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On March 20, 2007 Chinahs central bank governor announced that his country would stop accumulating foreign exchange reserves. He was quoted in Reuters (2007) as stating iforeign exchange reserves in China are large enough. We do not intend to go further and accumulate reserves.jAs shown in Figure 1, this statement followed several years of very large and accelerating Chinese reserve gains. The central bank did not follow through on the statement and kept accumulating reserves throughout 2007. But in all subsequent debates this option has never been completely off the table. The remainder of the year 2007 was characterized by accelerating Chinese currency appreciation and by a significant increase in domestic inflation.

Similarly, during 2007 Colombia experienced a period of large central bank foreign exchange purchases to stem the appreciation of its real exchange rate due to capital inflows. As reported in Kamil (2008), financial markets perceived this intervention as unsustainable and bet heavily against the central bank. As a result of its rapid accumulation of foreign currency denominated assets, the central bank soon ran out of domestic currency treasury bills, and its net creditor position visa vis the financial sector turned into a net debtor position. This made it very diffi cult to control the interbank nominal interest rate, which started to significantly undershoot the policy interest rate. As shown in Figure 1, exchange rate appreciation continued unchecked. The intervention policy was soon abandoned.

What these episodes have in common is a concern, either on the part of the central bank or of financial markets, that an existing monetary regime may not be sustainable because it involves the accumulation of too much foreign exchange. This problem is relatively new, and its theoretical implications have therefore, to our knowledge, not yet been studied by the literature. In this paper, we suggest that it is very useful to examine it through the lens of a familiar literature $ the literature on first generation balance of payments crises following Krugman (1979), Calvo (1987), the survey in Calvo and Vegh (1999), and Kumhof, Li and Yan (2007), which studies balance of payments crises under inflation targeting regimes. The critical difference is that in that literature the concern is with countries that experience the consequences of a central bank owning too little foreign exchange. While many emerging markets continue to have that concern, there is now also a large group of countries with very large and growing foreign exchange reserves who may be unwilling or unable to let them grow without bound. What these countries could then experience is what we will refer to as a balance of payments anti!crisis.

In this paper we focus on the effects of such anti$crises on the domestic economy. We therefore study this problem in the context of a small open economy, without emphasizing the global repercussions that might arise if the central bank of a larger player, like China, should discontinue foreign exchange purchases. We assume that a central bank, similar to the Chinese announcement of 2007, declares that it will continue accumulating reserves only up to an upper limit that is not too far above the existing level. To account for the fact that the countries concerned may be pursuing a variety of different monetary regimes, we examine the cases of exchange rate targeting, CPI inflation targeting and domestic (nontradables) inflation targeting.

We assume that the event that ultimately leads to an anti crisis is a favorable shock to the government budget. Specifically, we assume that the government starts to receive an additional tradables endowment equal to 1% of GDP. As illustrated in Figure 2, this may be a good stylized description of the situation experienced by several strongly performing economies prior to the recent financial crisis. Chile saw a rapid improvement in its fiscal balance starting in 2003, mainly due to a large increase in the world copper price. In Chile half of the copper sector is state$owned, while the privately$owned remainder generates higher taxes and royalties when prices rise. Norway and Russia, around the same time, saw a big fiscal improvement due to higher world prices for hydrocarbons. State ownership in this sector is large in both countries. In each of these three cases it was this improvement in the fiscal balance that was mainly responsible for the simultaneous improvement in the current account balance, and therefore a rapid accumulation of foreign exchange reserves. In 2007 all three countries experienced exchange rate appreciation accompanied by stable or even increasing aggregate inflation, which implies that domestic inflation was increasing. Unlike for China and Colombia, for these countries we are not aware of public information that would have suggested an imminent end to the continuation of reserve accumulation. But in each case the countries concerned did experience a tension, in that there was for several years little reason to expect the high raw materials prices and therefore the surpluses to discontinue, while the growth in reserves was exponential and, absent other budgetary changes, indicative of unstable government asset dynamics. The question is therefore what those budgetary changes could be. There are three possibilities. The first two are obvious, the government could increase spending or decrease taxation. The third possibility is what concerns us here the government could announce that it will stop reserve accumulation, or markets could force the government into doing so.

We show that this is enough to balance the budget endogenously if reserves are not already too large. The announcement causes downward pressure on exchange rate depreciation, with goods and money demand increasing in an accelerating fashion due to the resulting reduction in inflationary distortions. The increase in real money demand, to the extent that it is accommodated by nominal money issuance in exchange for foreign currency, causes a final burst of reserve accumulation, the anti$crisis. Under inflation targeting this crisis is continuous while under exchange rate targeting it is instantaneous. The reserve gains are fastest, and the anti$crisis therefore happens earliest, under monetary regimes that imply the strongest commitment to intervene in foreign exchange markets by issuing money against foreign exchange, and therefore the strongest commitment against letting the nominal exchange rate appreciate. The ranking of regimes in terms of reserve gains is therefore, from fastest to slowest, exchange rate targeting followed by CPI inflation targeting and domestic inflation targeting.

For the government the effect of lower exchange rate depreciation is a reduction in seigniorage income that balances the budget. The point at which this happens is not arbitrary, because by uncovered interest parity exchange rate depreciation cannot drop arbitrarily low without violating the zero lower bound on nominal interest rates. Because this limits the extent to which lower seigniorage can balance the budget, it ensures that the anti$crisis happens before reserves go beyond a certain maximum.

The rest of the paper is organized as follows. Section 2 develops the model. Section 3 discusses model calibration and the solution algorithm. Section 4 discusses the dynamics of balance of payments anti crises. Section 5 concludes. Technical details and a description of the solution algorithm are contained in the Technical Appendix accompanying the paper.

Contents

I. Introduction
II. The Model

A. Households
B. Firms
C. Government
D. Equilibrium
E. Government Revenue Shock

III. Model Solution

A. Parameter Values
B. Solution Method

IV. Anti Crises
V. Conclusion
References

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