China’s official foreign exchange reserves are on track to reach the two trillion dollar mark, equivalent to approximately $2000 for every Chinese citizen. Although China is currently the country with the largest foreign reserve accumulation, reserves have risen dramatically for many developing countries in recent years. Economic models suggest a number of motivations for reserve accumulation, including precautionary and mercantilist motives, which may be especially compelling for developing countries. However, the recent upsurge in reserve accumulation among developing countries cannot be explained solely on the basis of these rationales. This paper examines a potential new role for reserve accumulation in helping to mitigate distortions created by the undeveloped financial markets of developing countries.
The growth and liberalization of financial markets in industrial countries over the past three decades provides developing countries unprecedented access to international capital markets, and exposes them to sometimes dramatic and sudden swings in capital flows. The 1990s witnessed a number of economic crises in developing countries that were accompanied by (if not precipitated by) outflows of international capital. This recent experience with capital flow reversals can, at least in part, explain the desire by developing countries to decrease their dependence on international capital by accumulating foreign reserves.
While financial markets in industrial countries have deepened and broadened, financial markets in many developing countries remain incomplete. This paper focuses on the implications for developing countries of underdeveloped capital markets.
Caballero and Kirshnamurthy (2004) develop a model showing that underdeveloped capital markets cause under-valuation of international resources by the private sector, which encourages excessive external borrowing, dollarization of international liabilities, and other actions that increase their exposure to potential capital shortfalls. One way to mitigate the costs of this exposure is for developing country governments to accumulate international reserves.
The analysis in the paper considers the role of financial market underdevelopment in motivating reserve accumulation by developing countries, while also allowing for the more traditional mercantilist and precautionary motives. In theory there can be a strict distinction between the precautionary motive, which seeks to smooth consumption fluctuations, and the underdeveloped financial markets motive, which seeks to offset a tightening of a financial constraint. However, in practice, these two motivations for reserve accumulation may be difficult to disentangle. In particular, the desire to smooth intertemporal consumption is likely to be influenced by financial market constraints. Whereas Aiyagari (1994) in a closed economy framework suggests that for the U.S. private sector precautionary savings is likely to be sufficient to relax financial constraints, this is less likely to be the case in developing countries where distortions may bias the private sector against saving, thereby providing incentives for the public sector to step in.
Official foreign exchange reserve holdings by developing countries greatly exceed those of industrial countries (in the case of China, in absolute terms, and in most other cases relative to the sizes of their economies). This is yet another example of the capital flows paradox described by Lucas (1990). Capital should flow to where its return is highest, which ought to be where capital is scare. If instead capital flows from the capital-poor developing world to the capital-rich industrialized world, the explanation is likely to be found in distortions not entertained in standard models.
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International Reserves and Underdeveloped Capital Markets
