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Hoarding international reserves versus a Pigovian tax-cum-subsidy scheme: Reflections on the deleveraging crisis of 2008-9, and a cost benefit analysis

Listed author(s):
  • Joshua Aizenman

In this paper we outline a Pigovian tax-cum-subsidy scheme that deals with concerns about the costs and efficacy of hoarding international reserves (IR) as a means of self-insurance against a deleveraging crisis. We overview the degree to which IR provided self-insurance to Emerging Markets (EMs) during the 2008-9 crisis, pointing out that the fear of losing IR constrained the use of a pre-crisis IR war-chest. The crisis validates the need for external debt management policy. EMs found that their initial large stocks of IR were not enough to prevent runs on their IR and large currency depreciations, runs that were abated in some countries only with the proliferation of deep swap-lines. The experience of EMs during the crisis raises concerns regarding the efficacy of hoarding IR as means of self-insurance. We outline the case for supporting self-insurance by imposing a tax on external borrowing. We focus on a model of an emerging market, where entrepreneurs finance tangible investments via bank intermediation of foreign borrowing. Bank intermediation exposes the economy to the risk of deleveraging, inducing a costly premature liquidation of tangible investments; a risk that increases with the ratio of aggregate external borrowing to IR. In these circumstances, price taking economic agents ignore their marginal impact on the expected cost of a deleveraging crisis, and external borrowing is associated with negative fire-sale congestion externalities. We show that an optimal borrowing tax reduces the distorted activity (external borrowing), and induces borrowers to finance the precautionary hoarding of international reserves.

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Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (2010)
Issue (Month): Oct ()
Pages:

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Handle: RePEc:fip:fedfpr:y:2010:i:oct:x:2
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  1. Aizenman, Joshua & Pasricha, Gurnain Kaur, 2010. "Selective swap arrangements and the global financial crisis: Analysis and interpretation," International Review of Economics & Finance, Elsevier, vol. 19(3), pages 353-365, June.
  2. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear of Floating," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 379-408.
  3. Dani Rodrik, 2006. "The social cost of foreign exchange reserves," International Economic Journal, Taylor & Francis Journals, vol. 20(3), pages 253-266.
  4. Paul Krugman, 2000. "Fire-Sale FDI," NBER Chapters,in: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, pages 43-58 National Bureau of Economic Research, Inc.
  5. Sebastian Edwards & Márcio G. P. Garcia, 2008. "Financial Markets Volatility and Performance in Emerging Markets," NBER Books, National Bureau of Economic Research, Inc, number edwa05-1.
  6. Eduardo Levy Yeyati, 2008. "Liquidity Insurance in a Financially Dollarized Economy," NBER Chapters,in: Financial Markets Volatility and Performance in Emerging Markets, pages 185-218 National Bureau of Economic Research, Inc.
  7. Barry Eichengreen & Ricardo Hausmann & Ugo Panizza, 2003. "Currency Mismatches, Debt Intolerance and Original Sin: Why They Are Not the Same and Why it Matters," NBER Working Papers 10036, National Bureau of Economic Research, Inc.
  8. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
  9. Joshua Aizenman & Jaewoo Lee, 2007. "International Reserves: Precautionary Versus Mercantilist Views, Theory and Evidence," Open Economies Review, Springer, vol. 18(2), pages 191-214, April.
  10. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2004. "Smoothing sudden stops," Journal of Economic Theory, Elsevier, vol. 119(1), pages 104-127, November.
  11. Aizenman, Joshua & Sun, Yi, 2012. "The financial crisis and sizable international reserves depletion: From ‘fear of floating’ to the ‘fear of losing international reserves’?," International Review of Economics & Finance, Elsevier, vol. 24(C), pages 250-269.
  12. Joshua Aizenman & Stephen J. Turnovsky, 2002. "Reserve Requirements on Sovereign Debt in the Presence of Moral Hazard -- on Debtors or Creditors?," Economic Journal, Royal Economic Society, vol. 112(476), pages 107-132, January.
  13. Yin-Wong Cheung & Xingwang Qian, 2009. "Hoarding of International Reserves: Mrs Machlup's Wardrobe and the Joneses," Review of International Economics, Wiley Blackwell, vol. 17(4), pages 824-843, 09.
  14. Aizenman, Joshua & Lee, Yeonho & Rhee, Youngseop, 2007. "International reserves management and capital mobility in a volatile world: Policy considerations and a case study of Korea," Journal of the Japanese and International Economies, Elsevier, vol. 21(1), pages 1-15, March.
  15. Kletzer, Kenneth M, 1984. "Asymmetries of Information and LDC Borrowing with Sovereign Risk," Economic Journal, Royal Economic Society, vol. 94(374), pages 287-307, June.
  16. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
  17. Romain Ranciere & Olivier D Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries; Formulas and Applications," IMF Working Papers 06/229, International Monetary Fund.
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