Broaddus, J. Alfred, Jr. and Marvin Goodfriend, 2001, “What Assets Should the Federal Reserve Buy,” Federal Reserve Bank of Richmond Economic Quarterly, Vol. 87:1, pp. 7-22.
Genberg, Hans, Robert McCauley, Yung Chul Park and Avinash Persaud, 2005, “Official Reserves and Currency Management in Asia: Myth, Reality and the Future,” Geneva Reports on the World Economy (London, U.K.: Center for Economic Policy Research).
Prasad, Eswar S., and Shang-Jin Wei, 2005, “China’s Approach to Capital Inflows: Patterns and Possible Explanations,” IMF Working Paper No. 05/79 ((Washington: International Monetary Fund).
Reddy, Yaga V., 2005, “Overcoming Challenges in a Globalising Economy: Managing India’s External Sector,” Lecture delivered at the Foreign Policy Center, London, on June 23, 2005; available at www.rbi.org.in.
We are grateful to Marvin Goodfriend, Y.V. Reddy and numerous colleagues at the IMF for their comments and suggestions.
Recent experiences of some emerging market economies indicate that speculative inflows can seep in through both official and unofficial channels, notwithstanding the existence of controls on capital inflows (see Genberg, MaCauley, Park and Persaud, 2005, and Prasad and Wei, 2005).
The Indian authorities have taken a different approach of making foreign exchange available to corporates in order to facilitate outward FDI. This reflects a policy stance in respect of capital account liberalization that is based on a hierarchical ordering of economic agents, with corporates at the top, followed by financial intermediaries and individuals.
Genberg, McCauley, Park and Persaud (2005) have recently proposed the establishment of an Asian Investment Corporation, which would pool a portion of Asian economies’ reserves and manage them on commercial grounds as a national wealth fund. This could help increase the return on reserves relative to holding them in just industrial country government (or government agency) bonds, but it would not deal with the more basic issues related to reserve accumulation that our proposal aims to address. A smaller point is that, even if these reserves were managed more efficiently, such an investment corporation is likely to put liquidity considerations ahead of being on the risk-return frontier faced by individual investors (for an interesting discussion of this issue in the context of the composition of asset holdings of the U.S. Federal Reserve, see Broaddus and Goodfriend, 2001).
In these economies, exchange rate movements tend to be positively correlated with the strength of the domestic economy, implying that returns on foreign-currency-denominated assets would covary negatively with domestic macroeconomic fluctuations.
Note that our proposal has broader relevance than just in circumstances where capital inflows are the result of market assessments of exchange rate undervaluation. For instance, perceptions of improved economic prospects of a country can also generate surges in inflows that pose similar challenges for domestic macroeconomic management.
Shares in the fund could of course trade at a discount in secondary markets if investors’ cost-benefit evaluation were to change after the launch. But that would not have any implications for government finances.
We recognize that determining the “adequate” level of reserves is far from straightforward (see Reddy, 2005, for a policymaker’s perspective on this matter). But actions recently taken or under consideration by various emerging market country authorities to use their reserves for purposes such as bank recapitalization, infrastructure investment, debt management and so on suggests that there is indeed a sense in many of these countries that the level of reserves exceeds self-insurance requirements. News reports have quoted some Chinese and Korean officials as saying that their countries have accumulated more than adequate reserves.
There is also a redistributive element implicit in our proposal. The demand for foreign investments is likely to come mostly from relatively wealthy households. The existence of such demand would allow the government to auction licenses for the mutual funds at a premium, in effect procuring revenues for granting access to international investment opportunities. These revenues could then feed directly into the budget and help finance needed expenditures.