Journal Issue

Research: Studies Spotlight Investment, Reserves, and Inflation

International Monetary Fund. External Relations Dept.
Published Date:
May 2007
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Recently published research by the IMF, covering subjects as diverse as the prospects for sustained growth in Africa and the role of capital inflows in Europe, underlines the range and diversity of studies by Fund economists. Below are highlights from five recent IMF Working Papers. The full text is available

Examining prospects for sustained growth in Africa

“The Prospects for Sustained Growth in Africa: Benchmarking the Constraints,” Simon Johnson, Jonathan D. Ostry, and Arvind Subramanian, IMF Working Paper No. 07/52.

Africa is experiencing its strongest growth in years. But for those who view Africa’s prospects through the perspective of the “deep” determinants of development—geography, institutions, and history—the outlook still seems somewhat bleak. The paper tries to assess Africa’s prospects by comparing Africa today with countries that were similarly weak in the past—in terms of their institutional development—and yet managed to escape from poverty.

The authors say the data suggest that these deep indicators, especially for a group of “promising” countries, are not much worse in Africa today than they were in much of East Asia in the early 1960s or in Vietnam and China around 1980. There are inherited institutional weaknesses in Africa—and internal conflict and social fragmentation remain concerns—but the East Asian experience demonstrates that some institutional weaknesses can be fixed. So the good news for countries seeking to escape their current poverty trap is that breaking away from their institutional legacy is possible because it has been done by others.

Creating a stronger and more dynamic manufacturing export sector is likely to be one of the keys to sustaining growth. To achieve this, though, reducing direct regulatory costs for exporters and avoiding real exchange rate overvaluation will be essential. And on these scores, the authors see risks going forward that were less of an issue for the East Asian escapees: commodity-based growth and sizable aid inflows that partly underpin the positive prognosis for Africa may impede institutional development and make it harder to avoid real exchange rate overvaluation. Sub-Saharan Africa’s escape from poverty, although certainly possible, may be more challenging than it was for East Asia.

Brazilian growth is better than reported

“The Myth of Post-Reform Income Stagnation in Brazil,” Irineu de Carvalho Filho and Marcos Chamon, IMF Working Paper No. 06/275.

Brazil, the largest economy in South America, has exhibited lackluster growth for almost three decades. Although reforms in the mid-1990s helped raise the growth rate somewhat, it is still below that of the 1960s and 1970s. Economists have been puzzled by Brazil’s inability to boost economic growth despite widespread privatization and trade liberalization that transformed it from one of the world’s most closed economies to a relatively open one. Reforms also helped improve the productivity of Brazilian industry and brought inflation under control.

The authors suggest that there may be no need to explain the disappointing performance because household income growth in Brazil has been far more robust than published data indicate. That’s because Brazil’s consumer price index (CPI), which is used to deflate nominal growth figures, seriously overstated inflation. The CPI failed to fully take account of new goods and quality improvements following trade liberalization. For households in the metropolitan areas covered by the CPI, the difference between the estimated true cost of living and the official figure was 3 percent per year between 1987–88 and 2002–03.

Brazil recently revised real GDP figures upward by about 11 percent. Given the share of household income in GDP, the authors’ estimates would indicate that Brazil’s revisions have eliminated about one-third of a roughly 35 percent understatement.

Central banks are becoming more independent

A large body of research suggests that operational freedom of central banks from political interference has considerable benefits. For example, autonomy can help countries maintain low inflation or improve the stability of financial systems. The authors find that both political and economic autonomy of central banks have been growing and have helped to sustain low inflation worldwide. Although central bank autonomy is greatest in advanced economies, central banks in emerging markets and developing countries were on average more independent at the end of 2003 than central banks in advanced economies were in the late 1980s.

In the paper, the authors present indexes of central bank autonomy for 163 central banks representing 181 countries as of the end of 2003. They also calculate comparable indexes for 68 banks at the end of the 1980s.

The authors find that most central banks have been mandated to make price stability a goal of monetary policy, have been given independence to set the policy interest rate, and are not required to provide loans to the government. But the picture is mixed on bank supervision. In many emerging market and developing countries, central banks have kept their supervisory role, but in advanced economies relatively few have. The paper also finds that central bank autonomy tends to increase when the country is part of a currency union.

“Central Bank Autonomy: Lessons from Global Trends” Marco Arnone, Bernard J. Laurens, Jean-Frangois Segalotto, and Martin Sommer, IMF Working Paper No. 07/88.

Capital flows downhill in Europe

“International Finance and Income Convergence: Europe Is Different,” Abdul Abiad, Daniel Leigh, and Ashoka Mody, IMF Working Paper No. 07/64.

Crises in emerging markets have made economists and policymakers more aware of the potential dangers arising from large-scale capital flows. This skepticism has been on the rise recently, because research (including by IMF economists) has found little evidence that capital inflows can lift long-term economic growth in developing countries. But in this new Working Paper, IMF economists Abdul Abiad, Daniel Leigh, and Ashoka Mody show that in eastern and central Europe, capital flows facilitated by financial integration have helped support a more rapid income convergence between the new European Union members and their richer neighbors in western Europe.

Standard economic theory predicts that capital should flow from richer to poorer countries. But capital has in recent years been flowing instead from some fast-growing poor countries to some rich countries, most notably demonstrated by China’s large current account surplus and the United States’ large current account deficit. Some economists believe that this reflects a new state of affairs: fast growing developing countries run surpluses because they generate more savings than they can use, in part because their financial systems are underdeveloped. Which is fine, the argument goes, because there seems to be no growth dividend associated with capital inflows.

The authors argue that “it is important to recognize that growth processes around the world differ in substantive ways.”

They find that in a global sample of economies, capital does flow downhill from rich to poor countries, and this downhill flow is most evident in Europe, owing to its much higher level of financial integration. What is more, these European capital inflows have supported an impressive process of income convergence. When it comes to the role of international capital flows in economic development, “Europe is different,” they conclude.

The question, which the authors leave unanswered for now, is whether the patterns seen in Europe are a bellwether of a new and more positive role for international capital in helping increasingly integrated developing countries catch up with rich countries.

Finding the right level for reserves

“The Optimal Level of International Reserves for Emerging Market Countries: Formulas and Applications” Olivier Jeanne and Romain Ranciere, IMF Working Paper No. 06/229.

Since the Asian crisis in 1997-98, when a sudden reversal of investor sentiment led to withdrawals of massive amounts of capital in countries ranging from Thailand to Indonesia, emerging market economies in Asia and elsewhere have been accumulating foreign exchange reserves at a rapid rate, leading to levels of reserves not previously seen, worth trillions of dollars.

Although such reserves may help countries feel more secure in a world of open capital flows, countries pay a price for keeping all those U.S. treasury bills and other forms of bonds and notes in a vault. Reserves yield a lower return than the interest rate governments pay on their long-term external liabilities. Keeping the money locked up also prevents it from being invested in more productive endeavors that could help lift the country’s growth rate.

In this paper, IMF economists Olivier Jeanne and Romain Ranciere come up with a model that seeks to calibrate the optimal level of reserves for emerging market economies. Their model predicts a reserves-to-GDP ratio of 10 percent as being close to optimal. Incidentally, the 10 percent level is close to that observed in 34 middle-income countries during the period 1980-2003. It also in many instances closely matches the “Greenspan-Guidotti rule” for international reserves. This rule—named after Alan Greenspan, the former chairman of the U.S. Federal Reserve Board and Pablo Guidotti, a former deputy finance minister of Argentina—suggests that countries should aim for a level of reserves that fully covers all short-term external debt. The more traditional rule of thumb used by policymakers has been to aim for a level of reserves covering three months’ worth of imports.

Copies of IMF Working Papers are available for $18.00 each from IMF Publication Services. The full texts of all Working Papers are available on the IMF website (

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