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Representative Office for theAmericas

International reserves and gross capital flows dynamics

Enrique AlberolaJoint paper with Aitor Arce (ESM) and Jose M. Serena (Banco de España)

May 2015

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Outline

1. Intro2. Setup and Econometric results3. Economic significance4. Conclusions

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Introduction

Look at an old question: the role of international reserves Self insurance is common rationale for accumulation

- IMF, Calvo et al. (2008), …Obstfeld (2011)>capital flight Large literature on sudden stops.

- Inconclusive results -reserves hardly affect the occurrence of suddenstops (net flows)

…but countries do accumulate reserves & fear of losing reserves

Objective: revisit the role of international reserves during financial stress using a gross flows approach.

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Defining the variables

Gross flows, on a quarterly basis. 63 countries Time span: 1991-2011. Focus on emerging countries, also advanced Total flows & short term

Foreign financial inflows - non-resident investments in the country Gross financial inflows (GFI)= FDI+Portfolio inflows+Other inflows

short term

Domestic financial outflows –resident investments abroad Gross financial outflows (GFO)= FDI+ Portfolio outflows+ other outflows

In terms of GDP t-4 to t , also t, to t+3 Normalised using S.D.

Underlined = robustness checks

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Defining the variables. Financial Stress

Global financial stress, global EMBI:1. Episodes: 2 s.d over its mean & period to peak (as Calvo et al., 2007).

- Four episodes: 1Q95; 3Q98; 4Q01; 4Q08. B) 2. Financial stress intensity= EMBI spreads

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Reserve adequacy - two rules of thumb: R/IL, reserves to international

financial liabilities- potential disinvestments by

non-residents >>> grossforeign inflows

R/M2, Reserves to M2- potential capital flight by

residents>>> grossdomestic outflows

Stylized facts: R/IL and R/M2 are higher in

emerging economies R/M2 and R/IL contain different

information (corr 0.37 for EMEs)

Defining the variables. Reserves

510

1520

25si

mpl

e av

erag

e

19900 19950 20000 20050 20100period

R/FL, Emerging R/FL, Advanced

Reserves to FL

010

2030

40si

mpl

e av

erag

e

19900 19950 20000 20050 20100period

R/M2, Emerging R/M2, Advanced

Reserves to m2

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Preliminary evidence

Times of global stress followed by retrenchment of capital –in both directions-, in particular in emerging markets economies

-10

01

02

03

0 p

p,

sim

ple

avera

ge

19900 19950 20000 20050 20100period

Inflows Outflows Net flows

Financial flows, Advanced

05

10

15

20

pp G

DP

, si

mp

le a

vera

ge

19900 19950 20000 20050 20100period

Inflows Outflows Net flows

Financial flows, Emerging

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Basic model augmented by role of reserves in foreign inflowsand domestic outflows

�𝑥𝑥𝑖𝑖𝑖𝑖 = 𝛼𝛼 + 𝜃𝜃𝑖𝑖 + 𝜌𝜌𝑖𝑖𝑡𝑡 + 𝛿𝛿𝛾𝛾𝑖𝑖𝑖𝑖−1 + 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑖𝑖𝑖𝑖 + 𝜀𝜀𝑖𝑖𝑖𝑖

The econometric exercise

Estimation

Panel

Trend & country dummies

Robust errors:

-Heteroskedasticity-Autocorrelation-Cross-correlation(Driscoll-Kraay)

Flows

Gross foreigninflows (GFI)

Gross domesticoutflows (GFO)

-Short term v total

-EMEs

Controls

-E-r regime

-Rating

-GDP growth

-Embi

-VIX

-EVENT

-Dummy = 4q cumulated flows

-interaction withReserves

2 benchmarks- Reserves/IL >> GFI- Reserves/M2 >> GFO

1. Event analysis• Interaction with reserves• Linear and quadratic terms

2. Level of stress EMBI• Interaction with reserves• Linear and quadratic terms• Robustness checks

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Behaviour in EMEs during events, controlling for other determinants, usingReserves to M2

Reserves affect outflows and dilute event impact

No such effect on inflows (N.B, M2 is not the adequate scaling)

Gross flows and the role of reserves. Exploring the link. Preliminary evidence

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Behaviour during events, controlling for other determinants, using Reserves to international liabilities (IL)

Reserves do not affect inflows and event is still significant

Gross flows and the role of reserves. Exploring the link. Preliminary evidence

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EMBI as intensity of stress

Confirmed reserve bring about a retrenchment in outflows

Plus a level effect: higher reserves reduce outflows across the board

Gross flows and the role of reserves. Exploring the link. Intensity of stress

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Use Reserves and EMBI, with interaction between EMBI and Reserves

There is now an impact on inflows

Plus a level effect: higher reserves increase inflows

But results don’t hold in forward looking specifications considering short termoutflows

Gross flows and the role of reserves. Exploring the link. Intensity of stress

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Econometric analysis. Economic significance

How important are reserves, during financial stress? Not possible to ascertainfrom coefficients.

Reserves and EMBI appear in several variables 𝑅𝑅𝑖𝑖𝑖𝑖 𝑅𝑅𝑖𝑖𝑖𝑖2

, 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑖𝑖∗

𝑅𝑅𝑖𝑖𝑖𝑖 , 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑖𝑖∗ 𝑅𝑅𝑖𝑖𝑖𝑖2

, 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑖𝑖

Economic Impact at two EMBI values - 200 bp; and 1000 bp (average of financial stress during windows of instability)- for different ratios of reserves.

On gross domestic outflows: ratios of reserves to M2 [0-90] (99% of observations).

On gross financial inflows: ratios of reserves to FL [0-50] (99% of observations).

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Economic significance. Foreign inflows1. Lower during financial stress no matter the level of reserves; 2. Reserves mitigate –but don’t prevent- the reduction in inflows, up to a certain

level of reserves; 3. Higher reserves lead to boom-bust of financial inflows

-5

0

5

10

15

20

0 5 10 15 20 25 30 35 40 45 50

Reserves to financial liabilities

EMBI 200 bp EMBI 1000 bp

Note: non-linearitiesare not extremelyrobust

(2) R/IL MITIGATE,THE REDUCTION OF INFLOWS –ARE HIGHER FOR MEDIUM RESERVES

(3) HIGHER RESERVES MAY LEAD TO A BOOM-BUST IN FINANCIAL INFLOWS

(1) CONTRACT DURING FINANCIAL STRESS FOR ALL LEVELS OF RESERVES

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Economic significance. Domestic outflows

1. in times of stress, reserves foster sizable domestic capital retrenchment; 2. only up to a certain level of reserves, capital flight; 3. low stocks of reserves imply higher outflows of capital

0

2

4

6

8

10

12

14

0 10 20 30 40 50 60 70 80 90

Reserves to M2

EMBI 200 bp EMBI 1000 bpDomestic outflows (GDO), pp of GDP

(1) RESERVES FOSTER CAPITAL RETRENCHMENT DURING STRESS TIME (3) ONLY UP TO A

LEVEL OF RESERVES, ABOVE A GIVEN THRESHOLD THERE ARE RISKS OF CAPITAL FLIGHT

(3) COUNTRIES WITH LOW RESERVES ALSO EXPERIENCE LARGER OUTFLOWS UNDER STRESS Note: non-linearities

are robust, but fewdata may blurresults

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Conclusions Investigate dynamics of capital flows around periods of global financial stress –

and relate them to international reserves holdings –gross flows approach

Financial inflows contract as financial stress increases. As for the role of reserves, it is relevant, with some caveats:

Moderate levels of international reserves, mesured in terms of internationalfinancial liabilities, smooth , but not prevent, the contraction.

High levels of reserves may lead to a boom-bust of gross financial inflows

Domestic outflows do depend significantly on international reserves:

Medium/high levels of reserves to M2 ease retrenchment of domesticoutflows, and this is robust

Indeed, domestic outflows can increase wrt normal times if reserves are toolow

All in all, in EMEs reserves prevent a sharp adjustment of net flows during stress, in a somewhat unexpected way – mostly by reducing domestic outflows byresidents

….but they foster higher capital inflows and scope for boom-bust cycles16

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Complementary slides

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Complementary slides0

.005

.01

.015

.02

.025

Den

sity

0 50 100 150IR over M2

Note: IFS, WDI, own elaboration.

Ratio Reserves to M2

0.0

1.0

2.0

3.0

4.0

5D

ensi

ty

0 20 40 60 80IR over International Liabilities

Source: IFS, WDI, own elaboration.

Ratio Reserves to IL

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