Francophone economist working in the US seem to be on something of a roll.
Olivier Blanchard (with Giavazzi and Sa) has developed an interesting model for US current account adjustment.
Helene Rey and Pierre-Olivier Gourinchas have incorporated the fact that dollar depreciation helps the US external position by increasing the dollar value of US external assets into their model for the dollar's value. Being French, they emphasize the advantages of the United States' “exorbitant privilege.” Being sane, they realize that a bit of exorbitant privilege doesn’t make a 6-7% of GDP trade and transfers deficit sustainable forever.Olivier Jeanne and Romain Ranciere’s model for reserve adequacy strikes me as equally important. Their model can help to determine how many reserves emerging economies need to protect against the risk that a sudden stop in capital flows will lead to a sharp crisis. The current reserves of emerging economies can then be compared with the level predicted by the model. That is one way of determining who has too few reserves -- and who has too many.
Their conclusions are eminently reasonable.
More public debt creates more need for reserves. Balance sheet mismatches – something that Jeanne and Ranciere proxy using the ratio of foreign liabilities to money in the banking sector -- create more need for reserves. An over-valued exchange rate creates the need for more reserves. Capital account integration increases the need for reserves. That was the (hard) lesson of the 1990s.
So an emerging economies with lots of public debt, a heavily dollarized banking system, an open capital accout and an overvalued exchange rate (Argentina, circa 2000) really, really need reserves.
Jeanne and Ranciere determined that countries generally need more reserves than called for by the Guidotti-Greenspan rule (hold reserves equal to your short-term external debt) to limit the risk of a crisis. That seems right to me. I have long though that emerging economies should hold around 10% of their GDP as reserves – and it now seems that informal rule of thumb has a bit of empirical support.
Of greater interest right now, though, is the fact that their model can be used to determine is a country is holding more reserves than it needs:
“Our framework provides a decomposition of the observed level of reserves between one component that can be justified as insurance against sudden stops and one component that cannot.”
What are the results?
Well, Latin America had far too few reserves in the 1980s. And it has about the right amount now. Though they note that some unnamed big countries in Latin America are a little on the low side. Or least they were back in 2004. Some large countries have increased their reserves significantly since then.
“The model might be interpreted to suggest that the current level of reserves is, on average, adequate in Latin America. However if is important to note that reserve coverage is estimated to be insufficient in some relatively large individual countries.”
Emerging Asia, by contrast, now has far more reserves than it needs.
“For the Asian countries following 1997-98, however, the model suggests that the buildup of reserves has been excessive – a finding consistent with previous analyses.”
Indeed, their model suggest that Emerging Asia economies held twice as many reserves as they needed in 2004. Asian countries had reserves equal to 26% of GDP; Jeanne and Ranciere's model suggest that they only needed reserves equal to 12% of GDP. See p. 30.
And since 2004, Asian reserves have only gone up. Particularly in one very big and important country. Jeanne and Ranciere don’t provide the level of reserves their model suggests a country like China should hold. But given the structure of their model, it seems safe to assume that China has a relatively modest need for reserves. It doesn’t have much stated public debt, which cuts its need for reserves. You can argue that China has more public debt than the reported in the official data, given all the bad bank loans, bad local government debt and the AMC bonds that the central government will eventually have to assume. But China doesn’t have an overvalued exchange rate. It certainly doesn’t have an internal balance sheet mismatch. And it isn’t integrated into global capital markets. If emerging Asia is over-reserved, it is safe to assume that China is very-over reserved.
Even those who are not obsessed with China's reserves, though, should take a look at the Jeanne-Ranciere paper. It makes a real contribution to the debate on reserve adequacy in the emerging world. And it is precisely the kind of work the IMF should be doing.
p.s. Olivier Jeanne was a colleague during my stay at the IMF. I don’t know Romain Ranciere personally, so i am not 100% sure that he is part of the Francophone world -- though his surname is suggestive.