International Reserves in Emerging Market Countries: Too Much of a Good Thing?

With International reserves four times as large, in terms of their GDP, as in the early 1990s, emerging market countries seem more protected than ever against shocks to their current and capital accounts. Some have argued that this buildup in reserves might be warranted as insurance against the increased volatility of capital flows associated with financial globalization.¹ Others view this development as the unintended consequence of large current account surpluses and suggest that the level of international reserves has become excessive in many of these countries.² Do emerging market countries hold too much international reserves, and are there better ways to use those funds?

Answering these questions requires a normative benchmark for the optimal level of reserves. I present in this paper a simple welfare-based model of the optimal level of reserves to deal with the risk of capital account crises or of "sudden stops" in capital flows. On the basis of this model, I derive some formulas for the optimal level of reserves and compare them with conventional rules of thumb, such as the Greenspan-Guidotti rule of full coverage of short-term debt. I then calibrate the model for emerging market countries and compare its predictions with the actual data.

One lesson from this exercise is that the optimal level of reserves is subject to considerable uncertainty, because it is sensitive to certain parameters that are difficult to measure. The model nevertheless produces ranges of plausible estimates against which the data can be compared. I find that it is not difficult for the model to explain a reserves-GDP ratio on the order of 10 percent for the typical emerging market country (close to the long-run historical average), and that even higher ratios can be justified if one assumes that reserves have a significant role in crisis prevention. The levels of reserves observed in many countries in the recent period, in particular in Latin America, are within the range of the model's predictions.

Ultimately, however, the insurance model fails to account for the recent pattern of reserves accumulation in emerging market countries. The reason is that most of the reserves accumulation has taken place in Asian emerging market countries, where the risk of a capital account crisis seems much too small to justify such levels of self-insurance. The insurance model can account for the reserves accumulation observed in the Asian emerging market countries only if one assumes that the expected cost of a capital account crisis is unrealistically large (more than 60 percent of GDP for one of the two major types of crisis examined).

The conclusion that most of the current buildup of reserves is not justified by precautionary reasons has some implications for reserves management. There is little reason for countries to invest these funds in the liquid but low-yielding foreign assets in which central banks tend to invest. Rather, reserves should be viewed as a component of domestic external wealth that is managed by the public sector on behalf of the domestic citizenry, taking full advantage of the portfolio diversification opportunities available abroad. Indeed, an increasing number of emerging market countries are transferring a fraction of their reserves to "sovereign wealth funds," mandated to invest in a more diversified way and at a longer horizon than central banks normally do. This is a trend that might take on considerable importance looking forward.

The last part of the paper discusses some policy challenges and opportunities implied by the buildup in emerging market countries' "sovereign wealth." I discuss, first, the impact of sovereign wealth diversification on global financial markets, and second, some ways in which this wealth could be used in collective international arrangements—to insure against future crises or to promote financial development.

The Buildup in International Reserves

The growth in the international reserves of emerging market countries is striking when compared with the contemporaneous trends in reserves in industrial countries (figure 1).³ Whereas reserves in a group of industrial countries have remained stable below 5 percent of GDP, reserves in the emerging market countries have grown more...