Making the Poor Pay for the Rich: Capital Account Liberalization and Reserve Accumulation in the Developing World

AbstractSince the 1990s emerging market and developing countries (EMDCs) have been accumulating massive amounts of international reserves. The fundamental factor behind this reserve hoarding is financial in nature rather than trade-related, stemming from the widespread adoption of capital account liberalization in EMDCs, the resulting exposure to heightened financial volatility, and the consequent need to accumulate reserves as a self-insurance against potential disruptions in capital flows. Precautionary reserve hoarding, however, follows a circular logic that not only imposes heavy opportunity costs on EMDCs but also defeats the very purpose of capital account liberalization. When EMDCs accumulate reserves to hedge against capital account shocks, they are essentially recycling privately incurred short-term capital inflows into publicly incurred capital outflows, engaging in a reverse carry-trade that neither makes any economic sense nor results in any net transfer of financial resources from abroad. The net effect of this circular logic behind financial openness and precautionary reserve accumulation is a regressive and inequitable shifting of the costs of financial volatility from richer to poorer countries.EXTRACTOA partir de los 1990s, los países en desarrollo y los mercados emergentes (EMDCs - por sus siglas en inglés)) han venido acumulando enormes sumas en reservas internacionales. El factor fundamental detrás de esta masificación de las reservas es más de naturaleza financiera que derivado del comercio, brotando de la ampliamente diseminada liberalización de la cuenta de capital de los EMDCs, cuya resultante exposición es la elevación de la volatilidad financiera y la consecuente necesidad de acumular reservas como un auto-seguro contra posibles distorsiones en los flujos de capital. Esta acumulación preventiva de reservas, no obstante, atiende a una lógica circular que no solamente impone elevados costos de oportunidad a los EMDCs sino que destruye el propósito mismo de la liberalización de la cuenta de capital. Cuando los EMDCs acumulan reservas como cobertura contra los vaivenes de la cuenta de capital están esencialmente reciclando flujos entrantes de capital de corto plazo generados privadamente, convirtiéndolos en flujos de capital público salientes, creando así un intercambio de reservas que no tiene sentido económico ni tampoco resulta en una transferencia neta de recursos financieros desde el exterior. El efecto neto de esta lógica circular detrás de la apertura financiera y la acumulación preventiva de reservas es un desplazamiento regresivo e inequitativo de los costos de la volatilidad financiera de los países ricos hacia los países más pobres.Keywords: capital account liberalizationinternational reservescapital flowsemerging marketsglobal finance Notes1 Following the 2008 global financial crisis, a handful of EMDCs have introduced limited capital controls, such as Brazil's imposition of tax on short-term FPI, South Korea's restrictions on currency forward positions, and Taiwan's limits on foreign purchase of time deposits. These are, however, minor relative to both the historical pervasiveness of capital controls in these countries and the range of available options.2 This article follows the IMF's definition of EMDCs, except for the Czech Republic, South Korea, and Taiwan. Although the IMF classifies these countries as advanced countries, I classify them as EMDCs as they are still included in the vast majority of emerging-market indices.3 The noticeable dip in 2008 shown in Figures 2–4 reflects the reserve loss sustained by many EMDCs as a result of the large-scale capital outflows triggered by the global financial crisis, while the sharp rebound in 2009 is due to the contractionary impact of the crisis on the denominators (output and trade).4 Among DMEs, Japan and Switzerland are the two exceptions.5 In South Korea, for instance, the controversy over the huge book losses suffered by the Bank of Korea led to the creation of a sovereign wealth fund, Korea Investment Corporation, to invest part of the central bank's reserves in higher-yielding assets.6 This method also takes care of the monetary benefits of reserve accumulation in terms of lowering the overall risk premium and the cost of borrowing for a given EMDC, since these are already taken into account.7 According to the IMF's Currency Composition of Official Foreign Exchange Reserves database, reserve assets denominated in US dollars have hovered around 65–70% of the total. To the extent that the remaining reserves are held in equally low-yielding government instruments in euro and yen, currency composition itself has only a marginal impact on the opportunity cost of reserves.8 The 2008 global financial crisis has generated a cottage industry on this issue, but Kindleberger's work remains seminal. See Eatwell and Taylor (Citation2000), Kindleberger (Citation1978), Krugman (Citation1995), and Reinhart and Rogoff (Citation2011).9 There are some public insurance schemes, typically provided by official export credit agencies to cover trade financing, but the scope is extremely limited. The World Bank, through its Multilateral Investment Guarantee Agency, also provides insurance for private foreign investment in EMDCs, but again its scope is negligible.10 The Basle Capital Adequacy Accord of 1988 and its recent expansion are the most prominent examples.11 The idea of a sovereign bankruptcy procedure was floated by the IMF in the 2000s, but it died quickly at US objection.Additional informationYoungwon Cho is an assistant professor at the Department of Political Science, St Francis Xavier University, Antigonish, Canada. His current research interests include the political economy of emerging-market crashes, the global reserve system, sovereign wealth funds, and monetary regionalism in East Asia. His recent publications have appeared in International Journal, Pacific Focus, Journal of East Asian Affairs, and Asian Journal of Canadian Studies.

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