Large hoarding of international reserves in the 1990s was done mostly by East Asia. Latin America joined the “hoarders club” during the 2000s. The unprecedented international reserves levels in LATAM [more than 160 B. dollar in Brazil, 23 B. dollar in Peru, 20 B. dollar in Columbia, etc…] are stirring a lively debate. Should LATAM follow the policies of Asia? To put these trends in a broader perspective, recent studies suggest that the international reserves in Asia are above the optimal level, whereas in LATAM reserves may be still below the desirable level [Jeanne (2007) Brookings Papers on Economic Activity]. In this note I argue that, while the case of hoarding more international reserves in Latin America is warranted, attempting to follow Asian hoarding in LATAM will backfire.
The strongest case for hoarding reserves in LATAM is the possibility of a reversal of its recent terms of trade improvement, and self insurance. My work with Riera-Crichton [NBER WP 12363] points out that countries exposed to terms of trade volatility may reduce the resultant real exchange rate [REER] volatility by hoarding international reserves. This gain is in addition to the benefits associated with self insurance against financial instability of capital flights [Aizenman and Lee (2007) Open Economies Review, Mendoza and Terrones (NBER WP 13123)]. The stabilizing role of reserves has been vividly illustrated during the recent financial upheaval triggered by the sub prime mortgage crisis in the USA. In addition, hoarding reserves by countries with external debt overhang provides the benefit of reducing the risk premium on sovereign spreads [Levy Yeyati (2006), The Cost of Reserves], and provides a country with the option of earlier external debt repayment. All these factors are more important in explaining the gains from hoarding reserves for LATAM than for East-Asia: LATAM relies more on exports of commodities and natural resources than East Asia, and LATAM external debt/GDP is much larger than that of East Asia.
While the self insurance argument for hoarding reserves in East Asia explains well the hoarding there in late 1990s, it falls short of explaining the remarkable takeoff of hoarding reserves by China during the 2000s. The strongest advocacy supporting China’s hoarding during the 2000s came from Dooley et al. [NBER WP 9971], viewing it as part of an export led growth, where the undervalued real exchange rate facilitates faster transformation from agriculture to manufacturing. The optimality of such a policy for East Asia remains debatable; and even more questionable for LATAM [Aizenman and Lee, NBER WP 12718]. First, monetary mercantilism may lead to competitive hoarding among countries competing in similar third markets, which in turn may dissipate most of the competitiveness gains from hoarding reserves. My ongoing research with Jaewoo Lee also points out another fundamental limitation of such a policy. We show that the case for REER undervaluation as industrial policy may rest on the learning by doing externality [LBDE], where productivity increases with the aggregate manufacturing output of the economy. Yet, this finding is not robust. First, subsidizing exports can be accomplished by direct policies of the type followed by Korea and Japan during the period of their rapid growth during the 1970s-1980s, without relying on hoarding international reserves as the prime policy instrument. A selective subsidy to targeted exports, when done properly, has the advantage of targeting directly the margin that one wish to impact. In addition, the LBDE may be embodied in capital, as has been modeled frequently by the endogenous growth literature [Romer (JPE 1986)]. This would be the case when knowledge creation is a side product of investment, as is when productivity increases with aggregate capital. In these circumstances, the desirable policy is subsidizing the capital employed in the traded sector, with no room for undervalued exchange rate policy.
A practical concern is that, in the best circumstances, the Chinese type of mercantilism will work if other necessary conditions are met, including well developed infrastructure, and relative abundance of human capital. Hence, before experimenting with monetary mercantilism as a tool for export promotion, Brazil and other LATAM countries would benefit by investing directly in the needed infrastructure and in alleviating human capital bottlenecks. Furthermore, a deliberate industrial policy of undervaluation by hoarding international reserves may backfire if the sterilization would increase the cost of investment in the traded sector. This concern is highly relevant for LATAM, but not as much for China – the smaller saving rate in LATAM and the greater financial integration of the region implies that the impact of international reserves hoarding on the cost of funds should be of greater concern to LATAM.
To conclude, the case for hoarding international reserves in LATAM remains strong, yet it would be a mistake to overdo it in an attempt to follow Chinese type of policies. The differences in saving rates, financial integration, infrastructures and endowments between LATAM and East Asia imply that replicating East Asian hoarding in LATAM will backfire.