Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Obstfeld on FX Reserves and Panic of 2008

I have been reading an NBER Working Paper by Obstfeld, Shambaugh
and Taylor Financial
instability, reserves, and central bank swap lines in the panic of
. These are well respected authors, so I was quite
disappointed to find that they have made several errors and missed
several key features of what they call the “panic of

Most important of these is the fact that currency depreciations
during 2008 were driven to a very great extent by the foreign currency
liabilities of the banks and of the corporate sector. This reality was
staring them in the face in the form of Iceland, but they amazingly
treated Iceland as an outlier and dropped it from all their
analysis. They seemed to have forgotten that in risk management, the
outlier is the data and everything else is a distraction. Iceland was
an extreme case, but the short dollar position of banks and companies
were a critical factor behind currency depreciations in the three
large emerging economies that Obstfeld et al plot in Figure 1
(Russia, India and Korea).

Failure to consider the exposure of the banking system leads them
to under estimate the reserve needs of emerging economies. They make
the statement that countries like India “do have foreign reserves
sufficient to allow them to act as crisis lenders to foreign
governments.” This is simply not true.

Obstfeld et al make another mistake in asserting that for
countries like Korea, the swap lines from the US Fed served only a
signaling purpose because these countries had plenty of reserves and
the magnitude of the swap line was not meaningful in relation to the
reserves. This again is simply false. Earlier this month, the Wall
Street Journal quoted
a finance ministry official as saying that the Bank of Korea had drawn
down more than half of the swap line and that it might need a second
or third line. Korea is really short of reserves and it has also been
reported that not all of its reserves are sufficiently liquid.

It is distressing to find such serious errors in a paper by
economists of such high standing who have done so much of widely cited
work in this field. I know a working paper is supposed to be for
dissemination in preliminary form and is not necessarily subject to
peer review, but still …


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