Download Uri Dadush Bennett Stancil 9 May 2011, VOX.EU

Why are reserves so big?
Uri Dadush Bennett Stancil
9 May 2011, VOX.EU
Between 2000 and 2009, developing countries added almost $5 trillion to their foreign-exchange
reserves – a number deemed too high by many, prompting accusations of protectionism. But this
column argues that developed countries are equally to blame – as well as failures in international
coordination. It concludes that remedies therefore require action by both groups.
Foreign-exchange reserves play a crucial role in macroeconomic management. They provide a
safety net during times of economic turmoil and, for most developing countries, a means to peg
the nominal exchange rate. They also provide a means to manage windfalls from commodity
exports or from sudden surges of capital.
A traditional benchmark to assess reserve levels is whether they are enough to cover six months
of imports; another is whether they are enough to cover all short-term external debt. Recently,
economists have proposed adding 20% of M2 to the benchmarks, since increased financial
integration means that a large part of a country’s monetary base can head for the exits during a
crisis (de Beaufort Wijnholds and Kapteyn 2001). Recently, the IMF also proposed a measure
that combines exports, short-term debt and other portfolio liabilities, and M2 as indicators (IMF
2011)1.
These measures yield hugely different estimates of reserve adequacy, so developing countries
now hold between $1 trillion and $4 trillion in excessive reserves. From 2000 to the start of 2011,
the nominal stock of foreign exchange reserves in developing countries increased from around
$750 billion (11% of GDP) to nearly $6.3 trillion (29% of GDP), a staggering increase compared
to a rise from $1.3 trillion (5.1% of GDP) to $3.4 trillion (8.1% of GDP) in OECD countries. The
accumulation in developing countries paused only briefly during the Great Recession.
Over 90% of developing country reserves are concentrated in the 20 largest holders, which now
have enough reserves to cover over a year of imports or their short-term debt nearly five times
over. Even according to the more demanding criteria recently put forward, a majority of these
countries have excess reserves2.
Figure 1. 2009 reserve levels in the 20 largest developing country reserve holders ($ billions)
As always, the averages conceal large variation, as shown above. Reserves are below at least
one of the two traditional measures in Mexico, Poland, and Turkey, but are particularly high in
Asia. China alone accounts for over half the sample’s excess reserves.
How much is too much?
Despite these striking figures, estimates of reserve adequacy must be made with caution.
Benchmarks provide a useful guide, but countries differ, including in the probability they attach to
crisis and in aversion to risk. Just as some individuals buy minimalist healthcare because they do
not fear risk or do not believe they will get sick, and others buy coverage for every conceivable
treatment, countries too have different demands for insurance.
Moreover, though holding reserves entails an opportunity cost – they are, by definition, safe and
low-yielding assets – it is estimated to be about 0.5% of GDP in the median emerging market
(IMF 2011)3, though this opportunity cost is itself subjective since it entails an estimate of the
expected yield on higher risk assets. This cost pales in comparison to the deep and prolonged
cost and political disruption of financial crises, which can also entail a loss of sovereignty to
international creditors in severe cases4.
Reserves cannot completely insure against crises, but countries with large reserves holdings are
better able to maintain consumption growth during periods of market pressure. They also have
greater fiscal flexibility, allowing them to further mitigate the effects of the crisis6.
The global liquidity glut
Why did developing countries begin to rapidly accumulate reserves ten years ago? Following its
financial crisis, savings rates in developing Asia rose steadily from around 31% of GDP in the
1990s to 45% in 2009; investment, which collapsed during the crisis, was slower to return, rising
to 41% of GDP, implying a large current-account surplus. Rising oil and commodity prices also
played a role, with reserves in oil exporters reaching $1.5 trillion or so in 2010.
However, even a cursory review of the evidence suggests that, while these factors were clearly
important, they are not the whole story. Policies in reserve currency countries helped create a
“global liquidity glut” that contributed to the reserve build-up in many emerging markets. Though
this story differs from the “global savings glut” theory, which hypothesises that increased savings
in emerging markets forced lower long-term interest rates on advanced countries, the two
explanations are quite complementary.
Beginning around 2000, the US, the UK, and peripheral Europe went on a spending binge that
pushed their cumulative current account deficit from -0.5% of world GDP in the 1990s to -2% in
2005-2008. In the US, low interest rates, tax cuts, unfunded war spending, and a housing boom
steadily widened the current-account deficit from -1.6% of GDP in the 1990s to -6.1% of GDP in
2006. Meanwhile, the interest rate decline associated with creation of the euro sparked a
dramatic rise in demand in peripheral Europe, causing the average current account deficit in
Greece, Ireland, Italy, Portugal, and Spain to widen dramatically from -0.9% in the 1990s to below
-9% in 2008. The UK also saw a big housing and financial boom.
Meanwhile, prodded by improvements in developing countries and low international interest rates
(most evident in deflation-stricken Japan), private capital flows to emerging markets grew from
below 4% of emerging market GDP in 2000 to nearly 9% in 2007. This surge of capital (combined
with current account surpluses) was, in many instances so big that it resembled a commodity
price windfall and could not be absorbed quickly.
Developing countries could have responded in two ways:

By allowing the real exchange rate to appreciate, eventually leading to a reduced current
account surplus and stopping capital inflows;

or accumulating official reserves.
As it happens, real exchange rates in major emerging markets appreciated strongly, by an
average of 7.8% (though many countries saw different outcomes; see Figure 2). But the increase
in reserves was much more dramatic.
As Figure 2 below shows, over 2000–2007, changes in reserves and real exchange rates in
developing countries show no correlation. This puts some doubt on the claim that countries
intervened mainly to avoid a loss of competitiveness, but is in line with a large body of literature
which suggests that prolonged intervention often fails to influence real exchange rates, though it
does impact nominal exchange rates6.
Figure 2. Changes in real exchange rates and reserve levels from 2000 to 2007
The story is incomplete without reference to coordination failures. If -- despite the literature’s
findings – the main motivation for reserve accumulation was to prevent real-exchange-rate
appreciation, had all emerging markets agreed to allow their exchange rates to appreciate
together, losing competitiveness would have been less of a concern. Moreover, advanced
countries, particularly those that would have benefited from the increased demand, would have
probably let policy interest rates rise faster, thus reducing the capital flows to developing
countries. If (as we suspect) reserve accumulation was more motivated by windfalls and
precautionary concerns, however, coordination would only have helped had global
macroeconomic stability fundamentally improved.
Policy implications
Trying to impose hard and fast limits on reserve accumulation would be both futile and
undesirable. Individual countries have different perceptions on risk exposure and risk tolerance,
and are willing to pay different amounts for insurance.
Policies should instead focus on the causes of excess global liquidity and volatility. The US,
Europe, and Japan – who own the reserve currencies and still account for the large majority of
world output and trade – will continue to determine the economic environment within which
emerging markets operate. Until they regain their footing, fiscal deficits decline, and international
interest rates rise, developing countries will continue struggle with windfalls of foreign money, and
to seek insurance against global recessions and sudden stops.
That said, some emerging markets, beginning with China, should take a more serious look at
their reserve levels and the associated costs. Excessive reserve accumulation is not only directly
costly, but it can also contribute to inflation and overheating credit and asset markets. In addition,
efforts to sterilise its effect on the domestic money supply can distort domestic banking systems
(Mohanty and Turner 2006), while its effectiveness in preventing real exchange rate appreciation
in the long run is at best unproven.
No size fits all, but enhancing international coordination – through the G20’s mutual assessment
process, for example – could also help, provided it does not become another mercantilist
negotiation or an alibi for inaction.
References
De Beaufort Wijnholds, J Onno, and Arend Kapteyn (2001), “Reserve Adequacy in Emerging
Market Economies”, IMF Working Paper 01/143.
Hutchison, Michael M (2002), “The Role of Sterilized Intervention in Exchange Rate Stabilization
Policy”, Mimeo, June.
International Monetary Fund (2011), “Assessing Reserve Adequacy”, International Monetary
Fund.
Jurgensen, Philipe (1983), "Report of the Working Group on Exchange Market Intervention
[Jurgensen Report]", US Treasury Department.
Mohanty, MS and Phillip Turner (2006). “Foreign exchange reserve accumulation in emerging
markets: what are the domestic implications?”, BIS Quarterly Review (September):39-52.
Montiel,
Peter
J
(1998),
“The
Capital
Inflow
Problem”,
World
Bank.
Reinhart, Carmen M and Kenneth Rogoff (2008), This Time is Different: Eight Centuries of
Financial Folly, Princeton University Press.
Sarno, Lucio and Mark P Taylor (2001), “Official Intervention in the Foreign Exchange Market: Is
It Effective and, If so, How Does It Work?”, Journal of Economic Literature, 39(3):839-868.
Truman, Edwin M (2003), “The Limits of Exchange Market Intervention”, in C Fred Bergsten and
John Williamson (eds.), Dollar Overvaluation and the World Economy, Institute for International
Economics.
1 Based on historical evidence, the authors derived the following formulas to calculate
appropriate the appropriate levels of reserves: in fixed exchange rate regimes, reserves should
be equal to 1 to 1.5 times the sum of 30% of short-term debt (STD), 15% of other portfolio
liabilities (OPL), 10% of M2, and 10% of exports; in floating exchange rate regimes, reserves
should equal 1 to 1.5 times the sum of 30% of STD, 10% of OPL, 5% of M2, and 5% of exports.
2 Twelve of the 16 countries for which there is sufficient data currently hold reserves in excess of
short-term debt plus 20% of M2. Fifteen of the top 20 reserve holders are included in the IMF
analysis; eight are determined to hold excessive reserves.
3 It should be noted that for countries with low reserves and high debt, the opportunity cost of
reserves may be negative (i.e., a net gain) because increased reserves reassure creditors and
lower the costs of debt service; for countries with reserves well in excess of benchmarks, such as
China and Malaysia, the cost may be as high as 2% of GDP.
4 Reinhart and Rogoff (2008) find that financial crises, on average, reduce per capita GDP by
9%, while returning to the pre-crisis level takes an average of 4 years. In emerging markets,
these effects are often even more severe.
5 However, these benefits diminish as reserve levels rise.
6 As Montiel (1998) notes, suppressing nominal appreciation through intervention in foreign
exchange markets expands the money supply and increases inflation, implying a real
appreciation. Policy makers can sterilize this intervention by selling government bonds, thus
removing liquidity and reducing real appreciation pressures. However, the effectiveness of such
interventions has been long debated. Jurgensen (1983) and Truman (2003) argue that they are
largely ineffective; Hutchison (2002) notes that they are effective in the short term, but not
necessarily the long term. See Sarno and Taylor (2001) for a broader survey of the literature.