Foreign exchange reserves: too costly?

Foreign reserves in developing countries have risen four-fold since 1990 to almost 30% of GDP, yet they remain less than 5% in developed countries. While this dramatic accumulation provides greater liquidity and some protection against financial crisis, the "striking fact is that short-term debt exposure has continued to climb in many countries, even as these same countries were investing valuable resources in increasing reserve assets". So writes Harvard's Dani Rodrik in a recent paper, The Social Cost of Foreign Exchange Reserves, which has just been published as NBER Working Paper No. 11952. Here is the abstract:

There has been a very rapid rise since the early 1990s in foreign reserves held by developing countries. These reserves have climbed to almost 30 percent of developing countries' GDP and 8 months of imports. Assuming reasonable spreads between the yield on reserve assets and the cost of foreign borrowing, the income loss to these countries amounts to close to 1 percent of GDP. Conditional on existing levels of short-term foreign borrowing, this does not represent too steep a price as an insurance premium against financial crises. But why developing countries have not tried harder to reduce short-term foreign liabilities in order to achieve the same level of liquidity (thereby paying a smaller cost in terms of reserve accumulation) remains an important puzzle.

Rodrik concludes that this rapid build-up is far from optimal:

We are left with the inescapable conclusion that developing countries on the whole have responded to financial globalization in a highly unbalanced and far-from optimal manner. They have over-invested in the costly strategy of reserve accumulation and under-invested in capital account management policies to reduce their short-term foreign liabilities.

The reasons are perhaps not hard to fathom. Unlike reserve accumulation, controls on short-term borrowing hurt powerful financial interests, both at home and abroad. Somehow "market intervention" in the form of taxing short-term capital inflows has developed an unsavory reputation that "market intervention' in the form of buying reserves does not have. Perhaps it is time to start viewing the Guidotti-Greenspan-IMF rule as an admonishment that applies to short term foreign borrowing, and not just reserves.

A free PDF version of the paper is available here (and here).

Comments

[r4 software]

Well I guess throwing too much money into investments is neither good cos it may not turn out profitable either.

From my past experience in societies, I find that in certain batches or years, the committee were not able to bring in money from their activities or from their fund raising events, thus causing the future batches problems. When they do bring in money, the money is spent like nobodys business and yet forgetting that the societies need money for future events.

So same applies to the government. If the current ones are not thrifty and save up, the future may seem bleak for the country and it will force us to work much harder than we already have.