By now it should be apparent that the hottest issue in generally hot Latin America is the furious pace of international reserves accumulation. The current level of reserves in Brazil, about US $ 145 billion, is more than double the US$ 62.7 billion level of the end of June 2006. Likewise, both Colombia and Peru have increased their reserves by more than one third in less than one year; it is not hard to find other cases. While the absolute amounts are small relative to those of Asian economies, they are large relative to the size of Latin countries: the ratio of reserves to GDP is now approaching fifteen percent in Brazil and twenty percent in Peru.
Surely, a fraction of the accumulated reserves should be thought of as a “war chest” intended to prevent and fight against financial crises, as discussed by Andrés Velasco and myself (and then others) more than a decade ago now. But several countries, including those mentioned, now hold reserves substantially in excess of what most of us agree is needed for war chest reasons.
So the question has emerged: what should emerging countries do with their considerable excess reserves? Of course, the time honored tradition has been to invest international reserves in very safe and liquid assets, by and large meaning U.S. Treasury bills. But the low yields on those holdings compared with the large recent returns on risky securities have motivated a reconsideration of that strategy. What would be wrong, one could ask, if a portion of the reserves were invested in, say, the U.S. stock market?
Wall Street bankers, eyeing a profit opportunity, have started to peddle “sovereign wealth funds,” “future generation funds,” and the like, to our ministers and central bankers. A typical sales pitch emphasizes how much more money our reserves can be expected to make if only we were willing to take a little more risk. And the fact that China is already going for it (remember Blackstone) puts more pressure on our policymakers to jump into the bandwagon.
Is there something wrong with this? In principle, the answer is no. But in practice (and having seen some of the bankers’ presentations) I worry that there is too much emphasis in the risk-return tradeoff in contrast to other aspects of reserves management such as liquidity, enforceability, transparency, and political and social purpose. Unlike private investors, whose main focus is risk versus return, our governments and central bankers are agents acting on behalf of the ultimate owners of the excess reserves, our countries’ citizens. And that means, at least to me, that investing our reserves in sovereign wealth funds is a much thornier proposition than it appears. What if, for example, the Peruvian central bank loses one billion dollars (about five percent of its current reserves) in a U.S. stock market crash, after having committed its excess reserves in such a fund? I can imagine several scenarios (Congress investigations, corruption accusations, jail for the central bankers…), none of which is pretty. (Note, by the way, that this illustrates one reason why China is not a leading example for Latin America: we have democracy, China does not.)
I believe that the implication for our countries is not to refrain from investing in sovereign wealth funds, but to make sure that all the relevant stakeholders, not only government technocrats, are on that same page. And to make sure that our countries have competent and powerful representatives actively involved in the management decisions, monitoring, and reporting of the funds’ activities and performance.
Also, once we recall that international reserves belong to the people, the more fundamental question emerges: What exactly is the justification for the government or the central bank to invest excess reserves in sovereign wealth funds, as opposed to investing them on education, health, infrastructure, or just returning them to our citizens (via e.g. lower taxes)? Why should our policymakers assume they have such a mandate? While I am not arguing that a rationale does not exist, it is clear that we would all benefit if it were explicitly spelled out. A compelling argument should identify the applicable market failures (or political failures) and explain how investing in sovereign wealth funds would further our countries’ objectives and welfare more than by just returning excess reserves to the population.