Optimal Foreign Reserves: The Case of Croatia

1. Optimal Foreign Reserves: The Case of Croatia by:Anna Maria Čeh and Ivo Krznar Discussant: Iftekhar Hasan Rensselaer Polytechnic Institute

2. motivation • The consequences of sudden stop of capital flows can be very severe and costly • Output and investment contractions • Credit crunches • Bank crisis • Hoardings of international reserves can self-insurance against such shocks • Sharp increase of international reserves in Croatia over the past 10 years • This is also a global phenomenon

3. Research questions • Are the international reserves in Croatia adequate against shocks in capital flows?

4. summary • In order to answer the proposed research question, a benchmark needs to be established • This paper provides a utility-based welfare analysis of the optimal international reserves in Croatia • In addition, this study further calibrate the optimal international reserve in Croatia to allow for evaluation of the degree of adequacy of actual international reserves

5. Key findings • For plausible parameters, the Croatian National Bank (CNB) has enough reserves against the 1998/1999 crisis • For crisis with larger scale than the one in 1998/1999 • The CNB has adequate international reserves • Only if mother banks do not participate in a sudden stop • Optimal international reserves hoardings of CNB are above the evaluation of two indicators • Greenspan-Guidotti • 2-months-of-imports

6. Implications • This paper provides an evaluation of optimal international reserve hoardings in Croatia • Policy implication • The findings of strong accumulation of international reserves in Croata are consistent with a precautionary motive

7. Comments • Lacking of a background of Croatia economy • Floating with a Large Life Jacket: Monegary and Exchange Rate Policies in Croatia Under Dollarization (Vedran Šošič and Evan Kraft , 2006) • Without related background, the contribution of the paper can not be asserted • Why Croatia? • Why a dollarized economy? • What is the specialty about Croatia?

8. Cost-benefit framework • Any optimal model weighs cost and benefit • “Our framework builds on…from a prudential perspective instead of costs and benefits analyses of reserve accumulation..” (pp., 2) • “This optimality condition balances benefits and costs of holding reserves…” (pp., 16) • There is some inconsistence in the content • Need to explain a bit on the costs and benefits, especially in a dollarized economy • For example, in a highly dollarized economy, monetary policy is concerned with financial stability first and secondarily with output stabilization. This constitutes the cost of dollarization. Holding more international reserves can partially offset the inflexibility of monetary policy

9. comments • nonlinearity • Cost-benefit framework seeks the optimum when marginal benefit equals marginal cost • Why international reserves in Croatia continuously increase even when the actual reserves are above the optimal level?

10. Comments (cont’d) • Precautionary motive • Crisis mitigation • This paper only deals with this perspective • The probability of sudden stop is exogenous • Crisis prevention • The probability of sudden stop is a function of international reserves, thus becomes endogenous • International Reserves in Emerging Market Countries: Too Much of a Good Things? (Oliver Jeanne, 2007) • The paper needs to clearly identify which motive it is dealing with • The model implies that central bank needs to be ready… to prevent the crisis a central bank needs to hold…” (pp., 17) • There is some inconsistence here

11. Alternative explanation • This paper is solely based on precautionary motive • Foreign reserves were covering more than 100% of short-term debt (pp., 5) • During the whole period foreign reserves were covering only half of the euro deposits (pp., 5) • Are there any alternative explanations? • The results can not be fully explained by precautionary motive

12. What is the role of corporate deposits in the model? • The economy is populated by a representative consumer who holds a certain amount of foreign assets • “only euro household deposits that are withdrawn from banking system will not be used as a buffer against sudden stop effects,” (pp.,10) • What is the difference of household and corporate here by definition? (It is unclear)

13. The price of long-term debt, P The equation appears to be problematic (pp., 13)

14. Selection of start/end of crisis • This paper distinguishes itself with Goncalves (2007) paper in that “the model occurs as a result of the loss of households’ confidence in comparison to nonresident deposits withdrawal in Goncalves (2007)” (pp., 8) • Is it appropriate to identify the start/end of crisis based on “the peak and the trough of non-residential deposits?”

15. References • References • Aizenman, J. and Lee, J. (007). "International Reserves: Precautionary Versus Mercantilist Views, Theory and Evidence." Open Economic Review, Vol.18, pp. 191-214. • Aizenman, J. and Lee, J. (2008). "Financial versus Monetary Mercantilism: Long-run View of Large International Reserves Hoarding." The World Economy, pp. 593-611. • Goncalves, F. M. (2007). "The Optimal level of Foreign Reserves in Financially Dollarized Economies: The Case of Uruguay." IMF Working Paper, pp. • Jeanne, O. (2007). "International Reserves in Emerging Market Countries: Too Much of a Good Things?" Brookings Paper on Economic Activity, Vol.1, pp. 1-79. • Šošič, V. and Kraft, E. (2006). "Floating with a Large Life Jacket: Monegary and Exchange Rate Policies in Croatia Under Dollarization." Contemporary Economic Policy, Vol.24, No.4,pp. 492-506.