Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Whom do you bail out with your reserves?

Countries build up reserves in good times for many reasons including depressing the value of the exchange rate. The real proof of the pudding comes in bad times when the government needs to decide who should be bailed out, and who should be allowed to fail.

There have been two archetypes for this decision making. In the old Latin American model, the klepocratic elite was allowed to take its money out and everybody else was hung out to dry. The East Asian model (both in 1998 and 2008) was largely to bail out the banks (but not necessarily their owners) and to let the corporate sector go bust. Russia in 2008 followed a middle path: they bailed out the oligarchs till the reserves fell to uncomfortable levels, and then conserved the remaining reserves to protect the banking system.

The interesting question is which model is China following. The anti corruption campaign might suggest that China is following the East Asian path of forcing losses on the elite. But the scale of capital flight suggests a different interpretation: the anti corruption campaign is sending a signal to the klepocrats to take their money out of China before it is too late. Whatever the intentions might have been, China might end up in practice much closer to the Russian model. Maybe half the reserves will be used to allow the elite to unwind their carry trades and take their money out of the country. The remaining half would still be sufficient to stabilise the economy at a depreciated exchange rate.

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