt an international reserve diversification standard including disclosure fully of the composition and having gradually adjustment from small scale reserves.
Note
1 Kenen and Yudin (1965) treated reserves as a discrete-time random walk process which is probably similar to the continuous time Wiener process. Moreover, they argue that central bank reserve holding are sensitive to the volatility in the balance of payments rather than the absolute size of the gap between international payments and receipts. Claassen (1975) also used an inventory model of international reserve choice to explain the restocking costs. Under the FJ null hypothesis, foreign reserves follow a Wiener process until hit the lower zero boundary. After, in a one-step adjustment, reserves jump back up to their optimal restocking level adhere to Wiener process again.
2 Rajan and Bird, (2003) points out this equation is a second-order Taylor-series approximation of optimal reserves holding which isunder the assumption that the special case of no reserve drift between stock adjustments.
3 A key step in taking equation (11) to data is the additional assumption that observed reserves, Rt , are proportional to optimal reserves up to an error term that is uncorrelated with and r. Hence, .
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