Since the early 1990s, developing Asian countries have greatly increased their holdings of foreign-exchange reserves. Traditionally, developing countries have held foreign-exchange reserves to manage—or fix—their key exchange rates in a manner that might promote their international trade. Trade considerations alone, however, have not motivated the recent build up. Increasingly, developing Asian countries hold reserves as insurance against a sudden outflow of international funds resulting from domestic financial turmoil.
Developing Asian countries invest these reserves in interest-earning, liquid assets, usually dollar-denominated securities. Yet there are costs to holding reserves. Countries could use these funds to reduce their external debts or to undertake domestic investments in infrastructure or social needs. Typically, the interest cost of external debt and the foregone return on domestic investments substantially exceeds the return on developing countries’ reserve portfolios.
The Asian Development Bank (ADB) recently argued that most developing Asian countries, which together held $2.3 trillion in reserves at the end of 2006, have accumulated excessive amounts of reserves—typically 50 percent or more than their estimated needs. In addition to the opportunity cost of holding reserves, reserve accumulation in some developing countries has fueled excessive money growth.
The ADB suggests that we may see more developing Asian countries—like China—follow Singapore’s and South Korea’s lead and seek higher returns on their foreign-exchange portfolios. A greater share of reserves could go into stocks, corporate bonds, real estate, and commodities.
How this will affect the currency composition of Asian reserves is not clear, but countries constructing portfolios in search of higher yields will undoubtedly weigh the potential for valuation changes carefully. Incomplete data suggest that developing countries have reduced the share of dollar-denominated securities in their portfolios since 2001, even after allowing that valuation adjustments stemming from the dollar’s recent depreciation may skew the evidence. Anecdotal remarks also seems to support this pattern.