Over the past decade, emerging economies experienced a fast-paced accumulation of foreign currency reserves. According to figures from the International Monetary Fund, developing economies held $5000bn in foreign assets in 2007 – about 80% of global accumulated reserves.
This is causing a dramatic shift in international financial markets, as emerging economies gain importance as a source of capital flows. Latin America was an active contributor to this trend, amassing about $400bn by the end of last year. The main drivers of the reserve accumulation were current account surpluses, followed by capital inflows – although this trend was not homogeneous across countries. Reserve build-up in Argentina, Venezuela and Chile was the outcome of large export proceeds associated with the recent commodity boom; in Mexico and Colombia it resulted from capital inflows. In Brazil, reserves increased via the current account and the capital account. The present level of reserves makes the region’s economies more capable of withstanding crises. It has also allowed some countries to undertake debt buy-backs and improve their debt structure. As of 2007, reserves exceeded the adequate levels to meet precautionary requirements in a number of countries, such as Brazil, Mexico, Venezuela, Chile, Colombia and Peru.
Policy questions
In general, economies cannot absorb reserve windfalls without experiencing disruptive economic consequences. Reserve build-up and its sources therefore raise important policy questions in terms of making appropriate investment decisions that are not at odds with macroeconomic goals. Evidence suggests that foreign currency reserves in Latin America fluctuated more than exchange rates over the past decade, indicative of policy actions being taken to curb exchange rate appreciation.
Monetary authorities have employed a variety of tools, including exchange market interventions; changes in reserve requirements for the banking sector affecting the type, maturity and currency composition of deposits; and taxes on short-term capital inflows. The effectiveness, cost and pertinence of intervention is, as usual, subject to debate because it implies trade-offs. Exchange rate appreciation may be good for inflation but not for competitiveness. Sterilised interventions are costly and hard to sustain in the long term, and non-sterilised interventions may lead to inflation.
Alternatively, countries can assign a fraction of their export proceeds and excess reserves to liability management, domestic investment, or government-owned offshore investment vehicles or sovereign wealth funds (SWFs) to smooth consumption and distribute wealth across generations and/or pursue higher returns for foreign assets than those associated with traditional reserve management. In Latin America, only Chile and Venezuela have established SWFs but their size is marginal: at $1.4bn and $15bn respectively.
The growing importance and investment range of SWFs has elicited concern in the markets. The main concern relates to their lack of transparency and absence of prudential regulation that characterises most sovereign investors. The debate about SWFs is relevant not only for Latin American countries that have already established wealth funds, but for countries envisaging creating new ones. If this is the course of action to tackle reserve accumulation driven by current account surpluses, it would appear beneficial to adopt well-established investment rules and goals, good corporate governance, adequate risk management, transparency and accountability.
Although windfalls may be good opportunities for developing economies to undertake long-overdue domestic investments, if planned carelessly and executed beyond absorptive capacity, disregarding macroeconomic policy goals, investments may lead to resource dissipation in hasty and misguided projects, instability and inflation. It is therefore essential that countries fully understand SWFs’ potential stabilising role both within and beyond borders.
Enrique García is president of the Andean Development Corporation.
