Literature Review focusing on China’s Foreign Reserves

The recent surge in foreign reserves of emerging market has revived old debates about the optimal level of reserves. China is a typical representative case for this buildup. In 1990 China hold 29.5 billion dollars foreign reserves around 8% of GDP denoted by dollars. During past 5 years the average reserves to GDP ratio surge dramatically to 42.5%. In 2006 China overtook Japan as the country with the largest foreign exchange reserves.

For the sake to solve the puzzle of recent buildup it is necessary to establish a quantity criterion to measure the optimal level of reserves. Therefore this dissertation mange to extent original Jeanne and r(2008) ‘s model in order to establish a more precise standard to evaluate the optimal level of foreign reserves.

This dissertation contributes to a long list of literature on reserves.

The dissertation is structured as follows. Section 2 present the position of china’s foreign reserve, moreover measure the adequacy of the level of reserves by reference to several conventional benchmark. Section 3 exhibit the extend model yielding a modified formula for the optimal reserves. Section 4 show the calibration of the model and investigate the model by using sensitive analysis. Section 5 estimate the probability of sudden stop by employing Ben-Bassat and Gottlieb’s approach. Section 6 present the conclusion and reveal possible limitation of this dissertation.

Literature review

Early theories

Under the gold standard money system, gold serve as the fundamental preparation for currency issue. Meanwhile in this period gold is the main form of the international reserves. Therefore the relationship between gold reserves and domestic money supply attracted great research attention for the politics and academics. According to Thornton (1802), the level of the gold reserve is determined by the potential benefits in smoothing domestic fluctuations. This theory, however, fails to accounted the external factors such as trade deficits (Keynes 1913,1930). In 1940’s the researcher come to an agreement that international reserves should consider to be an stock for international transaction rather than backing of domestic money supply(Badinger 2001). Hence in the following period the academics conduct their study of level of international reserves on the area of international trade.

The Benchmark or ratio approach

With the development of international trade, the requirement of payment for international truncation became the main function of the foreign reserve. Nevertheless after the Second World War major countries implement exchange controls for the reason that inadequate international liquidity. Therefore IMF was required to supervise exchange controls by employed some benchmark or yardstick. Triffin(1946) state that the adequacy of international reserves should be judged by the ratio of reserve to imports. According to Triffin’s(1946) research if the reserve ratio maintain the level of 30%, it allows the country to mitigate the effect of external deficit. Triffin(1960) demonstrate that reserves to imports ratio (R/M) serves as a good indicator of optimal reserve level. Through the analysis of data from 12countries from 1950-1957, Triffin(1960) point out that the appropriate R/M ratio should be 40%, moreover 25% is the floor boundary for the level of the reserve.

R/M ratio approach become prevalence in the monetary authorities duo to its simplicity and practical which is quite easy to adopt. In practice, the government maintains the level of reserve enough to cover three months import (Williamson 1973). Also this approach is employed by academics to measure the adequacy of the demand foreign reserve.

Although the practical of the Triffin’s ratio, it is criticized by researchers due to its flaws. Foremost the R/M ratio approach is based on international trade, however, this statement is not consistent with the definition of the function of foreign reserve. Nurkse(1944) emphasize that foreign reserves are consider to use as finance deficit payment rather than trade purpose. In other word authorities not only have the obligation but also impossible to make a payment for the private sector. The central bank serves simply as an agent for the private sector during exchange controls period.

Furthermore the R/M ratio fails to include strong theoretical support. Grubel (1971) indicated that the Triffin’s ratio approach is simply a transform of the relation of money demand and the volume of transactions. This implication implies that there is a stable relationship between requirement of foreign reserve and international transaction. In other word the R/M ratio is only a replicate of the theory of money quantity. Thus the ratio approach is not an sufficient evidence to discriminate the optimal level of foreign reserve.

In addition, the Triffin’s ratio implies the demand of reserve is solely determined by trade. It fails account other factors relevant to the reserve such as the fluctuation of international trade (Nukse, 1944 and Heller, 1968) Last but not the least, it is not appropriate that set a stable standard about 40% to all countries through different time. The R/M ratio is too rigid to serve as an benchmark (Badinger 2000).Accordingly, Triffin’s R/M ratio is insufficient served as criteria to determine the level of foreign reserve.

With the development of the theory for the optimal reserve, researchers have capture improvement for the ratio approach by employed other factors such as: reserves to short-term external debt, reserves to M2 ratio and reserves to GDP ratio.

After the domination of the Triffin’s ratio, the most prevalent ratio used by researcher and political is reserves to short-term external debt ratio also called “Greespan Guidotti Rule”. This ratio imply that for the sake of maintain an rational country’s operation, the authority should hold enough foreign reserves to resist the possibility of a massive withdrawal of short term debt. Compared with Trufin’s ratio, Greenspan Guidotti Rule lead to a shift of attention to the vulnerability of a country’s financial account. According to Bussiere and Mulder (1999) reserves to short-term debt ratio is a proper benchmark for the emerging economy community that with good fundamentals. In other word by reference to the ratio, the authority is easy to avoid contagion-related crises. Besides this approach is supported by recent empirical research ( Jeanne and Ranci 2005 Jeanne 2007). Accordingly, this ratio have already been incorporated as an benchmark by IM