Over the last decade, central banks around the world have quadrupled the size of their foreign exchange reserves. The case of China, which multiplied its own stock by a factor of ten, is often mentioned as an example of these excesses, but China is not alone. Total reserves of sub-Sahara African countries have also risen by a factor of ten. The only exceptions to this worldwide phenomenon are the developed countries and a few odd developing countries.
It might seem surprising that developing countries, which badly need every penny that they can save to improve their production capacities, accumulate such a stockpile of low-yield assets. Are they simply trying to protect themselves against potential currency crises or are they manipulating their exchange rates to achieve a competitive advantage? Joshua Aizenman and Jaewoo Lee have tested these two alternative assumptions.1 Their conclusion is the precautionary motive vastly dominates the mercantilist motive. Olivier Jeanne and Romain Ranciere reach a similar conclusion although they identify a few countries – including China – as holders of suspiciously large reserve stocks.2 Yet, the perception remains that the reserves buildup is both excessive and a signal of exchange rate manipulation.
In recent work, I follow a different, informal approach.3 Looking at the 4,000 billion dollars of foreign exchange reserves now accumulated is indeed impressive, but shouldn’t we be careful when we deal with nominal measures? Inflation has been subdued over the last decade, so looking at the real value of foreign exchange reserves does not significantly alter the perception that an unusual phenomenon has occurred. It would seem natural to take into account growth. Indeed most theories of the demand for foreign exchange reserves take into account the country’s economic size, measured by GDP or trade. Indeed, for a long time, international financial institutions were promoting a simple rule of thumb: it is wise to hold reserves that represent about three month's worth of imports. The figure below shows the evolution of total world reserves in dollars and as a ratio to world GDP. Obviously, the buildup is considerably less dramatic once we take economic growth into account, yet the reserves-to-GDP ratio has still nearly doubled.
All of this, however, strangely misses the process of financial globalisation. Over the last two decades, a large number of developing countries have removed internal and external restrictions on financial markets. This is, after all, one key reason why we now talk about emerging market countries. A spectacular consequence of this process has been large-scale foreign investments, direct as well as indirect. As a result, residents from these countries have acquired large foreign liabilities, many of which are in foreign currencies. Financial diversification on a world scale is often hailed as a wonderful achievement that stands to optimally spread risks and opportunities. True as it may be, this rosy picture should not conceal that a side-effect is risk taking by emerging market countries, and, in particular, an exposure to rapid exchange rate movements. The Asian crisis in 1997-98 has amply illustrated how an economic development “miracle” can suddenly turn into a nightmare.
Viewed this way, it is entirely reasonable for the developing countries to scale up their reserves in line with their external exposure. Indeed, the old rule of thumb – three months of imports – is now being replaced by the Greenspan-Guidotti rule, the stock of short-term debt. Given that the definition of short-term is both arbitrary and illusory – long-term debt can promptly be downloaded for sale when markets panic – the figure above displays the ratio of reserves to total foreign liabilities, as measured by Phil Lane and Gian Maria Milesi-Ferretti.4 The picture is radically changed. If reserves have grown faster than external liabilities lately, any talk of them being excessive is exaggerated if one takes the long, historical view.
A more detailed country-by-country analysis still leaves the impression that a few countries, e.g. China and Korea, have accumulated reserves much faster than external liabilities,as shown below. Are they also trying to prevent an exchange rate appreciation, then? Both countries, and many other South East Asian countries as well, are clearly taking a leaf of the great Japanese book of rapid economic convergence. Throughout Asia, export-led growth is seen as a successful recipe, and there is little doubt that it is being adopted. True, an undervalued exchange rate is a “manipulated price” and this has adverse allocative effects but, as the example of Japan shows, the strategy is neither harmful to the rest of the world nor permanently advantageous. As a temporary device, it is a source of dynamic efficiency, speeding up productivity gains that well serve foreign customers.
At any rate, before branding some countries as “currency manipulators”, we should understand why they accumulate reserves. A defining moment is South East Asia has been the 1997-98 crisis. Hailed as the success economic development story of the late 20th century, these countries have suddenly seen IMF staffers coming to town to explain that nearly everything had been wrong. The IMF then imposed tough conditions for huge loans that did not prevent currency collapses and were never fully disbursed. Quite naturally, developing nations have concluded that they never want to find themselves in the same spot again. Large reserve stocks are not just self-insurance against currency turmoil, they are also an insurance against IMF borrowing. Maybe a better IMF approach to emergency lending might be the place to start for those who think that foreign exchange reserves are excessive.
1 Aizenman, Joshua and Jaewoo Lee (2007) “International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence,” Open Economies Review, forthcoming.
2 Jeanne, Olivier and Romain Rancière (2006) “The Optimal Level of International Reserves for Emerging Market Countries: Formulas and Applications,” Working Paper WP/06/229, Washington: International Monetary Fund.
3 Wyplosz, Charles (2007) “The Foreign Exchange Reserves Build-up: Business as Usual?”, unpublished paper, Geneva: Graduate Institute of International Studies.
4 Lane, P., and G.M. Milesi-Ferretti (2006) “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970–2004”, Working Paper No. 06/69, Washington: International Monetary Fund.