NBER WP # 14533
While the epicenter of the present liquidity crisis has been the US, the growing financial integration and the deepening globalization implies that the claim for the “decoupling” of developing countries from the rapid deterioration of the economic climate in the US is wishful thinking. Indeed, developing countries that on average benefited from the growth bonus of growing international trade, and improving terms of trade, are facing now the darker side of globalization – the rapid decline in trade, sudden stops and capital flight, propagated by the flight to quality and the unwinding and deleveraging of past financial inflows to developing countries. While there is no way to avoid the need to undergo the stabilization blues, the hope is that the stronger initial position of developing countries would allow them a softer landing. A key dimension of this position is the choices countries make with respect to the Trilamma — exchange rate flexibility, monetary independence and capital mobility. In a recent paper, we develop a methodology that allows us to characterize in an intuitive manner the choices countries have made with respect to the trilemma during the post Bretton-Woods period. We find that since 2000, measures of the three trilemma variables have converged towards intermediate levels characterizing managed flexibility, using sizable international reserves as a buffer, thus retaining some degree of monetary autonomy. Using these indexes, we also test the linearity of the three aspects of the trilemma: monetary independence, exchange rate stability, and financial openness. We find that the weighted sum of the three trilemma policy variables adds up to a constant, validating the notion that a rise in one trilemma variable should be traded-off with a drop of the weighted sum of the other two.
To recall, afundamental contribution of the Mundell-Fleming framework is the impossible trinity, or the trilemma, which states that a country simultaneously may choose any two, but not all, of the following three goals: monetary independence, exchange rate stability and financial integration. The trilemma is illustrated in Figure 1; each of the three sides – representing monetary independence, exchange rate stability, and financial integration – depicts a potentially desirable goal, yet it is not possible to be simultaneously on all three sides of the triangle. Over the last 20 years, most developing countries have opted for increasing financial integration. The trilemma implies that a country choosing this path must either forego exchange rate stability if it wishes to preserve a degree of monetary independence, or forego monetary independence if it wishes to preserve exchange rate stability. We begin by observing that over the last two decades, a growing number of developing countries have opted for hybrid exchange rate regimes – e.g., managed float buffered by increasing accumulation of international reserves [IR henceforth]. Despite the proliferation of greater exchange rate flexibility, IR/GDP ratios increased dramatically, especially in the wake of the East Asian crises. Practically all the increase in IR/GDP holding has taken place in emerging market countries. The magnitude of the changes during recent years is staggering: global reserves increased from about USD 1 trillion to more than USD 5 trillion between 1990 and 2006 (see Figure 2). The dramatic accumulation of international reserves has been uneven: while the IR/GDP ratio of industrial countries was relatively stable at approximately 4%, the IR/GDP ratio of developing countries increased from about 5% to about 27%. Today, about three quarters of the global international reserves are held by developing countries. Most of the accumulation has been in Asia, where reserves increased from about 5% in 1980 to about 37% in 2006 (32% in Asia excluding China).
The globalization of financial markets is evident in the growing financial integration of all groups of countries. While the original framing of the trilemma was silent regarding the role of reserves, recent trends suggest that reserve accumulation may be closely related to changing patterns of the trilemma for developing countries. The earlier literature focused on the role of international reserves as a buffer stock critical to the management of an adjustable-peg or managed-floating exchange-rate regime. While useful, the buffer stock model has limited capacity to account for the recent development in international reserves hoarding – the greater flexibility of the exchange rates exhibited in recent decades should help reduce reserve accumulation, in contrast to the trends reported above.
The recent literature has focused on the adverse side effects of deeper financial integration of developing countries – the increased exposure to volatile short-term inflows of capital (dubbed “hot money”), subject to frequent sudden stops and reversals (see Calvo, 1998). The empirical evidence suggests that international reserves can reduce both the probability of a sudden stop and the depth of the resulting output collapse when the sudden stop occurs. Aizenman and Lee (2007) link the large increase in reserves holding to the deepening financial integration of developing countries and find evidence that international reserves hoarding serves as a means of self-insurance against exposure to sudden stops. In extensive empirical analysis of the shifting determinants of international reserve holdings for more than 100 economies over the 1975-2004 period, Cheung and Ito (2007) find that while trade openness is the only factor that is significant in most of the specifications and samples under consideration, its explanatory power has been declining over time. In contrast, the explanatory power of financial variables has been increasing over time.
The increasing importance of financial integration as a determinant for international reserves hoarding suggests a link between the changing configurations of the trilemma and the level of international reserves. Indeed, Obstfeld, et al. (2008) find that the size of domestic financial liabilities that could potentially be converted into foreign currency (M2), financial openness, the ability to access foreign currency through debt markets, and exchange rate policy are all significant predictors of international reserve stocks.
We begin by constructing an easy and intuitive way to summarize these trends, in the form of a “Diamond chart,” where we add to the three trilemma dimensions – monetary independence, exchange rate stability and financial integration – a measure of international reserves hoarding (IR/GDP). Applying the methodology outlined in the next section, we construct for each country a vector of trilemma and IR configurations that measures each country’s monetary independence, exchange rate stability, international reserves and financial integration. These measures are normalized between zero and one. Each country’s configuration at a given instant is summarized by a ‘generalized diamond,’ whose four vertices measure monetary independence, exchange rate stability, IR/GDP, and financial integration.
Figures 3 and 4 provide a concise summary of the recent history of trilemma configurations for different income groups and regional groups. In each diamond chart, the origin is normalized so as to represent zero monetary independence, pure float, zero international reserves and financial autarky. Figure 3 summarizes the trends for industrial countries, emerging markets, and non-emerging developing countries. That figure reveals that, over time, developing countries moved towards greater exchange rate flexibility and deeper financial integration. Both trends are more pronounced for the emerging markets than for the non-emerging developing countries. There has been a decline in monetary independence and sizable increase in international reserves, trends that were more pronounced for the emerging markets than for the non-emerging developing countries in the 2000s. In contrast, industrial countries, after giving up some exchange rate stability during the 1980s, increased the stability of their exchange rates during the period of 1991-2006. They embraced rapid convergence to comprehensive financial integration at rates faster than the developing countries. On average, industrial countries ended up with lower monetary independence, and lower IR/GDP.
Figure 4 illustrates regional trends in developing countries. The move towards exchange rate flexibility is most evident in developing Asia, LATAM. Emerging Asian economies shared this trend until 2000, at which time exchange rate stability started increasing. The gain in IR/GDP is shared by all these regional blocs, but is much more pronounced in emerging Asia. And while the move towards financial integration applies to all these blocs, it’s more pronounced in LATAM than in developing Asia.
Figures 5 and 6 present the development of trilemma indexes for 50 countries (32 of which are developing) during the 1970-2006 time period for which we can construct a balanced data set. For the industrialized countries, financial openness accelerated after the beginning of the 1990s and exchange rate stability rose after the end of the 1990s, reflecting the introduction of the euro in 1999. The extent of monetary independence has experienced a declining trend, especially after the early 1990s. For developing countries, the experience is strikingly different. Up to 1990, exchange rate stability was the most pursued policy among the three, though it had been on the declining trend since the early 1970s. On average, during the 1990s, the level of monetary independence went up while more countries adopted floating exchange rates and liberalized financial markets. Since the millennium, interestingly, all three variables have converged, suggesting that developing countries have converged towards managed exchange rate flexibility buffered by sizable international reserves holding enabling the retention of monetary autonomy even as financial integration proceeded.
A key message of the trilemma is instrument scarcity – policy makers face a tradeoff, where increasing one trilemma variable (such as higher financial integration) would induce a drop in the weighted average of the other two variables (lower exchange rate stability, or lower monetary independence, or a combination of the two). Yet, to our knowledge, the validity of this tradeoff among the three trilemma variables has not been tested properly. A possible concern is that the trilemma framework does not impose an exact functional restriction on the association between the three trilemma policy variables.
We conduct a regression analysis to test the validity of the simplest functional specification for the trilemma: whether the three trilemma policy goals are linearly related. For this purpose, we also examine and validate that the weighted sum of the three trilemma policy variables adds up to a constant (see Figure 6). This result confirms the notion that a rise in one trilemma variable should be traded-off with a drop of a linear weighted sum of the other two trilemma variables. The regression results also provide another diagnostic tool, allowing a simple description of the changing ranking among the three trilemma policy goals over time. We close the paper by investigating the normative questions pertaining to the trilemma. More specifically, we examine how the policy choices among the three trilemma policies affect output growth volatility, inflation rates, and the volatility of inflation, with focus on developing economies. In this exploration, we also incorporate the effects of different types of cross-border financial flows.