With their strong growth prospects, emerging markets are once again becoming the darlings of international investors in search of decent yields. This will lead to even more capital flowing towards these economies, exposing them to the fickleness of these flows. Capital accounts of emerging markets, even those that ostensibly have capital controls, are becoming increasingly open in de facto terms, making it difficult to stanch these inflows.
Naturally, emerging markets want to protect themselves against volatile capital flows and reduce their vulnerability to balance of payments crises resulting from sudden stops or reversals of capital inflows, which have burnt many of them in the past. Building up reserves is one solution.
Do emerging markets need such large and expanding hoards of reserves? The crisis has in fact accentuated the incentives for reserve accumulation. First, during the crisis, reserve levels that were regarded as very high relative to traditional benchmarks such as imports and external debt didn’t seem to make economies bullet-proof. Countries like India and Russia lost about a fifth of their reserves in just a few months. Second, the resources of international financial institutions like the IMF were clearly not sufficient to support the major emerging markets if they all came under pressure at once. Even with the increase in the IMF’s financial resources sanctioned by the G-20, self-insurance still seems like a reasonable approach as the IMF may run out of money if another global crisis were to come along. Third, the leveraging effect of IMF loans disappeared during the crisis. In the past, accepting policy conditions attached to IMF loans would bring in private capital. That did not happen during the crisis, when there was a worldwide credit crunch.
Of course, it is inefficient and costly for emerging markets to self-insure by accumulating reserves. But they do not see any good alternatives. Regional insurance mechanisms are unlikely to be of much use as many shocks tend to be regional in nature, affecting many countries in the region at the same time. An international insurance mechanism through an institution like the IMF would be the obvious answer. However, any association with the IMF remains toxic for political leaders in emerging markets, especially those in Asia. The IMF also lacks legitimacy in the eyes of emerging markets as voting shares at the institution are heavily tilted towards advanced economies and reforms to give emerging markets more representation have been moving at a glacial pace.
What’s the solution? I have proposed a global insurance scheme that would allow countries to directly purchase insurance against crises, removing the stigma of depending on an institution like the IMF to save them from crises [see this]. Such a scheme would allow countries to buy as much insurance as they wanted (with the premiums determined by the quality of their macroeconomic policies and the desired quantum of insurance), with no ex-post conditionality attached to the payouts.
The IMF can still play a useful role through other lending mechanisms; reforming the institution’s governance structure would certainly make a difference in the level of trust that emerging markets have in the institution.
These steps would make a good start at reducing the need for self-insurance through reserve accumulation, which is costly for individual emerging markets and could perpetuate global imbalances—one factor that got us into this mess in the first place.