The most powerful actors in influencing economic policy today are

6.1.4 Chapter 17—Negotiation and Implementation of Trade Agreements (The Omnibus Trade and Competitiveness Act of 1988)20

During President Reagan's first term in office, the United States's trade deficit continued to grow. In response, the Reagan administration initiated several international economic policies codified in the Trade and Tariff Act of 1984. This Act, however, was generally criticized as inadequate to control the trade deficit.21 Thus two years later, in 1986, when the GATT participants launched the Uruguay Round with an ambitious agenda to increase world trade, both the president and Congress were eager to participate, especially since many U.S. companies, including telecommunications, computer, and software companies, faced increased worldwide competition. To protect these companies, products, and services, the president and Congress passed the U.S. Omnibus Trade and Competitiveness Act of 198822, which, among many issues affecting international trade, had three important aspects affecting telecommunications. First, it gave special attention to updating Section 301 of the 1974 Trade Act. The new language is very broad and states that the president of the United States or the U.S. Trade Representative must take action whenever “the rights of the United States under any trade agreement are being denied” or when “an act, policy, or practice of a foreign country … violates or is inconsistent with, the provisions of or otherwise denies benefits to the United States under, any trade agreement, or … is unjustifiable and burdens or restricts United States commerce.”23 Second, when a telecommunications or other U.S. company has a major trade or intellectual property dispute with another country, the 1988 Omnibus Act created “Super 301” and “Special 301” procedures through which the United States may address the offending nation to protect U.S. products and services. Third, the Act amended provisions in Title VII of the Tariff Act of 1930,24 regulating countervailing and antidumping duties, to broaden their scope and make it easier for U.S. telecommunications companies to obtain protection from unfair foreign competition or discrimination.

2 Economic Importance

Due to enormous advances in science and technology, in particular in communication and information technologies, biotechnology, and life sciences in general, on the one hand, and the global economic policy developments following the conclusion of the GATT-Uruguay Round and the establishment of the World Trade Organization in 1994, on the other, intellectual property rights have gained most remarkable economic importance. They have penetrated, or are about to penetrate, new areas of economy, such as the service sector, life sciences, and agriculture. Patents have been granted for instance, for microorganisms, plants and animals, genes, as well as computer programs and business methods. Universities and other academic institutions, primarily aimed at generating and disseminating new knowledge, have also not remained unaffected. Consequently, the new, knowledge-based economy has been characterized as ‘intellectual property economy’ or ‘intellectual capitalism.’ This trend is reflected, for instance, by the number of patent applications filed and patents issued, which in the USA almost doubled from 1988 to 1998, from 160,000 patents to 260,000 patent applications; by the amount of royalties paid for patent licenses, which increased in the USA from US$3 billion in 1980 to over US$100 billion in 1997; or by the fact that commodities constituted 62 percent of the market value of the manufacturing industry in the USA in 1980, but less than 30 percent in 1998. Also remarkable are the numbers of patents issued to US universities, which went up from 177 in 1974 to 2436 in 1997, the year in which US universities filed some 6,000 patent applications and granted around 3,000 patent licences.

24.5 Summary

We have provided an overview of several approaches to modeling market structure in MSGE models, including both oligopoly and monopolistic competition. We have emphasized open economy models and applications to international economic policy. From the beginning, MSGE models have often been characterized by constant returns to scale technologies, competitive markets and constant factor productivity. There have been important innovations, largely inspired by the “new” trade theory and the incorporation of industrial organization features into general equilibrium theory. Most recently, there is work underway in the MSGE literature to incorporate firm heterogeneity into MSGE models. The bulk of the applied work emphasizes monopolistic competition models with constant markups over marginal costs and average cost pricing. We argue here that reliance on models with average cost pricing may miss important income distributional impacts of policy through labor market outcomes. We also argue that better attention needs to be paid to model validation and performance tests.

Despite data constraints, specifying oligopoly in sectors (where appropriate) does matter and so the difficulties may be justified in terms of the policy insights to be gained. Oligopoly can lead to substantially different estimated welfare effects from trade policy adjustment. This is because reductions in trade barriers can reduce price–cost margins and result in gains to national income, resulting from output expansion and greater exploitation of scale economies as well as those from increased imports. A major difference between oligopoly approaches as outlined here and those under monopolistic competition is the assumption of average cost pricing under the latter. This precludes general equilibrium factor market effects (changes in real wages) linked to potential squeezing of price–cost margins with increased competition. The fact that different models yield different results is not in itself surprising. It does, however, highlight the need to choose specifications of market structure appropriate for the questions at hand.

Abstract

Normally, economists take the size of countries as an exogenous variable. Nevertheless, the borders of countries and their size change, partially in response to economic factors such as the pattern of international trade. Conversely, the size of countries influences their economic performance and their preferences for international economic policies – for instance smaller countries have a greater stake in maintaining free trade. In this paper, we review the theory and evidence concerning a growing body of research that considers both the impact of market size on growth and the endogenous determination of country size. We argue that our understanding of economic performance and of the history of international economic integration can be greatly improved by bringing the issue of country size at the forefront of the analysis of growth.

2.3 Interest Groups and Social Structure

A third line of domestic politics reasoning explains foreign policy by the demands made on governments by the social groups on which governments rely for support. Governments need backing in society. In democracies, they need to win elections and enjoy the confidence of key players in the economy; in authoritarian systems, they need the support of key members of the ‘selectorate’ or elite with control of major power centers. Policy will reflect the preferences of these groups.

International economic policy, concerning such issues as tariffs, trade treaties, and common markets, is examined in this approach as a function of social cleavages around the beneficiaries of policy change: competitive industries support free trade, uncompetitive ones oppose it. Similarly, defense policy has been analyzed in reference to lobbies: defense spending reflects the preferences of a military–industrial complex, a lobby that fights for contracts and a big establishment which confers influence and power.

These three approaches to domestic politics sustain research programs that call attention to quite different processes and types of evidence: on cognition, perception, psychological mechanisms, values, cultural systems, fables, myths, analogies; on the institutions of government, elections, party systems, bureaucracies, voting rules, procedures, agreements and mechanisms; and on the structure of society, the economy, religious groups, business associations, trade unions, and professional groups.

3.2.2 The Belt and Road Initiative

The Belt and Road Initiative (BRI) lies at the heart of President Xi Jinping's grand strategy to make China a global power again. With its ambitious spending program and wide geographical scope, the BRI is reshaping long-standing global alliances and steering some Western allies toward a rapprochement with China.

The One Belt One Road Initiative (OBOR), later known as the BRI, is one of the largest infrastructure projects in history. Unveiled in September 2013, the Chinese infrastructure development plan was meant to promote maritime and inland trade roads along the former Silk Road and to link South East Asia, Europe, and Africa (see Fig. 3.10). The Chinese government’s vision for the BRI includes providing more efficient resource allocation, deepening market integration and economic policy coordination, as well as fostering in-depth regional cooperation (Belt and Road Forum, 2015). As stated in the “Vision and Action” document issued in 2015 by the Chinese Government, the BRI “…is a positive endeavor to seek new models of international cooperation and global governance…” (Belt and Road Forum, 2015). Chinese leadership enshrined the project as a top priority in 2017 by writing the BRI into the Communist Party Constitution during the 19th National Congress of the Chinese Communist Party.7

The BRI has both land- and sea-based components. The land component (known as the Silk Road Economic Belt) is composed of a network of large infrastructure projects such as bridges, railways, roads, pipelines, hydroelectric dams, and logistic hubs across Asia and Europe. Its sea-based component (known as the Maritime Silk Road) comprises a matrix of shipping ports, hydrocarbon refineries, and industrial parks. While the Belt portion contains six distinct on-land corridors (Fig. 3.10), the Maritime Road will connect China not only to Africa and Europe through the Indian Ocean and the South China Sea, but also to the South Pacific through the South China Sea. An additional land corridor was proposed in 2018 linking Nepal to both China and India.

The contours of the BRI are not precisely defined. Its geographical scope has expanded since its inception and there is no official list of participating countries. The Chinese government’s 2015 Vision and Action plan for the BRI stated that the project would not be strictly limited to the area of the historic Silk Road but would be open to all countries. The list of BRI participants, which began with around 60 members grew to 125 countries by the end of March 2019, according to an official report on the BRI progress, (Office of the Leading Group for Promoting the Belt and Road Initiative, 2019). Members include countries that have signed an agreement with China on the initiative but may not yet have BRI projects planned.

The initial vision of corridors between Asia, Eurasia, and the eastern coast of Africa has expanded progressively to include connections to West and Central Africa as well as to Latin America and the Caribbean. In Africa, in addition to Djibouti, Egypt, Ethiopia, Tanzania, and Zambia—key BRI partners on the direct path of the Maritime Silk Road—about 30 other countries have signed memorandums of understanding with China to join the BRI (as of March 2019, according to the Belt and Road Portal). A number of these agreements were concluded following visits by Chinese President Xi Jinping during China-Africa Cooperation Forums. A limited number of projects are already in place (such as the flagship railway line from Addis Ababa to Djibouti, or the port facilities in Djibouti, Lagos, Lomé, and Abidjan), but there are several important projects planned or under construction falling under three main priority areas: (1) railway lines (e.g., from Dakar to Bamako, or across Nigeria, Tanzania, Kenya, and Zambia); (2) pipelines (e.g., from Tanzania to South Africa along the coast); and (3) ports (e.g., Walvis Bay, Beira, Maputo, Libreville, São Tomé, Mombasa, and Conakry, among others). Several of these projects will connect Africa’s hinterland to key ports on the eastern and western coasts of the continent.

The BRI grew its footprint later in Latin America. Panama paved the way for it when it signed a memorandum of understanding in December 2017, with agreements including investment in the Colón mega-port for containers and rail. In January 2018, China’s Foreign Minister Wang Yi extended an invitation to other Latin American countries at the China-CELAC (Community of Latin America and the Caribbean) conference, indicating that the BRI would open up new prospects for cooperative partnerships. A total of 19 LAC members have since joined the initiative, including 10 from the Central America and Caribbean region alone (Belt and Road Portal). Though the size of many of these investments is relatively small in some of the countries involved (such as the Bahamas, Barbados, Antigua, and Barbuda), they can have a significant impact on local economies in the Caribbean. As of June 2019, large Latin American economies such as Brazil, Argentina, and Mexico have not joined the initiative.

Finally, several Western developed countries have joined the BRI. Particularly notable is Italy, a founding EU member, which became the first G-7 member to sign a BRI agreement in March 2019. Others include Austria, Greece, Luxemburg, New Zealand, Portugal, and Switzerland.

The estimated financing resources required by the BRI are nothing short of enormous. Many of the projects are still in the planning phase, which makes it hard to assess the initiative’s true scale. As of early 2019, most estimates point to around $1 trillion, but much higher figures were hypothesized in earlier stages of the BRI, mentioning several trillion dollars (Deloitte, 2018; Hillman, 2018). Financing will come from multiple sources, including the AIIB, which is expected to be a key financier. Other development banks, as well as foreign financial institutions and capital markets are expected to participate. China’s Sovereign Wealth Fund, established in 2007, and the Silk Road Fund, founded in 2014 are both expected to play a role. However, the largest financial contributors are projected to be the two Chinese state-owned institutions, the Export-Import Bank and the China Development Bank (the latter pledged $800 billion over the course of several years), as well as other Chinese state-owned commercial banks (South Asia Journal, 2018).

Another motivation for China to pursue the BRI is to provide alternatives to the existing maritime routes that are outside of Chinese control. New ports, railways, roads, and pipelines on the Indian subcontinent, such as those along CPEC, would allow China to bypass passages such as the Strait of Malacca (between Malaysia and Indonesia), through which 80% of China’s crude oil imports passes. A deepwater port development project in Gwadar, Pakistan, would alleviate some of the burden, as would new port infrastructure projects in Sri Lanka. Pipelines to China transporting oil offloaded at terminals in the Indian Ocean (such as the one opened in Myanmar in 2017) would also reduce China’s energy import vulnerability.

The BRI also has the potential to bring development to West and Central China, which would lessen the regional disparity between China’s fast growing urban eastern coastline and its western interior. Projects along the corridors would strengthen the development prospects of inland China by further connecting China’s landlocked west to key maritime trade routes. Some interior cities such as Xi’an are already establishing economic zones to facilitate trade across China, Central Asia, and the Middle East.

BRI infrastructure projects could also prove a boon to domestic firms, especially Chinese multinationals in energy, transport, and logistics industries that are well positioned to benefit from investment opportunities in the BRI recipient countries (see Chapter 4). Several Chinese firms—all SOEs—are now global leaders in those sectors at the core of BRI (see Chapter 1) and benefit from state financial backing. SOEs like China National Petroleum Corporation, China Merchants Group, China Ocean Shipping Company (COSCO), and China Railway Rolling Stock Corp are well positioned to lead upcoming BRI projects. Based on the information from the State-Owned Assets Supervision and Administration Commission of the State Council, for instance, by early 2019, Chinese central SOEs undertook more than 3000 projects in countries along the BRI (Belt and Road Portal, 2019a, 2019b).

Furthermore, Chinese authorities have established a specific payment system, the China International Payment System, to facilitate cross-border renminbi transactions for BRI-related purposes. This may spur international use of the renminbi.

Responding to many countries’ unfulfilled need for investment, the BRI is also enabling China to expand its zone of influence. In Africa, for instance, the construction of major railway lines and ports bolsters China’ foothold in the continent. China has long lacked the soft power that some other nations possess. Vis-à-vis other countries and continents, it did not benefit from a commonality of culture, or political or other ties inherited from colonization, and its clout through donor agencies and the Bretton Woods institutions remained limited. Financing globe-spanning infrastructure projects through the BRI is providing it with opportunities to quickly make gains in that respect. Indeed, with infrastructure, BRI is touching a hot spot, a sensitive issue between advanced economies and multilateral development institutions on the one hand and many Latin American, Asian, and African countries on the other. Infrastructure financing is a high-risk, long-term investment and sources of finance are limited. Financing, particularly from development institutions, national or international, has long given rise to protracted processes of checking and approval. Even then, ultimate financial decisions have sometimes proved to be politically motivated. In the meantime, populations are left waiting for vital infrastructure. The number of people in the world without access to clean water, electricity, or transportation is still enormous. Under these circumstances, a new and alternative source of infrastructure development—from China—was bound to meet the interest of many.

Even in some advanced economies, financing from China may also be a potential rescue line for financially distressed governments. In the EU, where infrastructure financing has been starved in the name of budgetary rebalancing, Chinese financing could provide a crucial lifeline, as illustrated by Chinese investments made since 2016 in Greece’s Port of Piraeus. Portugal is another example: as noted by the country’s Prime Minister Antonio Costa, in the crisis years only China was willing to put money into the EU periphery (Financial Times, 2019).

A project of the size and ambition of the BRI naturally carries its load of economic risks and financial challenges. Delays, like those experienced during the construction of the rail line between Jakarta and Bandung in Indonesia, escalate costs beyond those originally envisioned. In addition, some BRI countries are particularly vulnerable to ballooning debt. The IMF issued warnings that countries with high levels of public debt should proceed with caution in order to protect both the local and Chinese governments from later financial complications. In Sri Lanka, for instance, the fate of Hambantota Port was called into question, as the country was unable to service its contracted debt for the project. Sri Lanka entered in a debt equity swap with China, relinquishing control over the port as well as strategic land around it to China. Some countries took action to address the situation. For instance, in 2018, Malaysia’s newly elected government suspended two projects (a rail line from Malaysia to Thailand and a pipeline), citing their high cost. In early 2019, the Malaysian rail line project was finally approved following an agreement with China, substantially reducing the cost of the project for Malaysia. New leadership in the Maldives also pushed back in an effort to reduce the country’s debt exposure, while Sierra Leone cancelled a planned Chinese-funded airport in late 2018.

Some analyses, however, challenge the debt-trap argument put forward by some critics (Bräutigam, 2018; Broder, 2019). A study by the Center for Global Development in 2018, while observing that the BRI could increase debt sustainability problems in eight countries, found that the majority of BRI countries will likely avoid problems of debt distress due to BRI projects (Hurley, Morris, & Portelance, 2018). A study of China’s external debt renegotiations by the Rhodium Group also revealed that, despite its economic weight, China’s leverage in such renegotiations is limited. Asset seizures (as in the case of Hambantota port) are rare and many of the renegotiation cases examined in the study involved an outcome in the borrower’s favor (Kratz, Feng, & Wright, 2019). Finally, some experts also consider that the majority of BRI projects are economically viable for the host governments (Bluhm et al., 2018; Broder, 2019).

Internal economic headwinds may impact the BRI. For instance, China’s economic growth rate is lower than when the BRI was first announced. Its foreign reserves, although still by far the largest in the world, have declined from an estimated $4 trillion in 2013 to $3 trillion in 2018, and a number of the country’s large SOEs are highly leveraged.

Other challenges include security issues and public perception of the projects in recipient countries. Some of the BRI’s proposed routes pass through unstable regions or terrorism-affected area. In Pakistan, for instance, extremists have targeted some CPEC construction sites. Support has wavered in some countries, such as Laos, as locals objected to contract opportunities that went to Chinese companies and employees rather than Laotians.

Finally, geopolitical issues make up serious risks facing the BRI’s expansion. Some analysts argue that China is looking to establish a military presence, for instance, in certain BRI areas where infrastructure facilities need to be secured. Meanwhile, India fears that the CPEC could undermine its territorial claims in the Kashmir region. The EU, too, has concerns as China reaches out to Eastern Europe with initiatives such as the “16 + 1” Summits, a platform initially bringing together China and 16 Central and Eastern European countries. In May 2019, Greece joined the platform. 12 of its member countries are now from the EU, and the EU is worried about the impact that such moves might have on its unity. The signature of a BRI cooperation agreement with Italy, a founding member and the third largest economy of the EU, has only heightened such worries. The United States, on its side, is concerned by the consequences of China’s influence over US naval leverage and alliances in Asia, and potential military implications (Council on Foreign Relations, 2018).

Just 5 years after its launch, the BRI has become a visible reality. Taking center stage in international debate, it has also given rise to a number of concerns. At the Second Belt and Road Forum held in Beijing in April 2019, China addressed some of them, regarding financing and environment sustainability for instance. It unveiled new initiatives, such as the creation of a debt sustainability framework. While the true extent and impact of this adjustment remains to be seen, it shows that China has heard these concerns and criticism. That being said, Chinese authorities are determined to make the BRI a pillar of the country’s power and influence. They will learn and adapt to respond to the challenges, they may redirect and scale down as required, but, clearly, they will not give up.

Distributional Implications of Financial Globalization

Depending on the type of financial globalization under investigation, different coalitions of the above actors can arise to support or challenge state economic policies. Political economy scholars have rarely tried to develop a general model of support for globalization, rather they have looked to see the constellation of actors that forms around specific policy issues.

In general, political economy literature has been less successful at establishing robust empirical relationships between exposure to financial flows and distributional outcomes than international trade literature. One debate has been whether exposure to international financial flows leads to greater inequality. For instance, increased financial globalization was expected to increase inequality in the developed world and decrease it in the developing world. Instead, the literature has found little evidence of globalization increasing inequality within countries over time. Indeed, some scholars have found microevidence that the distributional effects of globalization were off the mark. In developing countries, it is high-skilled labor that appears most supportive of globalization, not low-skilled labor as an HOS approach would predict. In panel analyses of countries exposed to financial openness, the most robust finding is that inequality differs more across countries than over time, indicating increased exposure to the international economy that has little to do with the distributional effects.

Where inequality has increased in recent years, skill-biased technological change seems to be the greater culprit than financial globalization. What has been more important has been how the distributional effects of globalization have been mediated by the strength of organized labor, political institutions, and partisan political dynamics. In the developing world specifically, it has been shown that initial distributions of land and education drive inequality growth after economic integration.

A second debate has taken place over what is known as the compensation hypothesis, whereby winners from globalization may compensate the losers with greater social assistance programs. Sometimes this has been referred to as the ‘embedded liberalism’ of international economic policy, indicating that liberal economic policies are accompanied by a generous social welfare state reflecting a societal debate and subsequent social contract. If the compensation hypothesis holds up, this may help explain the lack of correlation between globalization and inequality, but it offers an interesting prediction in its own right. That is, increased financial globalization should be associated with larger welfare states. This has been shown to be the case in the small states of Western Europe, within the Organisation for Economic Co-operation and Development (OECD), and among developing countries.

The supportive findings for the compensation hypothesis use the level of trade openness as their core measure of globalization; studies focusing on changes in financial globalization, however, show that openness is actually negatively correlated with changes in social welfare spending. Some contributions offer more nuanced analysis, demonstrating that one must consider the interaction between globalization and labor strength and organization. Where unions are strong and have an influential say in public policy, changes in global integration are actually positively associated with the size of the welfare state.

On the other hand, some have argued that increased economic integration restricts the independent monetary authority of nation-states, thereby limiting the size of welfare states, hypothesizing that in highly globalized countries, governments would be forced to cut taxes, and consequently spending, in order to maintain an attractive environment for foreign portfolio and equity investors. Two political economy theories help explain this constraint. First, foreign portfolio investors demand fiscal discipline. Second, opportunities to borrow in foreign capital markets dry up during economic downturns. A tremendous amount of work has explored this hypothesis empirically, finding little evidence of a negative correlation between capital openness and government spending. Indeed most work has actually identified a positive relationship between the two, further establishing the compensation argument.

Evidence of the positive relationship has come under fire. First, critics argue that omitted variable bias is influencing the results, believing wealthier states are both more likely to have larger welfare states and to be open to international financial movements. Related to this point, a second stream of criticism argues that the compensation hypothesis that has been observed among OECD countries appears to be nonexistent among developing countries. In repeated studies, scholars have found limited empirical support for the claims that spending on health, education, and targeted antipoverty programs has grown more rapidly in integrated economies. Indeed, comprehensive analyses of social spending programs around the globe conclude that the compromise of embedded liberalism in the advanced industrial states that occurred after World War II has not been replicated in the social policies of Latin America, East Asia, and Eastern Europe. Since World War II, globalization has proceeded without enhanced compensation, and perhaps even with less compensation, in the global South.

Attempting to explain the weakness of the compensation hypothesis, researchers have pointed out that a key intervening variable between financial globalization and the size of the welfare state is economic insecurity. Globalization must make citizens more concerned about their individual economic prospects, and they must be willing to express these views at the ballot box, before national governments would agree to compensation as mollification. Some analyses rely on economic indicators of volatility, showing that international price volatility is often less than domestic price volatility. Secondly, greater openness actually diversified the risk faced by individual actors, thus helping them hedge against economic security. Others rely on survey data, but come to very similar conclusions. Individual perceptions of risk, even among unskilled labor, tend to be reduced with increased economic integration.

These finding are at odds with previous survey work that financial globalization (particularly FDI) increased economic insecurity by raising the elasticity of demand for labor in England, which raised the volatility of wages and employment. A more recent analysis finds evidence for every stage of the compensation hypothesis (globalization to risk, risk to vote choice, and vote choice toward welfare state provision), based on Swiss panel and survey data. Why the contradictory results? One important reason may be where scholars are looking. Those finding support for insecurity induced by globalization study developed countries (particularly, the United Kingdom and Switzerland), while those finding no evidence of insecurity study developing country data. The different research arenas may explain some of the differences, but the drastically different conclusions also warrant deeper thinking about the theory.

A new literature has started to move beyond survey data, and test voting behavior of individuals directly to see if it conforms to the compensation hypothesis. This work, however, has also provided extremely ambiguous results. Studies of the 1996 US presidential election and of the 1998 election to the Australian Federal House of Representatives find that job insecurity increases the likelihood that an individual will vote for parties that run on an antiglobalization platform. At the same time, however, other scholars find that economic internationalization actually leads voters to care less about the economic performance of leaders, assuming that they have little control over international forces.

Moving away from the distributional effects of globalization, other scholars focus on policy choice. If the strength of various actors in a polity is known, perhaps the particular policies that political elites might choose can be forecast. This has been best explored in terms of capital account liberalization and foreign investment regulation. Here again, scholars have found limited evidence of a direct effect of particular sectoral interests on policy choices.

The first cut at the political economy literature was simply to see whether exposure to interest groups at all was more likely to lead to greater capital account liberalization. Because authoritarian regimes tend to be more insulated from public pressure, one might think it would be easier to achieve such policies in the authoritarian setting. Others claim that authoritarian regimes are predominantly captured by elites in the domestic economy, and economic policy therefore tends to follow the interests of those groups. In democracies, however, there is more opportunity for those who might benefit from globalization to assert themselves on the policy-making process. Recent work has found a positive correlation between democracy and capital account openness.

The relationship between democracy and capital account openness is interesting, but also confusing. Democracies contain a wide variation in economic structures, constituent preferences, and constellations of powerful actors. Which actors exactly, actually benefit from greater liberalization? Direct testing of the three workhorse models of economic preferences has failed to provide robust empirical support. The lack of direct empirical support for interest group preferences and financial openness policies outcomes stands in stark contrast to trade liberalization. As a result, most scholarship has tended to focus on the negotiations of elite actors. The divergence between analyses of trade and financial openness has led some to conclude that because capital account liberalization involves opaque and confusing changes, but has the potential to create severe economic risk, the political strategy is one of blame avoidance. As a result, polities where political authority is fragmented and multiple parties are involved in decision-making are most likely to pursue extensive liberalization.

As with the inequality debates, the real advances in scholarship have not come from the direct tests of economic models on openness to global financial flows. Rather, the most robust findings are those that show how preference for capital account openness is mediated by partisanship, political institutions, and the beliefs of political leaders.

1 Introduction

The ultimate objective, according to Friedman (1953), is a world in which exchange rates are free floating and at the same time highly stable. Exchange rate stability apparently underlies the desirability of the intervention policy. The basic rationale behind the intervention framework is determined by whether the markets are efficient or not. When the markets are efficient, the prices fully reflect available information and the exchange rates have the correct rates that is when forward exchange rates are equal to future spot exchange rates. Nevertheless, authorities believe that the markets are inefficient due to irrational market behaviour and exchange rates have the wrong rates causing misallocation of resources. Speculation due to excessive risk aversion and bandwagon effects result in moving exchange rates from its fundamentals towards misalignments. Intervention in instances of market inefficiency does not claim that central banks need to know the correct rate. It, nevertheless, presupposes that markets can not be relied upon to achieve stability and therefore central bank intervention has a stabilising effect (Pilbeam, 1991). Reserve holdings, which averaged about 5 percent of GDP in the 1980s, have doubled every decade since, reaching some 25 percent of GDP by in 2010 (Gosh et al., 2012, p.3). Increased intervention activity has coincided with higher exchange rate variability. This suggests that authorities have intervened more in the face of greater exchange rate movements, without eliminating fluctuations (Domanski et al., 2016).

The scale and the frequency of the intervention highly depends on the prolonged and substantial accumulation of foreign reserve in that country. The source of foreign reserve accumulation may vary either due to the discovery of a real resource, as in the case of Saudi Arabia and Norway, or due to the foreign exchange interventions, as in the case of China and other emerging market. Since the latter is more likely to cause the accumulation of foreign reserves, the analysis of the motivation behind foreign reserve accumulation may also be useful in determining the reasons for central bank intervention. There are basically two motivations behind foreign reserve accumulation: the precautionary motive and the mercantilist motive. According to Green and Torgerson (2007), the major reasons for the precautionary motive are to insure against shocks; to intervene in non-crisis times with the intent to reduce volatility, maintain a target exchange rate or be used as a tool for deflation; to serve, as lender of last resort to banks with high levels of foreign currency liability; and to use reserves for day-to-day transactions such as the purchase of foreign goods or payment of obligations to international organisations. For the mercantilist motive, the foreign reserve accumulation is used to pursue policy objectives related to the exchange rate and competitiveness, to stimulate growth or to eliminate rising commodity prices. Most studies focus on the volatility of the exchange rates for either the precautionary motive or the mercantilist motive. There is also the prevalent belief that emerging market economies, mainly in Asia, hold more than enough reserves for financial safeguard purposes with the desire to prevent currencies from appreciating significantly.1 As a result, this belief was the cause of massive foreign reserve accumulation together with on-going global macroeconomic imbalances.2

The reserve accumulation is important since it affects the policy choice of monetary authorities and the level of foreign exchange intervention. The available literature provides a range of analyses of foreign reserve accumulation and its determinants based on the self-insurance motivation (Aizenman and Marion, 2003; IMF, 2003; Mendoza, 2004; Aizenman et al., 2004). The IMF (2003) tests various determinants of foreign reserve holdings, finding most of the macroeconomic determinants to be statistically significant.3 An additional established area of interest is seen to be the testing of reserve adequacy, such as in the analyses of Bird and Rajan (2003), Aizenman and Marion (2003), Edison (2003), Ruiz-Arranz and Zavadjil (2008), Williams (2005), Park and Estrada (2009), IMF (2011), and Gosh et al. (2012).

Pontines and Rajan (2011) used central bank intervention reaction to find evidence of fear of appreciation. They concluded that Asian central banks react more strongly to currency appreciations than they do to depreciations. For the mercantilist motive, export competitiveness is the development strategy for foreign reserve holders aiming to prevent appreciation of domestic currencies against the US dollar and to promote export-led growth. Some studies, such as Hviding et al. (2004); and Dooley et al. (2004) are in favour of the mercantilist motive; and other studies, such as Aizenman and Lee (2005) express limited support for it. Their results, however, find strong support for foreign reserve accumulation as a result of the precautionary motive, even for China. Other studies evaluate how international reserves hoarding affects the real exchange rate. For example, Aizenman and Riera-Crichton (2008) observe that international reserves cushion the impact of terms of trade shocks on the real exchange rate, especially in Asian countries and countries that export natural resources.

In other studies, reserves are analysed as determinants for other macroeconomic variables. For example, Fukuda and Kon (2010) deal with the cost of foreign reserve accumulation.4 Gonçalves (2008) investigates the interaction between monetary policy and foreign reserves. He concludes that there is a trade-off between reserve accumulation and macroeconomic stability, and that intervention decisions have an impact on the public’s expectations for the monetary authority’s inflation goal. Larger interventions lead to an increase in both the expected inflation target and the current inflation rate. Therefore, fast reserve accumulation may harm anti-inflationary credibility of the monetary authority.

The aim of this paper is to examine the behaviour of central banks’ foreign reserve management since the recent financial crisis and analyse the complex relationship between movements of the foreign reserve and the fluctuations in exchange rates. The complexity of the analysis arises from the two-way causality between foreign reserves and exchange rates. It is important to observe how central banks react to exchange rate movements and equally important to identify how exchange rates, alongside other fundamentals, react to changes in foreign reserves. The three-step analysis conducted in this study starts with measuring the reaction of central banks to exchange rate appreciations/depreciations. The second step is the study of the fundamentals of exchange rates and the final step is the analysis of the effects of these fundamentals on central bank intervention policy changes. Additionally, the study uses matching techniques to ascertain the causality effect of intervention on exchange rates.

The analysis cover 31 emerging economies and 21 advanced economies spanning ten years including the recent financial crisis and post-crisis period. The value of foreign exchange reserves for the selected countries in this study constitutes approximately 80 percent of the total foreign reserves. China has the highest amount of foreign exchange reserves by far, compared to other countries. In Europe, there has been a significant increase in the speed of reserve accumulation since the 2008 Financial crisis. Nearly all countries have increased their foreign reserves significantly; Japan comes second to China in terms of high foreign reserve accumulation. Countries with a large accumulation of reserves during the pre-crisis period witnessed large reductions during the crisis. Since then, there have been huge jumps in total amount of foreign reserves in many countries such as China, Japan, Saudi Arabia, Switzerland, Brazil, Korea, Hong Kong, India, Singapore, Mexico, Thailand and Malaysia. All countries, excluding the euro zone (namely Slovakia and Lithuania) and Indonesia, have increased their foreign reserves between 2005 and 2015. The ten countries with the highest percentage increases (from 2005 to 2015) are Saudi Arabia, Libya, Switzerland, Singapore, Thailand, Malaysia, Japan, India, Korea and Israel. Incremental increases were also identified in Asia, oil exporting countries and most of the countries in Latin America. In Europe, the figure is slightly different so that the foreign reserves increase outside of the euro zone but significantly decrease within. This evidently shows the use of foreign reserves during crisis and post crisis periods.

This paper is different from earlier studies in several ways. Most studies to date have focused on the adequacy and/or the determinants of foreign reserves in a conventional way or they have studied interventions for a limited number of central banks with actual official released interventions. The central banks’ foreign reserve management and intervention policy affects many economies, yet it is extremely difficult to measure this intervention due to the lack of actual intervention data.5 Central banks have traditionally been reluctant to release intervention data to researchers, considering it to be too sensitive (Neely, 2000; Vitale, 2003). Then, the researchers are left to construct proxy variables for detecting central bank intervention. Sometimes daily intervention operations are reported from unofficial sources such as news or financial press. For example, Chang et al. (2017) followed Reuters’ news to determine intervention. Others used central banks’ holdings on international reserves (see Taylor, 1982; Kearney and MacDoland, 1986 and Gartner, 1987). Lack of actual intervention data is the major difficulty in measuring the effectiveness of intervention policy. Furthermore, foreign exchange reserves may be an imperfect proxy for intervention, since reserves may be changed not only when central banks conduct foreign exchange intervention but also for other reasons such as government payment of debt denominated in a foreign currency.6 Furthermore, Dominguez et al. (2012) criticised the misleading use of changes in foreign currency reserves in models regarding its active and passive reserve accumulation. They argued that, especially during the period of a crisis, the value of some reserve assets would decline unless there is a reserve accumulation and the value of reserves would remain with reserve accumulation. Thus, it is necessary to discern the motives for the purchase and sale of foreign currencies when deciding what constitutes intervention by a central bank. This paper proposes an alternative approach so that, under these constraints, it is still possible to find a solution to represent the closest obtainable approximation for official intervention. Policy changes are detected in a binary analysis and interventions are determined either by examining the behaviour of foreign reserves in relation to exchange rates or by examining the magnitude of the change in foreign reserves. Filtering the reserves data to increase the correlation and the causal effect between intervention and exchange rate is an important part of the analysis. This includes many other macroeconomic variables to filter the foreign reserves data to obtain a better proxy for intervention. For example, the direction of the movement of foreign reserves in relation to the direction of the exchange rate and the percent changes in foreign reserves with the 2.5% and 5% threshold values are the main benchmarking in foreign exchange interventions. Furthermore, the behaviour of central banks for carrying out intervention operations are further analysed by including some benchmarks inspired by the criteria for the assessment of reserve adequacy (IMF, 2011). One benchmark is the possibility of intervention when increases in foreign assets are coincided with decreases in money stock, which is called as the sterilised intervention. Another benchmark for the possibility of intervention is when foreign assets are growing faster than the output. Final benchmark is set by including the possibility of intervention in countries where they experience trade surplus. Reserves to GDP ratio by and the reserves in relation to current account balance are the popular criteria for defining the reserve adequacy and determining excess reserves (Park and Estrada, 2009; Obstfeld et al., 2010; Gagnon, 2012). This paper is different from previous analyses since it does not only focus on the movement of foreign reserves alone, but also includes other important variables and detects the closest approximation to official intervention amongst many possible intervention alternatives. Rather than scaling the excess reserves, this paper compares the changes in the growth rate of reserves to changes in these variables to determine intervention. After interventions are detected, the focus of the analysis shifts to the determinants of intervention policy and finally to test whether these presumed interventions are meaningful and show a causal inference for the exchange rate movements by using the PSM technique.

Results show that central banks in both emerging and advanced economies behave more aggressively towards appreciation. There is a strong relationship between exchange rate fundamentals and intervention policy. Data from the official reserves is useful in detecting central bank intervention policy. Exchange rate fundamentals determine intervention policy and the model is more meaningful for countries with trade surplus and/or in which reserves are growing faster than the economy.

This paper is structured as follows. Section 2 presents the theoretical analysis. Section 3 describes the central bank reaction function, and Section 4 displays the corresponding results. Section 5 describes the Propensity Score Matching methodology, the related estimation results being exposed in Section 6. Section 7 concludes the paper.