The build-up of global imbalances has been driven in part by emerging market economies’ accumulation of large stocks of reserves – a trend that some authors view as self-insurance against volatility in international capital flows (Aizenman 2009, Aizenman and Sun 2009).1 Consistent with this view, Managing Director Dominique Strauss-Kahn recently declared that the IMF had the potential to contribute to the resolution of global financial imbalances by serving as an alternative provider of insurance to emerging market economies (IMF 2009). Ricardo Caballero (2009) proposes the introduction of new insurance instruments against sudden capital reversals that would allow those countries to dispense with large holdings of international reserves.
Global imbalances and precautionary reserves
Emerging market countries accumulate reserves to insure themselves against a variety of risks. In particular, a significant share of capital outflows from emerging markets originates in commodity-exporting countries that are exposed to fluctuations in the price of their main export.2 This risk seems more insurable and raises less moral hazard concerns than other country risks (such as sudden stops in capital flows or sovereign defaults) that are more endogenous to country policies.
In principle, hedging against commodity price risk could substantially reduce the demand for reserves of commodity-exporting countries and increase their welfare, but we know relatively little about the magnitude of these effects.
In a recent paper (Borensztein, Jeanne, and Sandri 2009), we attempt to fill this gap by quantifying the potential impact of hedging for commodity-exporting countries using a calibrated model.
Hedging for commodity exporting countries
Many countries earn a large share of their income from the export of commodities, oil and natural gas primarily but also minerals and agricultural goods. These countries tend to rely on precautionary savings (in the form of stabilisation funds or international reserves) in order to smooth the impact of commodity price fluctuations on domestic absorption. This strategy has potential drawbacks. The fund can be mismanaged (for example, by trying to offset a permanent negative shock), and it may have a significant opportunity cost in terms of resources that are no longer available for domestic consumption and investment.
As an alternative to foreign asset accumulation, commodity-exporting countries can insure themselves against price fluctuations by using the existing markets for hedging instruments that have developed considerably in the last two decades. However, the extent of hedging remains fairly limited relative to the potential size of the risk. For example, the total open interest position in futures on the two largest markets for oil, the New York Mercantile Exchange and the Intercontinental Exchange, is currently less than six weeks of world exports or 0.2% of the known oil reserves.
How would commodity-exporting countries benefit from greater reliance on hedging? Conceptually, hedging brings two sources of welfare gains. First, stabilising export income leads to a steadier level of consumption (the “consumption-smoothing channel”). Second, hedging allows the exporting country to save on its stock of international reserves and to reduce the default risk on its external liabilities (the “balance sheet channel”). The lower risk of default, which comes from the fact that the country can reduce the downside risk in the collateral value of future export income, allows the country to borrow more abroad.
How big are the gains?
To address the “how much” question, we turn to a dynamic optimising model of a small open economy that is populated by a representative consumer. Domestic welfare is the intertemporal utility of the representative consumer and the welfare gains from hedging are expressed in terms of an equivalent permanent increase in domestic consumption. We look at hedging strategies that remove the price risk at an infinite horizon but most of the gains are captured by hedging at a horizon of five to ten years, depending on the persistence in price shocks.
We find that:
- The gains from the “consumption-smoothing channel” are fairly modest (equivalent to around a 0.4% permanent increase in consumption);
- The benefits from the “balance-sheet channel” can be 10 times as large.
The gains from the balance-sheet channel are large for countries that are scarce in capital inflows and derive significant benefits from relaxing their external borrowing constraint. Greater reliance on hedging instruments allows these countries to attract a large volume of capital inflows, which significantly increases their level of welfare, and (as a collateral benefit) also helps to reduce global financial imbalances.3
Our results suggest that increased reliance on hedging against commodity price fluctuations might be a worthy policy objective for the international community. But before one can jump to policy conclusions, one important question must be addressed – what are the obstacles currently preventing a more extensive use of the markets for hedging instruments that already exist?
The puzzle of insufficient hedging is old question and difficult. It arises in many economic contexts where one has reasons to suspect underinsurance by the private or public sector (see Athanasoulis et al. 1999 and Borensztein et al. 2004 for reviews of possible explanations in the context of country risk).
While excessively high risk premia may be partly to blame, a strong impediment could also be the fear of the consequences of loss-making positions for the decision-makers in charge of hedging. This problem is illustrated by the case of Ecuador, where the head of the central bank was put under investigation in 1993 after “wasting” money in a hedging strategy against downside risk in the oil price that did not materialise. Decision-makers may prefer to blame a loss on the international environment than being blamed by their opponents for “reckless speculation”. Of course, policymakers can also receive kudos when the insurance pays off, as in Mexico recently (Financial Times 2009). But the balance of risks seems to bias the policymaker against taking insurance.
The main impediments to commodity price hedging remain unknown, and they could be on the supply or demand side. Determining the underlying reasons for underinsurance is a key topic for further research, because those reasons determine the nature of the appropriate remedial policy actions.
Aizenman, Joshua (2009), “Alternatives to sizeable hoarding of international reserves: Lessons from the global liquidity crisis”, VoxEU.org, 30 November.
Aizenman, Joshua and Yi Sun (2009), “International reserve losses in the 2008-9 crisis: From “fear of floating” to the “fear of losing international reserves”?”, VoxEU.org, 15 October.
Athanasoulis, Stefano, Robert Shiller, and Eric van Wincoop, (1999), “Macro Markets and Financial Security”, Economic Policy Review, Federal Reserve Bank of New York.
Borensztein, Eduardo, Marcos Chamon, Paolo Mauro, and Jeromin Zettelmeyer, (2004), “Sovereign Debt Structure for Crisis Prevention”, Occasional Paper 237, IMF, Washington DC.
Borensztein, Eduardo, Olivier Jeanne, and Damiano Sandri, (2009), “Macro-Hedging for Commodity Exporters,” CEPR Discussion Paper 7513.
Caballero, Ricardo J., (2009), “Sudden Financial Arrest,” Mundell-Fleming Lecture prepared for the IMF 10th Jacques Polack Annual Research Conference.
Caballero, Ricardo J., (2009), “Sudden Financial Arrest”, VoxEU.org, 17 November.
Durdu, Ceyhun B., Enrique G. Mendoza, and Marco E. Terrones, (2008), “Precautionary Demand for Foreign Assets in Sudden Stop Economies: an Assessment of the New Merchantilism,” Journal of Development Economics, 89: 194-209.
Financial Times (2009) “Mexico’s Big Gamble On Oil Pays Off”, 8 September.
IMF Survey (2009), “IMF Backs Continued Chinese Stimulus, Economic Rebalancing”, November 17.
Jeanne, Olivier, (2007), “International Reserves in Emerging Market Countries: Too Much of a Good Thing?”, in Brookings Papers on Economic Activity 1, W. C. Brainard and G. L. Perry eds., pp. 1-55 (Brookings Institution, Washington D.C.)
1 See Durdu, Mendoza, and Terrones (2008) for an exposition of this view based on a calibrated model. The alternative view, of course, is that reserve accumulation results from a strategy to promote export-led growth with a competitive exchange rate (see, e.g., Jeanne, 2007).
2 For example, between 2002 and 2007 the surplus of commodity exporting countries (as listed in Table 1 in Borensztein, Jeanne and Sandri, 2009) accounted for 44% of the U.S. current account deficit.
3 Our model does not capture the welfare gains in terms of global financial stability that might result from lower global imbalances.