## 3. History of Current Account Balances in East Asia

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### Overview
- Two broad interpretations explain large international reserve accumulation:
  - Modern mercantilism (Dooley, Folkerts-Landau, and Garber (2005)): hoarding international reserves as part of a deliberate development strategy to maintain an undervalued real exchange rate and facilitate growth; reserves potentially serve as “collateral” for encouraging foreign direct investment.
  - Self-insurance/precautionary demand (Ben-Bassat and Gottlieb (1992); Aizenman and Marion (2003) and others): reserves as output stabilizers that reduce the probability or depth of output collapse from capital flight or sudden stops.
- Empirical modeling and findings:
  - Aizenman and Lee (2005) augment conventional econometric specifications for international reserves with variables capturing mercantilism and self-insurance; both sets are statistically significant, but self-insurance variables play a greater economic role in recent trends.
  - Rodrik (2005) notes an alternative path to raising the reserve-to-short-term-debt ratio: reduce short-term debt exposure while accumulating reserves.

### Financial versus Monetary Mercantilism (1970–2005)
- Definitions and distinctions:
  - Financial mercantilism: outward-oriented growth via preferential financing (direct subsidies funded by state banks, financial repression, moral suasion), subsidizing investment in targeted sectors.
  - Monetary mercantilism: hoarding international reserves to affect the real exchange rate (monetary instrument).
- Key historical regularities for Japan and Korea:
  - During years of rapid growth, international reserves were almost flat at a low level; reserves “took off” during periods of relatively sluggish growth (Japan: early 1990s; Korea: from 1998).
  - Compared to the average over the decade prior to crisis, foreign exchange reserves in percent of GDP rose by nearly fivefold after 8-10 years since the crisis.
- Financial mercantilism: evidence and consequences
  - Financial mercantilism was vigorously applied during rapid growth phases in Japan and Korea (Amsden, 1989; Kim and Leipziger, 1993; Noland, 2005; Rodrik, 1995; Noland and Pack, 2003; Doi and Hoshi, 2002).
  - Japan example: Fiscal Investment and Loan Program (FILP)
    - Outstanding amount of the FILP stood at more than 80% of GDP as of the end of fiscal 2000 (March 2001).
    - Postal savings accepted 35% of total household deposits as of the end of fiscal 2000.
    - Doi and Hoshi (2002) estimate “as much as 75% of the FILP loans are bad. The expected losses are likely be 16% of GDP, or higher.”
  - Legacy: deteriorating bank balance sheets, increasing financial fragility that is sustainable during rapid growth but can induce banking crises when growth flounders.
- Monetary mercantilism: constraints and costs
  - Effectiveness requires very sluggish price and wage adjustment and that trade rivals do not adopt similar policies.
  - Monetary policy typically has only business-cycle duration real effects; long-run effects over a generation are not supported by evidence.
  - Monetary mercantilism often implies costly sterilization; if rivals follow suit, competitive hoarding can dissipate competitiveness gains.

### The Hazard of Competitive Hoarding
- Competitive hoarding framed as a negative externality akin to competitive devaluation:
  - Two symmetric countries H and F; additional hoarding by H depreciates H’s real exchange rate and improves H’s short-run competitiveness.
  - Reduced-form setup: H’s net exports depend positively on relative hoarding: *)]1log(1[0 RRgXNE−++=, with quadratic cost of hoarding (sterilization and indirect costs).
  - Policymaker H maximizes: 2 00 )(5.0*)]1log(1[RRbRRgX−−−++.
  - Reaction functions and symmetric Nash equilibrium described; cooperative outcome differs from noncooperative outcome.
  - Numerical example plotted: symmetric world with g = 2, b = 10; non-cooperative equilibrium at S, cooperative at O.
  - Welfare cost associated with competitive hoarding stated as: 2 0.5/0.5gbgχ=.
- Policy implication:
  - Regional pooling (an “Asian International Reserve Fund”) could commit countries to refrain from competitive hoarding and internalize the negative externality.
  - The case for an Asian fund is argued to be stronger than for a similar Latin American regional fund given the greater importance of manufacturing in East Asia and the deeper financial repression in some East Asian countries.
  - Caveat on risk-sharing: if regional risks are more positively correlated inside the region than with outside countries, risk sharing favors outside partners (Imbs and Mauro (2006)); nevertheless, pooling can reduce competitive hoarding externalities and lower precautionary reserve needs.

### Do Financial Mercantilists Beggar Their Neighbors?
- Comparison of externalities:
  - Monetary mercantilism directly targets relative prices between home and foreign exports and can harm trading partners’ competitiveness.
  - Financial mercantilism targets the relative price of capital to foster sectors with dynamic externalities; negative externalities on trading partners are not a necessary outcome and depend on whether export promotion shifts world relative prices.
- Empirical notes:
  - During rapid growth, Korea and Japan did not always run large current account surpluses (see Figure 3).
- Cost of bank restructuring and international reserves:
  - The foreigner does not pay the cost of domestic banking sector problems simply because reserves are held in foreign government securities; these were bought at market prices and are financial transactions—not transfers from borrower to lender.
  - Restructuring costs are typically borne by domestic taxpayers rather than foreign holders of reserves.

### Bank Fragility: Observational Equivalence of Monetary Mercantilism and Self-Insurance
- Relationship between bank fragility and reserve hoarding:
  - Growing bank fragility often accompanies the shift from financial mercantilism to large reserve hoarding.
  - Fragility arises from legacy bad borrowing and deteriorating borrower growth prospects.
- Empirical stylized fact:
  - Hutchison and Noy (2005) report that “... the onsets of 31% of banking crises were accompanied by currency turmoil. Furthermore, there is a statistically significant correlation between lagged banking crises and contemporaneous currency crises but not vice versa.”
- Observational equivalence and data uncertainty:
  - Precautionary hoarding to avoid banking-to-currency crisis transmission may be observationally indistinguishable from monetary mercantilism when reserve data are good but data on non-performing loans are spotty.
  - Example metrics and uncertainty for China:
    - Foreign exchange reserves rose from $105 billion at the end of 1996 to $820 billion at the end of 2005 (and to $950 billion in July 2006).
    - In percent-of-GDP terms, China’s reserves rose about fivefold, similar to post-crisis increases in Japan and Korea.
    - Ratio of banks’ non-performing loans/international reserves in China is estimated to be in the range of about 20% (Bank of China estimate) to more than 90% (Jim Peterson’s report, International Herald Tribune, 9-11-2006).
    - Barnett (2004) estimated non-performing loans at 23 percent of GDP on average for 2002-03, more than 90 percent of the international reserves in 2002-03.
  - Empirical literature on China:
    - Aizenman and Lee (2005) find reserves accumulation more closely associated with precautionary variables related to financial fragility than with monetary-mercantilist variables.
    - Cheung, Chinn, and Fujii (2006) find China’s currency substantially undervalued by 2004 in terms of price-level deviation from the international trend, but the undervaluation still lies within the two standard-deviation band of the international trend; authors conclude little evidence of statistically significant real undervaluation.
- Implication:
  - Given data limitations and near-observational equivalence, both precautionary motives and monetary mercantilism may be at work; competitive hoarding among regional peers can amplify reserve accumulation.

### Conclusion and Policy-Relevant Findings
- Aggregate facts:
  - International reserves held by China, Japan, and Korea exceeded 2 trillion dollars by the summer of 2006.
  - Reserve accumulation patterns: low reserves during rapid growth; reserves “took off” during growth collapses or slowdowns (Japan early 1990s; Korea after 1997 crisis; China after the Asian crisis though without a preceding sharp slowdown).
- Interpretive conclusions:
  - Financial mercantilism (credit allocation/subsidies) appears to have been a central instrument during East Asia’s rapid growth decades; monetary mercantilism is less plausible as a long-run instrument given the limited long-run real effects of monetary policy.
  - Financial mercantilism carries significant costs—heightened financial-sector fragility and large contingent liabilities—which can prompt precautionary reserve accumulation once growth slows or banking problems surface.
  - Monetary mercantilism can lower the perceived cost of precautionary hoarding (by providing competitiveness benefits), but if replicated by peers it can lead to competitive hoarding with welfare losses.
- Policy implications and recommendations:
  - Regional reserve pooling could help internalize negative externalities from competitive hoarding and reduce inefficient over-accumulation of reserves.
  - Prudent macroeconomic (especially fiscal) policies are critical to limit the long-run burden on the financial sector created by financial mercantilism.
  - Distinguishing precautionary hoarding from monetary mercantilism requires better data on banking sector health (non-performing loans and balance-sheet fragility) to avoid misattribution of motives for reserve accumulation.

*Source: _wp06280 - 3. History of Current Account Balances in East Asia*

### References..............................................................................................................

### References............................................................................................................................... 20

### Figures

- 1. Japan and Korea: Foreign Exchange Reserves and Economic Growth ...............................16
- 2. Competitive Hoarding..........................................................................................................17

*Source: _wp06280 - References............................................................................................................................... 20*

### 3. History of Current Account Balances in East Asia..............................................................18

### 3. History of Current Account Balances in East Asia

### Overview
- Two broad interpretations explain large international reserve accumulation:
  - Modern mercantilism (Dooley, Folkerts-Landau, and Garber (2005)): hoarding international reserves as part of a deliberate development strategy to maintain an undervalued real exchange rate and facilitate growth; reserves potentially serve as “collateral” for encouraging foreign direct investment.
  - Self-insurance/precautionary demand (Ben-Bassat and Gottlieb (1992); Aizenman and Marion (2003) and others): reserves as output stabilizers that reduce the probability or depth of output collapse from capital flight or sudden stops.
- Aizenman and Lee (2005) augment conventional econometric specifications for international reserves with variables capturing mercantilism and self-insurance; both sets are statistically significant, but self-insurance variables play a greater economic role in recent trends.
- Rodrik (2005) notes an alternative path to raising the reserve-to-short-term-debt ratio: reduce short-term debt exposure while accumulating reserves.

### Financial versus Monetary Mercantilism (1970–2005)
- Definitions and distinctions:
  - Financial mercantilism: outward-oriented growth via preferential financing (direct subsidies funded by state banks, financial repression, moral suasion), subsidizing investment in targeted sectors.
  - Monetary mercantilism: hoarding international reserves to affect the real exchange rate (monetary instrument).
- Key historical regularities for Japan and Korea:
  - During years of rapid growth, international reserves were almost flat at a low level; reserves “took off” during periods of relatively sluggish growth (Japan: early 1990s; Korea: from 1998).
  - Compared to the average over the decade prior to crisis, foreign exchange reserves in percent of GDP rose by nearly fivefold after 8-10 years since the crisis.
- Financial mercantilism: evidence and consequences
  - Financial mercantilism was vigorously applied during rapid growth phases in Japan and Korea (Amsden, 1989; Kim and Leipziger, 1993; Noland, 2005; Rodrik, 1995; Noland and Pack, 2003; Doi and Hoshi, 2002).
  - Japan example: Fiscal Investment and Loan Program (FILP)
    - Outstanding amount of the FILP stood at more than 80% of GDP as of the end of fiscal 2000 (March 2001).
    - Postal savings accepted 35% of total household deposits as of the end of fiscal 2000.
    - Doi and Hoshi (2002) estimate “as much as 75% of the FILP loans are bad. The expected losses are likely be 16% of GDP, or higher.”
  - Legacy: deteriorating bank balance sheets, increasing financial fragility that is sustainable during rapid growth but can induce banking crises when growth flounders.
- Monetary mercantilism: constraints and costs
  - Effectiveness requires very sluggish price and wage adjustment and that trade rivals do not adopt similar policies.
  - Monetary policy typically has only business-cycle duration real effects; long-run effects over a generation are not supported by evidence.
  - Monetary mercantilism often implies costly sterilization; if rivals follow suit, competitive hoarding can dissipate competitiveness gains.

### The Hazard of Competitive Hoarding
- Competitive hoarding as a negative externality akin to competitive devaluation:
  - Two symmetric countries H and F; additional hoarding by H depreciates H’s real exchange rate and improves H’s short-run competitiveness.
  - Reduced-form setup: H’s net exports depend positively on relative hoarding: *)]1log(1[0 RRgXNE−++=, with quadratic cost of hoarding (sterilization and indirect costs).
  - Policymaker H maximizes: 2 00 )(5.0*)]1log(1[RRbRRgX−−−++.
  - Reaction functions and symmetric Nash equilibrium described; cooperative outcome differs from noncooperative outcome.
  - Numerical example plotted: symmetric world with g = 2, b = 10; non-cooperative equilibrium at S, cooperative at O.
  - Welfare cost associated with competitive hoarding stated as: 2 0.5/0.5gbgχ=.
- Policy implication: regional pooling (an “Asian International Reserve Fund”) could commit countries to refrain from competitive hoarding and internalize the negative externality.
  - The case for an Asian fund is argued to be stronger than for a similar Latin American regional fund given the greater importance of manufacturing in East Asia and the deeper financial repression in some East Asian countries.
  - Caveat on risk-sharing: if regional risks are more positively correlated inside the region than with outside countries, risk sharing favors outside partners (Imbs and Mauro (2006)); nevertheless, pooling can reduce competitive hoarding externalities and lower precautionary reserve needs.

### Do Financial Mercantilists Beggar Their Neighbors?
- Comparison of externalities:
  - Monetary mercantilism directly targets relative prices between home and foreign exports and can harm trading partners’ competitiveness.
  - Financial mercantilism targets the relative price of capital to foster sectors with dynamic externalities; negative externalities on trading partners are not a necessary outcome and depend on whether export promotion shifts world relative prices.
- Empirical notes:
  - During rapid growth, Korea and Japan did not always run large current account surpluses (see Figure 3).
- Cost of bank restructuring and international reserves:
  - The foreigner does not pay the cost of domestic banking sector problems simply because reserves are held in foreign government securities; these were bought at market prices and are financial transactions—not transfers from borrower to lender.
  - Restructuring costs are typically borne by domestic taxpayers rather than foreign holders of reserves.

### Bank Fragility: Observational Equivalence of Monetary Mercantilism and Self-Insurance
- Growing bank fragility often accompanies the shift from financial mercantilism to large reserve hoarding.
  - Fragility arises from legacy bad borrowing and deteriorating borrower growth prospects.
  - Empirical stylized fact: Hutchison and Noy (2005) report that “... the onsets of 31% of banking crises were accompanied by currency turmoil. Furthermore, there is a statistically significant correlation between lagged banking crises and contemporaneous currency crises but not vice versa.”
- Observational equivalence:
  - Precautionary hoarding to avoid banking-to-currency crisis transmission may be observationally indistinguishable from monetary mercantilism when reserve data are good but data on non-performing loans are spotty.
  - Example metrics and uncertainty:
    - China: foreign exchange reserves rose from $105 billion at the end of 1996 to $820 billion at the end of 2005 (and to $950 billion in July 2006).
    - In percent-of-GDP terms, China’s reserves rose about fivefold, similar to post-crisis increases in Japan and Korea.
    - Ratio of banks’ non-performing loans/international reserves in China is estimated to be in the range of about 20% (Bank of China estimate) to more than 90% (Jim Peterson’s report, International Herald Tribune, 9-11-2006).
    - Barnett (2004) estimated non-performing loans at 23 percent of GDP on average for 2002-03, more than 90 percent of the international reserves in 2002-03.
  - Empirical literature on China:
    - Aizenman and Lee (2005) find reserves accumulation more closely associated with precautionary variables related to financial fragility than with monetary-mercantilist variables.
    - Cheung, Chinn, and Fujii (2006) find China’s currency substantially undervalued by 2004 in terms of price-level deviation from the international trend, but the undervaluation still lies within the two standard-deviation band of the international trend; authors conclude little evidence of statistically significant real undervaluation.
- Implication: given data limitations and near-observational equivalence, both precautionary motives and monetary mercantilism may be at work; competitive hoarding among regional peers can amplify reserve accumulation.

### Conclusion and Policy-Relevant Findings
- Aggregate facts:
  - International reserves held by China, Japan, and Korea exceeded 2 trillion dollars by the summer of 2006.
  - Reserve accumulation patterns: low reserves during rapid growth; reserves “took off” during growth collapses or slowdowns (Japan early 1990s; Korea after 1997 crisis; China after the Asian crisis though without a preceding sharp slowdown).
- Interpretive conclusion:
  - Financial mercantilism (credit allocation/subsidies) appears to have been a central instrument during East Asia’s rapid growth decades; monetary mercantilism is less plausible as a long-run instrument given the limited long-run real effects of monetary policy.
  - Financial mercantilism carries significant costs—heightened financial-sector fragility and large contingent liabilities—which can prompt precautionary reserve accumulation once growth slows or banking problems surface.
  - Monetary mercantilism can lower the perceived cost of precautionary hoarding (by providing competitiveness benefits), but if replicated by peers it can lead to competitive hoarding with welfare losses.
- Policy implications:
  - Regional reserve pooling could help internalize negative externalities from competitive hoarding and reduce inefficient over-accumulation of reserves.
  - Prudent macroeconomic (especially fiscal) policies are critical to limit the long-run burden on the financial sector created by financial mercantilism.
  - Distinguishing precautionary hoarding from monetary mercantilism requires better data on banking sector health (non-performing loans and balance-sheet fragility) to avoid misattribution of motives for reserve accumulation.

*Source: _wp06280 - 3. History of Current Account Balances in East Asia..............................................................18; https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06280.pdf*

### REFERENCES

### _wp06280 - REFERENCES

### References list

- Aizenman, Joshua, and Nancy P. Marion, 2003, “The High Demand for International Reserves in the Far East: What’s Going On?” Journal of the Japanese and International Economies, Vol. 17, pp. 370–400.  
- ———, 2004, “International Reserves Holdings with Sovereign Risk and Costly Tax Collection,” Economic Journal, Vol. 114, pp. 569–91.  
- Aizenman, Joshua, and Jaewoo Lee, 2005, “International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence,” NBER Working Paper No. 11366   (Cambridge, Massachusetts: National Bureau of Economics Research).  
- Amsden, Alice H., 1989, Asia’s Next Giant: South Korea and Late Industrialization, (New York: Oxford University Press).  
- Barnett, Steven, 2004, “Banking Sector Developments,” in China’s Growth and Intergration into the World Economy, edited by Eswar Prasad, IMF Occasional Paper No. 232 (Washington: International Monetary Fund), pp. 43–50.  
- Ben-Bassat, Avraham, and Daniel Gottlieb, 1992, “Optimal International Reserves and Sovereign Risk,” Journal of International Economics, Vol. 33, pp. 345–62.  
- Caballero, Ricardo, and Stavros Panageas, 2004, “A Quantitative Model of Sudden Stops and Liquidity Management,” (unpublished; Cambridge, Massachusetts: MIT).  
- Caballero, Ricardo, Emmanuel Farhi, and Pierre-Olivier Gourinchas, 2005, “An Equilibrium Model of Global Imbalances and Low Interest Rates,” (unpublished; Cambridge, Massachusetts: MIT).  
- Chang, Roberto, and Andres Velasco, 1999, “Liquidity Crisis in Emerging Markets: Theory and Policy,” NBER/Macroeconomics Annual, pp. 11-57.  
- Cheung, Yin-Wong, Menzie D. Chinn, and Eiji Fujii, 2006, “The Overvaluation of Renminbi Undervaluation,” (unpublished; Santa Cruz, California: UCSC).  
- Doi, Takero, and Takeo Hoshi, 2002, “FILP: How Much Has Been Lost? How Much More Will Be Lost?” (unpublished; Sand Diego, California: USSD).  
- Dooley P. Michael, David Folkerts-Landau, and Peter Garber, 2005,“International Financial Stability,” (unpublished; London, U.K.: Deutsche Bank). This is a manuscript with all their papers, at http://econ.ucsc.edu/~mpd/Int%20Fin%20Stab.pdf.  
- Eichengreen, Barry, 2006, “Insurance Underwriter or Financial Development Fund: What Role for Reserve Pooling in Latin America?” NBER Working Paper No. 12451 (Cambridge, Massachusetts: National Bureau of Economics Research).  
- Fundenberg, D., and J. Tirole, 1983, “Learning by Doing and Market Performance,” Journal of Economics, Vol. 14, pp. 522–30.  
- Garcia, Pablo, and Claudio Soto, 2004, “Large Holdings of International Reserves: Are They Worth It?” Central Bank of Chile, Working Papers No. 299 (Santiago).  
- Hutchison, M., Michael, and Ilan Noy, 2005, "How Bad Are Twins? Output Costs of Currency and Banking Crises," Journal of Money, Credit, and Banking, Vol. 37, No. 4, pp.725-52.  
- Imbs, Jean, and Paolo Mauro, 2006, “Pooling Countries” (unpublished; Washington: International Monetary Fund).  
- Iwamoto, Yasushi, 2002, “The Fiscal Investment and Loan Program in Transition” (unpublished; Tokyo: Hitotsubashi University).  
- Jeanne, Olivier, and Romain Ranciere, 2005, “The Optimal Level of International Reserves for Emerging Market Economies: Formulas and Applications,” IMF Research Department (unpublished; Washington: International Monetary Fund).  
- Kaminsky, Graciela L., and Carmen M. Reinhart, 1999, “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems,” American Economic Review; Vol. 89 No.3, pp. 473-500.  
- Kim, Kihwan, and Danny Leipziger, 1993, “Korea: A Case of Government Led Development,” World Bank Country Study (Washington: World Bank).  
- Krueger, Russell, 2002, “International Standards for Impairment and Provisions and Their Implications for Financial Soundness Indicators (FSIs)” (unpublished; Washington: International Monetary Fund).  
- Krugman, Paul, 1987, “The Narrow Moving Band, the Dutch Disease, and the Competitive Consequences of Mrs. Thatcher: Notes on Trade in the Presence of Dynamic Scale Economies,” Journal of Development Economics, Vol. 27, pp. 41–55.  
- Leahy, Dermot, and Peter Neary, 1999, “Learning by Doing, Precommitment and Infant-Industry Promotion,” Review of Economic Studies, Vol. 12, No.3, pp. 435-40.  
- Lee, Jaewoo, 1996, “Financial Development by Learning,” Journal of Development Economics, Vol. 50, pp. 147–64.  
- ———, 2004, “Insurance Value of International Reserves,” IMF Working Paper No. 04/175 (Washington: International Monetary Fund).  
- McCauley, Robert, 2005, “Distinguishing Global Dollar Reserves from Official Holdings in the United States,” BIS Quarterly Review, September, pp. 57–72.  
- Melitz, Jacques, 1996, “Assessing the Costs of European Monetary Union,” Atlantic Economic Journal, Vol. 24, No. 4, pp. 269–80.  
- Noland, Marcus, 2005, “South Korea’s Experience with International Capital Flows,” NBER Working Paper No. 11381 (Cambridge, Massachusetts: National Bureau of Economic Research).  
- Noland, Marcus, and Howard Pack, 2002, Industrial Policy in an Era of Globalization, (Washington: Institute for International Economics).  
- Rajan, Raghuram, and Luigi Zingales, 2003, Saving Capitalism from Capitalists, (New York: Crown Business).  
- Rodrik, Dani, 1995, “Getting Interventions Right: How South Korea and Taiwan Grew Rich,” Economic Policy, No. 20.  
- ———, 2006, “The Social Cost of Foreign Exchange Reserves,” International Economic Journal, Vol. 20. No. 3, pp. 253-66.  
- Romer, P., 1990, “Endogenous Technical Change,” Journal of Political Economy, Vol. 98, No. 5, pp. S71–S102.  
- Spencer, B., and J. A. Brender, 1983, “International R&D Rivalry and Industrial Policy,” Review of Economic Studies, Vol. 50, pp. 707–22.  
- World Bank, 1993, The East Asian Miracle (New York: Oxford University Press).  
- Wyplosz, Charles, 2002, “Regional Monetary Arrangements: Lessons from Europe,” (unpublished; Geneva: Graduate Institute for International Studies).  
- Wyplosz, Charles, 1996, “French Postwar Growth: From (Indicative) Planning to (Administered) Market,” in N. Crafts and G. Toniolo, eds., Economic Growth in Europe since 1945 (Cambridge: Cambridge University Press).

*Source: _wp06280 - REFERENCES*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06280.pdf_