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Precaution Versus Mercantilism: Reserve Accumulation, Capital Controls, and the Real Exchange Rate

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  • Choi, Woo Jin
  • Taylor, Alan M.

Abstract

We document a new international stylized fact describing the relationship between real exchange rates and external asset holdings. Economists have long argued that the real exchange rate is associated with the net international investment position, appreciating as external wealth increases. This mechanism has been seen as central for international payments equilibrium and relative price adjustments. However, we argue that the effect of external assets held by the public sector -reserve accumulation- on real exchange rates may be quite different from that of privately held external assets, and that capital controls are a critical factor behind this difference. For 1975-2007, controlling for GDP per capita and the terms of trade, we find that a one percentage point increase in external assets relative to GDP (net of reserves) is related to an 0.24 percent real exchange rate appreciation. On the contrary, a one percentage point increase in reserve accumulation relative to GDP has virtually no effect on the real exchange rate in financially open countries (low capital controls), and is related to a 1.65 percent real exchange rate depreciation in financially closed countries (high capital controls). Results are stronger in developing countries and in more recent periods. Gross rather than net positions matter and we present a new theoretical model to account for the stylized fact. The framework encompasses so-called precautionary and mercantilist motives for reserve accumulation, and also explains how the optimal capital account policy -the mix of reserve accumulation and capital controls- is determined. Further empirical support arises from evidence that reserve accumulation is associated with a trade surplus, along with higher GDP and TFP growth in countries with high capital controls, findings that are consistent with the mechanisms of our model.

Suggested Citation

  • Choi, Woo Jin & Taylor, Alan M., 2017. "Precaution Versus Mercantilism: Reserve Accumulation, Capital Controls, and the Real Exchange Rate," CEPR Discussion Papers 11963, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:11963
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    Cited by:

    1. Fidora, Michael & Giordano, Claire & Schmitz, Martin, 2017. "Real exchange rate misalignments in the euro area," Working Paper Series 2108, European Central Bank.
    2. Mika Nieminen, 2017. "Patterns of international capital flows and their implications for developing countries," WIDER Working Paper Series 171, World Institute for Development Economic Research (UNU-WIDER).

    More about this item

    Keywords

    capital controls; economic growth.; Financial crises; International Reserves; real exchange rates; Trade;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies
    • O24 - Economic Development, Innovation, Technological Change, and Growth - - Development Planning and Policy - - - Trade Policy; Factor Movement; Foreign Exchange Policy

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