The Foreign Exchange Reserves Buildup: Business as Usual? Charles Wyplosz Graduate Institute of International Economics and CEPR Workshop on Debt, Finance and Emerging Issues in Financial Integration, 6-7 March 2007

The issue Excessive?

Need to answer two questions Measurement Criteria Both related to motive

Measurement Nominal reserve stocks Usual scale variables  GDP  Trade (imports, exports)

Measurement Nominal reserve stocks Usual scale variables  GDP  Trade (imports, exports) Popular rules  3 months of imports  Stock of short-term external liabilities Greenspan-Guidotti-Fischer rule

A different picture Excessive?

The impact of financial globalization

More details: Who does it?

More details: Who does it and why?

And some outliers

Excessive? The motives approach The cost-benefit approach

Motives Self-insurance  Shifting risks from trade balance to capital account from 3 months of imports to Greenspan-Guidotti- Fischer rule Mercantilism  Variant 1: Export-led growth strategy  Variant 2: Keep savings home  Variant 3: Hold reserves for the sake of it  Variant 4: Directed credit

Testing motives Aizenman and Lee (2006)  Strong effect of variables related to self- insurance Capital account liberalization Crisis dummies  Some effect of variables related to mercantlism, but much weaker Undervaluation Export growth

Testing motives Aizenman and Lee (2006) Jeanne and Rancière (2006)  Model of self-insurance  Reserve build-up well explained  But some outliers in South-East Asia

Testing motives Aizenman and Lee (2006) Jeanne and Rancière (2006) Official and unofficial statements Conclusion: self-insurance and fear of IMF

Costs and benefits Costs  Direct costs Rodrik (2006): 1% of GDP for reserves =30% of GDP  Opportunity costs Better returns at home (private and public) The case of China

Costs and benefits Costs Benefits  Export-led growth  Self-insurance

Export-led growth Apparently successful, so a benefit? Only if systematic undervaluation works  No evidence that it does  No theory Nominal vs. real exchange rate Strong foreign demand inflation Unless domestic demand is weak High saving is the key success factor But then what to do with the savings? Invest at home or abroad

Self-insurance Currency crises can be very expensive A good reason to buy insurance Do high reserve stocks provide insurance?  Not really an insurance  Reduce the odds of crisis  Unlikely to eliminate the threat  False sense of immunity Could discourage reforms Could encourage imprudent policies

Wrap-up Limited evidence of excessive accumulation  Some prominent exceptions Little evidence of mercantilist motive Mostly self insurance Recent build-up is business as usual  What has been unusual is financial gloablization