The problem of reserves in developing countries

The latest turmoil underscores the need for financial reform, particularly to protect developing countries. One promising reform proposal involves the use of Special Drawing Rights (SDRs) both to finance the development needs of poor countries and, ultimately, as a global reserve currency to supplement the US dollar. In the following three articles, Soren Ambrose and Bhumika Muchhala consider this proposal, with this first article explaining the need for an alternative to the US dollar as a reserve currency, pointing to problems faced by developing countries under the current system.

THE global financial and economic crisis that struck in 2008 forced governments and international institutions to adopt measures that seemed unthinkable in 2007. Leading industrialised-country governments have spent an estimated $17 trillion in bailing out their largest banks, and many prestigious financial institutions have gone out of business or come under partial government ownership. Developed countries have the means to borrow or create money to fuel the fiscal stimulus packages necessary to start recovering from the global recession, but most developing countries do not have those options without external financial assistance.

Even if developed countries are now beginning to recover - and that is by no means certain - it is clear that the impacts of the crisis will linger for some time in developing countries. The recent financial crisis has caused a severe reduction of liquidity in the global economy as multiple sources of revenue - exports, migrants' remittances, foreign direct investment (FDI), and tariff income - have declined precipitously. Banks reduced lending in order to build their capital reserves, and access to private capital and development aid has become a challenge. According to the World Bank, world trade is on track to register its largest decline in 80 years. Global industrial production has declined by over 20% and as a result, unemployment across both developed and developing countries is at an all-time high (World Bank, 2009).

Developing countries are confronting a massive shortfall in external financing. According to the United Nations Conference on Trade and Development (UNCTAD), this shortfall could reach up to $3 trillion in 2009 alone (UNCTAD, 2009). Many developing countries are experiencing sharp reductions in their foreign exchange reserves, and the International Monetary Fund (IMF, 2009) predicts that many low-income countries (LICs) could run out of foreign exchange to pay for imports or service their foreign debts. The need for immediate liquidity to developing countries is clear. In particular, LICs that are dependent on concessional loans and development aid are especially vulnerable, as they need external funds to protect core public expenditures, including for social protection programmes.

The crisis has spurred discussions of the flaws, and possible fixes, of the global reserve system. Although the political challenges involved in changing the status of the US dollar and the introduction of a global reserve unit are daunting, the present moment is the first in which a broad range of players have acknowledged their desirability. If done effectively, such reform could free up significant financial resources for developing countries. Many of the consistent distortions of today's global economy, such as the inherent asymmetry of responsibilities between deficit countries and surplus countries and the trend where developing countries lend to rich countries, particularly the US, in order to self-insure against financial volatility and boom-and-bust crises, could be transformed into a fairer system for all countries.

Why a new system?: The risks of relying on the US dollar

As economist Robert Triffin pointed out nearly 50 years ago, an international reserve system based on a national currency suffers from inescapable contradictions. Triffin's point applies as much to today's system as to the system in place when he wrote in 1960 - the 'dollar-gold' or 'Bretton Woods' arrangement, in which currencies were linked to the US dollar, and the dollar in turn held a steady value to gold. With the world relying on the dollar, the US must maintain a current account deficit in order to maintain the level of liquidity required for global trade and growth. But when it runs such deficits, feeding the global appetite for dollar liquidity, it accumulates liabilities to the extent that confidence in, and the value of, the dollar can be negatively affected.

If that happens, restoration of confidence and resisting inflationary pressure would require rising interest rates in the US. But that would mean falling deficits and a reduction in global economic activity. Thus, while it seems that the US, as the issuer of the global reserve currency, has the flexibility to finance its deficits, it actually takes on unique restrictions to its monetary policy autonomy, since to preserve the global growth it relies on it must balance the requirement of running deficits with the risk of declining confidence in its currency.

The difficulties of maintaining that balance doomed the Bretton Woods arrangement; the world went from struggling with a dollar shortage after World War II - for which the creation of the Special Drawing Right (SDR) was one of the solutions - to a glut when the US started printing money to finance the combination of its expansive social programmes and the Vietnam War in the 1960s. That glut finally forced the US to break the dollar-gold convertibility in the early 1970s, leading to the collapse of the Bretton Woods system and the introduction of the system of floating exchange rates and currency trading we have today.

According to Jos‚ Antonio Ocampo, this transfer of resources from developing countries to the US that the global reserve system requires can be called an 'inequity bias', which was built into the post-war design of the reserve system. As developing countries accumulate reserves, global imbalances between surplus and deficit countries are worsened and a deflationary bias is created, in that dormant reserve holdings have a contractionary effect on the world economy. This creates the 'instability link', which together with the inequity bias results in a dangerous combination of inequity and instability in the world reserve system (Ocampo, 2009).

The growth of reserves in developing countries - and the cost

As pointed out by Yilmaz Akyuz, former Director of UNCTAD's Division on Globalisation and Development Strategies, it was initially assumed that in the post-Bretton Woods era, countries would need lower reserve levels as more of them gained greater access to international financial markets, but in fact the opposite has been the result. Growing international flows of capital have allowed countries to run larger current account deficits, 'but this has also resulted in an accumulation of large stocks of external liabilities and growing presence of foreigners in domestic securities markets', making debtor countries vulnerable to 'reversals in capital flows, with grave consequences for stability, growth and development'. With the onset of the East Asian financial crisis, IMF lending was the only meaningful insurance available, and the delays and conditions imposed on it made it both unreliable and often counter-productive.

Akyuz sums up: 'The combination of increased capital account liberalisation in DEEs [developing and emerging economies], accumulation of external liabilities, pro-cyclical behaviour of international financial markets, and the absence of effective multilateral arrangements for the provision of international liquidity and orderly debt workout procedures has forced DEEs to look for self-insurance by accumulating large stocks of international reserves, mostly held in dollars.' While the IMF's standard gauge of reserves for LICs - sufficient funds to cover three months of imports - was used for most developing countries, the new gauge for emerging economies was reserves that would meet or exceed a country's total short-term external liabilities. Reserves held by these countries soared to about $5.5 trillion, roughly the equivalent of seven months of imports.

For most countries other than oil producers and China, these reserves are essentially borrowed, since they represent claims on the domestic economy by non-residents, e.g. in the form of equity investments.

These reserves are typically invested in low-yielding assets such as US Treasury bills and bonds, with the 'carry cost' - the difference between the cost of acquiring the reserves and the income earned on them - estimated by Akyuz to reach $130 billion per year for developing countries, a figure which is larger than total official development assistance to developing countries. Those funds are essentially subsidies offered by developing countries to industrialised ones, especially the US. This figure, says Akyuz, is actually too low, since it does not include estimates for the growth that could have been achieved if the resources had instead been put into productive domestic investments. In other words, the opportunity cost of not using the reserve assets for economic activities needs to be considered in addition to the 'carry cost' to arrive at the total cost of reserve accumulation in DEEs. Many, including the Stiglitz Commission (2009), have highlighted that in a world where there is so much demand for development financing and for building national productive capacities through public investments. The assets being held in reserves in developing countries have many alternate uses for economic and social development needs or for investments that would yield much higher returns than the primary mode of investments in US Treasury bills today.           

Soren Ambrose is Development Finance Coordinator at ActionAid, and Bhumika Muchhala is a researcher with the Third World Network. The above is an edited extract from their joint paper 'Fruits of the Crisis: Leveraging the Financial & Economic Crisis of 2008-2009 to Secure New Resources for Development and Reform the Global Reserve System' (January 2010).

References

IMF (2009). 'The Implications of the Global Financial Crisis for Low-Income Countries', http://www.imf.org/external/pubs/ft/books/2009/globalfin/globalfin.pdf.

Ocampo, Jos‚ Antonio (2009). 'Special Drawing Rights and the Reform of the Global Reserve System', Intergovernmental Group of Twenty-Four (G24), http://www.g24.org/TGM0909.htm.

UNCTAD (2009). 'The global economic crisis: systemic failures and multilateral remedies', http://www.unctad.org/en/docs/gds20091_en.pdf.

World Bank (2009). 'Swimming Against the Tide: How Developing Countries Are Coping With the Global Crisis', http://siteresources.worldbank.org/NEWS/Resources/swimmingagainstthetide-march2009.pdf.

*Third World Resurgence No. 234, February 2010, pp 21-22