Between 2000 and 2009, developing countries added almost $5 trillion to their foreign exchange reserves—a number deemed too high by many observers, prompting accusations of protectionism. However, estimates of what level is “adequate” are inherently subjective, as risk perceptions and tolerance vary.
Moreover, policies in developing countries are only one factor driving reserve accumulation; others include policies pursued by advanced countries and coordination failures by the international community. As a result, slowing reserve growth requires action by both developing and advanced countries.
A Question of Excess
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.
One traditional benchmark to assess reserve levels is whether they are enough to cover six months of imports; another is whether they are sufficient to cover all short-term external debt. In the last decade, economists have proposed adding 20 percent of M2 to these benchmarks, as increased financial integration means that a large part of a country’s monetary base can head for the exits during a crisis. Recently, the IMF proposed a measure that uses exports, short-term debt and other portfolio liabilities, and M2 as factors in determining reserve adequacy.1
These benchmarks yield vastly different estimates of reserve adequacy; as a result, the range of excess reserves now held by developing countries is between $1 trillion and $4 trillion. From 2000 to the start of 2011, developing countries increased their nominal stock of foreign exchange reserves from around $750 billion (11 percent of GDP) to nearly $6.3 trillion (29 percent of GDP), a staggering increase compared to a rise from $1.3 trillion (5.1 percent of GDP) to $3.4 trillion (8.1 percent of GDP) in OECD countries. The accumulation in developing countries paused only briefly during the Great Recession.
More than 90 percent of developing country reserves are concentrated in the 20 largest holders, which now have enough reserves to cover more than a year of imports or nearly five times their short-term debt. Even according to the more demanding criteria recently put forward by the IMF and others, a majority of these countries have excess reserves.2
As always, the average reserve levels among these 20 countries conceal large variation, as shown in the chart. Reserves fall below at least one of the two traditional measures in Mexico, Poland, and Turkey, while China alone accounts for more than half of 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 in the probability they attach to crisis and in their aversion to risk. Just as some individuals buy minimal health care because they are not risk averse or do not believe they will get sick, and others buy coverage for every conceivable treatment, countries have different demands for insurance as well.
Moreover, though holding reserves entails an opportunity cost—they are, by definition, safe and low-yielding assets—which is estimated to be about 0.5 percent of GDP in the median emerging market,3 this opportunity cost is itself subjective; it is based on an estimate of the expected yield on higher-risk assets. Furthermore, this cost pales in comparison to the deep and prolonged cost and political disruption of financial crises, which, in severe cases, can entail a loss of sovereignty to international creditors.4
Reserves cannot completely insure countries against crises, but countries with large reserve 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 a crisis.5
The Global Liquidity Glut
Why did developing countries begin to rapidly accumulate reserves ten years ago? Following the financial crisis in developing Asia in 1997–1998, savings rates there rose steadily from around 31 percent of GDP in the 1990s to 45 percent in 2009. However, investment, which collapsed during the crisis, was slower to return, rising from 33 to 41 percent of GDP over the same period, implying a large current account surplus. Rising oil and commodity prices also played a role, with reserves held by oil exporters reaching about $1.5 trillion in 2010.
However, even a cursory review of the evidence suggests that, while these factors were clearly important, they do not tell 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 hypothesizes 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 United States, the UK, and peripheral Europe went on a spending binge that pushed their cumulative current account deficit from -0.5 percent of world GDP in the 1990s to -2 percent in 2005–2008. In the United States, low interest rates, tax cuts, unfunded war spending, and a housing boom steadily widened the current account deficit from -1.6 percent of GDP in the 1990s to -6.1 percent of GDP in 2006. The UK also saw a big housing and financial boom. 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 percent in the 1990s to -9.1 percent in 2008.
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 less than 4 percent of emerging-market GDP in 2000 to nearly 9 percent 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 respond in one of two ways: allow a sharp appreciation of the real exchange rate, eventually leading to a reduced current account surplus and stopping capital inflows; or accumulate official reserves. As it happens, real exchange rates in major emerging markets appreciated, by an average of 7.8 percent from 2000 to 2007(though many countries saw different outcomes; see the chart below). But the increase in official reserves was much more dramatic.
As the chart below shows, over 2000–2007, changes in reserves and real exchange rates in developing countries show no correlation. This raises doubt about the claim that countries intervened mainly to avoid a loss of competitiveness, but is in line with a large body of literature suggesting that prolonged intervention often fails to influence real exchange rates, even though it impacts nominal exchange rates.6
The story is incomplete without a reference to coordination failures. Despite the literature’s findings, if the main motivation for reserve accumulation by emerging markets was to prevent real exchange rate appreciation, then agreeing to allow their exchange rates to appreciate together would have made the loss of competitiveness less of a concern for those countries. Moreover, advanced countries—which would have benefited from the increased demand—would likely have let policy interest rates rise faster, thus reducing the capital flows to developing countries. However, if, as we suspect, reserve accumulation was motivated by windfalls and precautionary concerns more than fears of exchange rate appreciation, coordination among emerging markets would only have helped if global macroeconomic stability had fundamentally improved.
Trying to impose hard-and-fast limits on reserve accumulation is both futile and undesirable. Individual countries have different perceptions of risk exposure and risk tolerance, and are willing to pay different amounts for insurance.
Policies should focus instead on the causes of excess global liquidity and volatility. The United States, Europe, and Japan—which 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 the core advanced countries regain their footing, lower their fiscal deficits, and raise their interest rates, developing countries will continue to struggle with windfalls of foreign money, and to seek insurance against global recessions and sudden stops in capital flows.
That said, some emerging markets, beginning with China, should take a more serious look at their reserve levels and the associated costs. Not only does the accumulation of excess reserves imply direct opportunity costs, but it can also contribute to inflation and overheating credit and asset markets. In addition, efforts to sterilize the effect of reserve levels on the domestic money supply can distort domestic banking systems, while their ability to prevent real-exchange rate appreciation in the long run is, at best, unproven.
No one size fits all countries, but enhancing international coordination between developing and advanced countries—through the G20’s mutual assessment process, for example—could also help mitigate excessive reserve accumulation, provided it does not become another mercantilist negotiation or an alibi for inaction. What is certain is that advanced and developing countries can both benefit from a deeper understanding of the forces driving the remarkable acceleration of foreign exchange reserves.
Uri Dadush is the director of Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program. A previous version of this article was published by VoxEU.
1. Based on historical evidence, the authors derived the following formulas to calculate the appropriate level of reserves: in fixed-exchange rate regimes, reserves should be equal to 1 to 1.5 times the sum of 30 percent of short-term debt (STD), 15 percent of other portfolio liabilities (OPL), 10 percent of M2, and 10 percent of exports; in floating exchange rate regimes, reserves should equal 1 to 1.5 times the sum of 30 percent of STD, 10 percent of OPL, 5 percent of M2, and 5 percent 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 percent of M2. Of the 20 largest reserve holders, 15 are included in the IMF analysis; eight were found to have excess reserves.
3. 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 percent of GDP.
4. Reinhart and Rogoff (2008) find that financial crises, on average, reduce per-capita GDP by 9 percent and returning to the pre-crisis level takes an average of four years. In emerging markets, these effects are often even more severe.
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. The Jurgensen Report (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.