Capital Control With International Reserve Accumulation. Can Be This Optimal. Ph. Bacchetta PDF

Capital Controls with International Reserve
Accumulation: Can this Be Optimal?
Philippe Bacchetta Kenza Benhima Yannick Kalantzis

University of Lausanne University of Lausanne Banque de France
January 2012
BBK () Reserves January 2012 1/2

The debate on China’s external imbalance
the “policy” view:

“the accumulation of reserves
is policy-induced”
the “policy” view:

“the accumulation of reserves
is policy-induced”
the “structural” view:

“the current account surplus
is driven by structurally large
saving in the private sector”
The semi-open economy
the private sector has

no access to the
international capital
market

no access to the
international capital
market
only the Central Bank
does

no access to the
international capital reframe the “structural”
market view as a policy problem
only the Central Bank
does
Objective of the paper
Study a semi-open economy
where the private sector

has a strong need for saving
What is the optimal policy
of the Central Bank?
Does the optimal policy consist
in replicating the open economy?
Ingredients of the model
precautionary saving fluctuating endowment

in private sector credit constraint

I precautionary demand for liquid assets

I precautionary demand for liquid assets
Central Bank as a provides liquid assets to private sector

Ramsey planner has access to foreign reserves
Main results
What is the optimal

policy of the
Central Bank?
Main results
What is the optimal accumulate reserves

policy of the (at least when instruments are limited)
Central Bank?
Main results

Central Bank?
Does it consist
in replicating the
open economy?
Main results

Central Bank?
Does it consist (qualified) no

in replicating the
open economy?
Main results

Central Bank?
Does it consist (qualified) no

in replicating the not when credit constraints are binding
open economy? capital controls are optimal
Related literature
Global imbalances Caballero et al. (2008), Mendoza et al. (2009),

Song et al. (2010), Wen (2011)
Int’l reserves as Aizenman (2011), Aizenman and Lee (2007), Bar-

self-insurance nichon (2009), Durdu et al. (2009), Jeanne et
Ranciere (2011), Obstfeld et al. (2011)
Optimal non-ricardian environments

Government debt aggregate shocks: accumulate assets
(Aiyagari et al.,2002)
idiosyncratic shocks: issue debt
(Aiyagari and McGrattan, 1998)
Optimality of pecuniary externality

capital controls Korinek (2010), Jeanne and Korinek (2011),
Bianchi (2011), Bianchi and Mendoza (2010)
Outline
1 The model
2 Decentralized equilibrium
3 Optimal policy
4 Conclusion
1. Model
Main assumptions
One-good real economy
Two groups of infinitely-lived households

as in Woodford (1990)
Households have endowments that fluctuates

between high and low value
Ramsey planner: the Central Bank

Households
Aggregate endowment: (1 + a)Yt 0≤a<1

Households

Catching-up: Yt+1 = (1 + gt+1 )Yt with gt+1 = µgt 0≤µ<1
Households

Two groups of households
t t +1 t +2 ...
first group Yt aYt+1 Yt+2
second group aYt Yt+1 aYt+2
Households

Two groups of households
t t +1 t +2 ...
first group Yt aYt+1 Yt+2
second group aYt Yt+1 aYt+2
P∞ t u(c )
Households maximize t=0 β t
Household with high endowment in period t (depositor)
Budget constraints
Yt − rt Lt = τt ctD + Dt+1
L
aYt+1 + rt+1 Dt+1 = τt+1 ct+1 − Lt+2
Budget constraints
L
aYt+1 + rt+1 Dt+1 = τt+1 ct+1 − Lt+2
Credit constraint
rt+2 Lt+2 ≤ φYt+2
Budget constraints
L
aYt+1 + rt+1 Dt+1 = τt+1 ct+1 − Lt+2
Credit constraint
rt+2 Lt+2 ≤ φYt+2
Euler equations
τt
u 0 (ctD ) = βrt+1 L
u 0 (ct+1 )
τt+1
τt
u 0 (ctL ) = βrt+1 D
u 0 (ct+1 ) (1 + λt+1 )
τt+1
Insufficient supply of liquid assets
Bond market
high-endowment hh:
natural lenders
low-endowment hh:
natural borrowers
Bond market Credit constraint

high-endowment hh: low supply of liquid
natural lenders assets by borrowers
low-endowment hh: country can be
natural borrowers liquidity-scarce
Bond market Credit constraint

high-endowment hh: low supply of liquid
role for provision of
natural lenders assets by borrowers
liquidity by the
low-endowment hh: country can be Central Bank
natural borrowers liquidity-scarce
Central Bank
P∞ h i
Ramsey planner with social objective t D L
t=0 β u(ct ) + u(ct )
Central Bank
P∞ h i
t=0 β u(ct ) + u(ct )
Issues domestic liquidity Bt+1 , that pays domestic interest rate rt+1
Central Bank
P∞ h i
t=0 β u(ct ) + u(ct )
∗ , that pay world interest rate r ∗ = β −1
Buys foreign reserves Bt+1
Central Bank
P∞ h i
t=0 β u(ct ) + u(ct )
Affects interest rate by intervening on the domestic bond market

Central Bank
P∞ h i
t=0 β u(ct ) + u(ct )
Affects interest rate by intervening on the domestic bond market

I Bond market equilibrium: Bt+1 = Dt+1 − Lt+1
Fiscal side to Central Bank policy
If r 6= r ∗ : revenues or losses
I affect fiscal balance of Government
Consolidated budget constraint of Central Bank and Government
r ∗ Bt∗ + Bt+1 + (τt − 1)(ctD + ctL ) = Bt+1

∗
+ rt Bt

∗
+ rt Bt
We consider two cases

1 Central Bank cannot choose the tax rate
Assume τ is constant with
X cD + cL X (rt − r ∗ )Bt
t t
(τ − 1) + r ∗ (B0∗ − B0 ) =
t≥0
(r ∗ )t t≥0
(r ∗ )t

∗
+ rt Bt
We consider two cases

1 Central Bank cannot choose the tax rate
Assume τ is constant with
X cD + cL X (rt − r ∗ )Bt
t t
(τ − 1) + r ∗ (B0∗ − B0 ) =
t≥0
(r ∗ )t t≥0
(r ∗ )t
2 Central Bank can choose tax rate in each period

Possible policy regimes
Closed economy: B ∗ = 0 and r ∈ <+
Open economy: B ∗ ∈ < and r = r ∗
Semi-open economy: B ∗ ∈ < and r ∈ <+
Remark: closed and open economy are nested in semi-open economy

2. Decentralized equilibrium
Precautionary saving
Consider log-utility to get analytical results
Household with high endowment in period t

1 aYt+1 Lt+2
Dt+1 = β(Yt − rt Lt ) − −
1+β rt+1 rt+1

1 aYt+1 Lt+2
Dt+1 = β(Yt − rt Lt ) − −
| {z } 1 + β rt+1 r
↑ | t+1
{z }
↓

1 aYt+1 Lt+2
Dt+1 = β(Yt − rt Lt ) − −
| {z } 1 + β rt+1 r
↑ | t+1
{z }
↓
Higher deposits when constraint is expected to bind next period
Issuance of liquid assets Bt+1 by Central Bank can accomodate need for
precautionary saving
(Symmetric) steady states
The steady state depends on the amount of liquidity B


B 1−a
Y <β 1+β − 2φ
credit constraint is binding

interest rate r < r ∗ = β −1
B
interest rate increases with Y

B 1−a B 1−a
Y <β 1+β − 2φ Y ≥β 1+β − 2φ
credit constraint is binding credit constraint is not binding

interest rate r < r ∗ = β −1 interest rate r = r ∗ = β −1
B
interest rate increases with Y
(Symmetric) steady states [cont’d]
Assume no tax
Assume no tax
Open economy
credit constraint is not
binding
1−a
NFA is positive if 2φ < 1+β
Assume no tax
Open economy Closed economy

credit constraint is not credit constraint are binding
1−a
binding and r < r ∗ if 2φ < 1+β
1−a
Assume no tax

1−a
1−a
1−a
2φ < 1+β defines a liquidity-scarce country
Assume no tax

1−a
1−a
1−a
2φ < 1+β defines a liquidity-scarce country
private sector cannot create enough liquid assets
to satisfy the demand for saving instruments
3. Optimal policy
Strategy
1. Analytical results
yes
consider optimal to replicate
the open economy the open economy
evaluate FOC are they

of Ramsey problem satisfied?
optimal to deviate
from the open economy
no (capital controls are optimal)
Strategy
1. Analytical results
yes
consider optimal to replicate
the open economy the open economy
evaluate FOC are they

of Ramsey problem satisfied?
optimal to deviate
from the open economy
no (capital controls are optimal)
2. Numerical results
I simulate the optimal policy
Optimal policy
Steady state
The open economy satisfies FOC of Ramsey problem
I optimal policy replicates the open economy
(capital controls are useless)
Optimal policy
Steady state
The open economy satisfies FOC of Ramsey problem
I optimal policy replicates the open economy
(capital controls are useless)
Transition with binding constraints

Optimal policy deviates from the open economy

relaxing credit constraints
optimal interest rate solves trade-off b/w
providing liquid assets
Lagrangian for the Ramsey problem
No fiscal instrument (τt is constant)
∗
Maximization over {Lt+1 , Dt+1 , Bt+1 , ctD , ctL , rt+1 }t≥0
∞
(
X
t
L= β u(ctD ) + u(ctL )
t=0

D
+γt Yt − τ ctD − Dt+1 − rt Lt

+γtL aYt + rt Dt + Lt+1 − τ ctL

+γtG r ∗ Bt∗ − Bt+1
∗
+ (1 + a)Yt − ctD − ctL

+κD 0 D 0 L
t u (ct ) − βrt+1 u (ct+1 )

+κLt u 0 (ctL ) − βrt+1 u 0 (ct+1
D
)(1 + λt+1 )
)
+ Λt [φYt − rt Lt ]
First-order condition w.r.t rt+1
L D
γt+1 Dt+1 − (γt+1 + Λt+1 )Lt+1 − κD 0 L L 0 D
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 ) = 0
L D
γt+1 Dt+1 − (γt+1 + Λt+1 )Lt+1 −κD 0 L L 0 D
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 ) = 0
| {z }
distributive effects
b/w depositors and borrowers
L D
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 ) = 0
| {z } | {z }
distributive effects distortion of
b/w depositors and borrowers intertemporal choice
L D
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 ) = 0
| {z } | {z }
∗
Evaluate It+1 = LHS along the policy that replicate the open economy:
L D
∗
It+1 = γt+1 Dt+1 − (γt+1 + Λt+1 )Lt+1 − κD 0 L L 0 D
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 )
L D
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 ) = 0
| {z } | {z }
∗
L D
∗
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 )
| {z }
=0
L D
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 ) = 0
| {z } | {z }
∗
L D
∗
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 )
| {z }
=0
∞
! ∞
!
X X
= Λt+2i Dt+1 − Λt+1+2i Lt+1
i =1 i =0
L D
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 ) = 0
| {z } | {z }
∗
L D
∗
t u (ct+1 ) − κt u (ct+1 )(1 + λt+1 )
| {z }
=0
∞
! ∞
!
X X
= Λt+2i Dt+1 − Λt+1+2i Lt+1
i =1 i =0
In the steady state: constraints are lax so Λ = 0 and I ∗ = 0.

I optimal r = r ∗
∗ ) = sign (D
sign(It+1 t+1 /Lt+1 − Λt+1 /Λt+2 )
∗ ) = sign (D
sign(It+1 t+1 /Lt+1 − Λt+1 /Λt+2 )
I increases with the ratio D/L

I depends on the future evolution of the credit constraint
∗ ) = sign (D
sign(It+1 t+1 /Lt+1 − Λt+1 /Λt+2 )

∗ ) = sign ( 1−a
sign(It+1 (1+1/µ)(1+β) − φ)
∗ ) = sign (D
sign(It+1 t+1 /Lt+1 − Λt+1 /Λt+2 )

∗ ) = sign ( 1−a
sign(It+1 (1+1/µ)(1+β) − φ)
I a → 1 (representative agent): optimal r < r ∗

I φ → 0 (no borrowing): optimal r > r ∗
I large µ (sustained growth): optimal r > r ∗
I small µ (short-lived growth): optimal r < r ∗
Optimal policy in China?
high income uncertainty

small a
strong borrowing constraint
small φ
sustained growth
large µ
this suggests optimal r > r ∗

high income uncertainty
small a initially accumulate
strong borrowing constraint more reserves
small φ than in the open economy
sustained growth
large µ
Simulations
Optimal interest rate r − 1, in percentage points
7.0
6.5
6.0
5.5
5.0
4.5
4.0
baseline
3.5
open economy
3.0
lower µ
2.5
higher φ
2.0
higher a
1.5
0 2 4 6 8 10 12 14
Baseline: µ = 0.4 , a = 0, φ = 0.1

Simulations: high optimal interest rate
Percentage change from initial value
B∗ B D
18 18 18
16 16 16
14 14 14
12 12 12
10 10 10
8 8 8
6 6 6
4 optimal policy 4 4
2 open economy 2 2
0 0 0
0 1 2 3 4 5 0 1 2 3 4 5 0 1 2 3 4 5
L cD cL
18 18 18
16 16 16
14 14 14
12 12 12
10 10 10
8 8 8
6 6 6
4 4 4
2 2 2
0 0 0
0 1 2 3 4 5 0 1 2 3 4 5 0 1 2 3 4 5
Parameters: µ = 0.4 , a = 0, φ = 0.1

Simulations: low optimal interest rate
Percentage change from initial value
B∗ B D
20 16 16
14 14
15 12 12
10
10 10
8
8
6
5 6
4
2 4
0 optimal policy
0 2
open economy
-5 -2 0
0 1 2 3 4 5 0 1 2 3 4 5 0 1 2 3 4 5
L cD cL
18 16 16
16 14 14
14 12 12
12
10 10
10
8 8
8
6 6
6
4 4 4
2 2 2
0 0 0
0 1 2 3 4 5 0 1 2 3 4 5 0 1 2 3 4 5
Parameters: µ = 0.3 , a = 0, φ = 0.2

Optimal policy with flexible consumption tax
rates
With flexible tax rates, the Ramsey planner achieves the first best
non-binding credit constraints
u 0 (c) constant across periods and households
depletes reserves to consume future endowments
Optimal policy with flexible consumption tax
rates
With flexible tax rates, the Ramsey planner achieves the first best
non-binding credit constraints
u 0 (c) constant across periods and households
depletes reserves to consume future endowments
In general, this requires deviating from the open economy

subsidize consumption at beginning of transition and tax it later
a varying tax rate distorts the intertemporal choice of households
interest rate deviates from world rate to offset distortion:
τt
rt+1 τt+1 = r∗
Extension: real exchange rate
Possible extension: introduce endowment of non-tradable goods

I real-exchange rate is the relative price of two goods
Then: accumulation of reserves ⇒ depreciated real exchange rate

see Jeanne (2011)
Depreciation at the beginning of the transition would be optimal

Conclusion
study a semi-open economy where private sector has a demand

for precautionary saving but no access to world capital market
analyze optimal policy of Central Bank with access to world

capital market
find that accumulation of reserves combined with capital

controls is optimal when taxation instruments are limited

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Capital Controls with International Reserve

Accumulation: Can this Be Optimal?

Philippe Bacchetta Kenza Benhima Yannick Kalantzis

BBK () Reserves January 2012 1/2

the “policy” view:

the “policy” view:

the “structural” view:

the private sector has

the private sector has

the private sector has

Study a semi-open economy

where the private sector

precautionary saving fluctuating endowment

precautionary saving fluctuating endowment

precautionary saving fluctuating endowment

Central Bank as a provides liquid assets to private sector

What is the optimal

What is the optimal accumulate reserves

What is the optimal accumulate reserves

What is the optimal accumulate reserves

Does it consist (qualified) no

What is the optimal accumulate reserves

Does it consist (qualified) no

Global imbalances Caballero et al. (2008), Mendoza et al. (2009),

Int’l reserves as Aizenman (2011), Aizenman and Lee (2007), Bar-

Optimal non-ricardian environments

Optimality of pecuniary externality

One-good real economy

Two groups of infinitely-lived households

Households have endowments that fluctuates

Ramsey planner: the Central Bank

Aggregate endowment: (1 + a)Yt 0≤a<1

Aggregate endowment: (1 + a)Yt 0≤a<1

Aggregate endowment: (1 + a)Yt 0≤a<1

Two groups of households

Aggregate endowment: (1 + a)Yt 0≤a<1

Two groups of households

Bond market Credit constraint

Bond market Credit constraint

Affects interest rate by intervening on the domestic bond market

Affects interest rate by intervening on the domestic bond market

Consolidated budget constraint of Central Bank and Government

r ∗ Bt∗ + Bt+1 + (τt − 1)(ctD + ctL ) = Bt+1

Consolidated budget constraint of Central Bank and Government

r ∗ Bt∗ + Bt+1 + (τt − 1)(ctD + ctL ) = Bt+1

We consider two cases

Consolidated budget constraint of Central Bank and Government

r ∗ Bt∗ + Bt+1 + (τt − 1)(ctD + ctL ) = Bt+1

We consider two cases

2 Central Bank can choose tax rate in each period

Closed economy: B ∗ = 0 and r ∈ <+

Open economy: B ∗ ∈ < and r = r ∗

Semi-open economy: B ∗ ∈ < and r ∈ <+

Remark: closed and open economy are nested in semi-open economy

Household with high endowment in period t

Household with high endowment in period t

Household with high endowment in period t

Higher deposits when constraint is expected to bind next period

The steady state depends on the amount of liquidity B

The steady state depends on the amount of liquidity B

credit constraint is binding

The steady state depends on the amount of liquidity B

credit constraint is binding credit constraint is not binding