Accumulation of Foreign Exchange Reserves In reality, not all countries in ASEAN+3 practise strict inflation

4. Accumulation of Foreign Exchange Reserves In reality, not all countries in ASEAN+3 practise strict inflation

targeting, with some having adopted more flexible policies. Aside from inflation, the policy objectives of the central banks of many countries also include exchange rate stability but they are not any more setting of exchange- rate targets (Filardo and Genberg, 2009). As pointed out by Calvo and Reinhart (2002), because of the ‘fear of floating’, avoiding large exchange rate fluctuations continues to play a significant role in the monetary policy of emerging economies so as to avoid adverse impacts on their economies. here are four factors that drive this fear of floating, namely: (i) the fear of increases in foreign liabilities denominated in foreign currencies, (ii) the fear of output costs associated with exchange rate fluctuations, (iii) the fear of inelastic supply of funds during times of crisis; and (iv) the fear of losing credibility and accesses on the international capital markets.

Flexible exchange rate requires a smaller war chest of external reserves as the system reduces the need for market intervention. In reality, for a number of reasons, Asian countries accumulating large international reserves following the Asian financial crisis in 1997-98 (Ruiz-Arranz and Zavadjil, 2008). he first reason, as discussed earlier, is to stabilize exchange rate and avoid excessive exchange rate appreciation. An appreciated exchange rate makes import cheaper and reduces competitiveness of exports. At the same time, such an overvalued exchange rate discourages reallocation of resources from the less productive non-traded sector of the economy to the more productive traded sector. Second, is to prepare for a defense against speculative attack and foreign exchange rate instability due to shortfalls in exports and to capital flow reversals. hird, the less volatile exchange rate eliminates currency risks and provides incentives for overseas borrowing, particularly when international interest rates are lower than domestic interest rates.

he fourth reason is for the external reserve accumulation is to provide for a fiscal space when facing the crisis. he bitter experience of Asian financial crisis in 1997 was associated with the IMF conditionality to adopt pro-cyclical macroeconomic policy, including tight fiscal policy, high interest rate and large exchange rate devaluation during the crisis that had over killed their banks, corporations and the economy and caused wide political and social implications. Because they were treated badly when they sought help in the past, Asian countries are quite reluctant to turn to the IMF. At that time the crisis hit countries recovered quickly by devaluating their national currencies to boost exports. During the recent global financial crisis in 2007-08, as the world economy was in recession, exchange rate devaluation could not be effective to stimulate the economy. Monetary policy was powerless as interest rate was already close to zero. Under liquidity trap, fiscal policy is the only hope to get out of recession. But, only those with adequate external reserves, access to external financing can afford the cost of fiscal stimulus. At the same time, reserves availability would increase the scope for accommodating monetary policy, relaxing domestic financial constraints and reducing the risk of crowding out he fourth reason is for the external reserve accumulation is to provide for a fiscal space when facing the crisis. he bitter experience of Asian financial crisis in 1997 was associated with the IMF conditionality to adopt pro-cyclical macroeconomic policy, including tight fiscal policy, high interest rate and large exchange rate devaluation during the crisis that had over killed their banks, corporations and the economy and caused wide political and social implications. Because they were treated badly when they sought help in the past, Asian countries are quite reluctant to turn to the IMF. At that time the crisis hit countries recovered quickly by devaluating their national currencies to boost exports. During the recent global financial crisis in 2007-08, as the world economy was in recession, exchange rate devaluation could not be effective to stimulate the economy. Monetary policy was powerless as interest rate was already close to zero. Under liquidity trap, fiscal policy is the only hope to get out of recession. But, only those with adequate external reserves, access to external financing can afford the cost of fiscal stimulus. At the same time, reserves availability would increase the scope for accommodating monetary policy, relaxing domestic financial constraints and reducing the risk of crowding out

ASEAN+3 countries have introduced a number of policy measures to protect their financial systems from the recent global turmoil of 2007-08. In line with the policies adopted elsewhere, the authorities of this region temporarily banned short selling of equity shares of financial institutions. Non-viable and non-systemic banks have been allowed to go bankrupt. he supply of liquidity in domestic currencies has been augmented by reducing the minimum reserve ratio requirements and introducing emergency credit facilities. Japan continues to apply monetary easing by supplying liquidity to the market and reducing nominal interest rates close to zero.

he quantitative easing monetary policy in Japan has been in place since the instability in its financial system in the 1990s.