Global Policy Forum

By Eduardo Porter

It's often argued that foreigners funnel their money into the United States because it is a great investment. But for many countries, plowing money into the United States these days is not all that compelling a deal.

Poor nations are financing much of the United States' current account deficit. They are losing money in the process, and as the losses mount, they will be tempted to do something better with their cash. Consider Russia. Over the last five years, its foreign currency reserves have multiplied by eight, to more than $200 billion.

Like most monetary authorities across the globe, the Russian central bank does not disclose the composition of its investment portfolio or the kind of returns it receives on its reserves. But the typical process of reserve acquisition and management is well known. To accumulate reserves without stoking inflation, the central bank will typically get the necessary cash by selling ruble bonds, which are paying a return of about 12 percent a year. It will then buy dollars or euros to invest in American or European government securities, which offer yields around 5 percent or less.

Seven percentage points are a lot to give up. With the ruble stable on foreign exchange markets, the annual cost to the Russian government of maintaining $200 billion in reserves could amount to $14 billion a year or more, about three times what it spent on education in all of 2004. Russia's central bank is not the only one that is leaving a fortune on the table. China has amassed one of the largest stashes of reserves in history: more than $800 billion at the end of last year. Reserves of the African countries reached $162 billion at year-end.

Altogether, by the count of the International Monetary Fund, international reserves held by developing countries doubled in just three years, reaching $2.9 trillion at the end of 2005, equivalent to almost one-third of their total gross domestic product. Much of this money is languishing at low rates of return in American government bonds.

"It is an irony of our times that the majority of the world's poorest people now live in countries with vast international financial reserves," Lawrence H. Summers, the president of Harvard and a former Treasury secretary, told an audience of Indian economists in Mumbai last month. "It seems appropriate that part of the focus of the international financial architecture move toward the challenge of deploying their large reserves as effectively as possible."

There is a logic to this investment strategy, unprofitable as it is. The Treasury bond binge by China is part of a policy of exchange-rate management to keep the value of its currency competitive against the dollar — a core component of the nation's export-led economic strategy.

For most other developing nations, these reserves are simply insurance against financial disaster. A long list of developing countries have experienced devastating crises in the last 15 years: Mexico in 1994; Thailand, Indonesia and other Asian countries in 1997; Russia in 1998; Brazil in 1999; and Argentina in 2002.

The crises followed a more or less standard path. Investors pulled money out of the country; the country ran out of foreign currency and devalued its own currency; if it had a lot of short-term foreign debt, it defaulted; and interest rates soared. These crises exacted a heavy cost. Michael M. Hutchison and Ilan Neuberger, economists at the University of California, Santa Cruz, said the affected countries lost 13 to 15 percent of their output over three years.

And they turned the developing world into a much more prudent place. As the dust settled over the ruins of many former "emerging" economies, a new creed took hold among policy makers in the developing world: Pile up as much foreign exchange as possible. These days, many poor countries are guided by what is known as the Guidotti-Greenspan rule — named after Pablo Guidotti, a former Argentine finance official, and Alan Greenspan, the former American Federal Reserve chairman who called for developing countries to amass enough foreign reserves to cover all their foreign debt coming due within the next year.

Dani Rodrik, an economist at the John F. Kennedy School of Government at Harvard, calculated that if a country had a 10 percent chance of suffering a big reversal in capital inflows in any given year, and if a financial crisis would cost about 10 percent of its G.D.P., it would not be unreasonable for it to pay an insurance premium equivalent to 1 percent of G.D.P.

But developing countries seem to have been carried away by prudential excess. Many poor countries hold vastly more in reserves than recommended by the Guidotti-Greenspan guidelines. Russia has "excess reserves" equivalent to about a fifth of its G.D.P., Mr. Summers said. Malaysia's excess is equivalent to half its total output.

India, Mr. Summers told his Mumbai audience, has excess reserves of more than $100 billion. If it invested them better, he said, it could reasonably expect a return equivalent to 1 to 1.5 percent of its $785 billion gross domestic product; that share would be more than the Indian government spends on health care. These calculations should concern not only policy makers in India and other developing countries. As an American somewhere spends another Indian-supplied dollar, American authorities should be worrying about what to do when the spigot is shut off, as one day it will surely be.

There are cheaper forms of insurance: rather than accumulating reserves, poor countries could achieve the same level of financial security by limiting the accumulation of short-term debt, Mr. Rodrik said. Moreover, years have gone by without new financial disasters, and the memory of past crises is fading. If this continues, governments across the developing world will question the value of such costly insurance when there are so many other things to do with the money.

"People are going to start to re-evaluate the objectives of economic policy," Mr. Rodrik said. "They are likely to put more weight on employment and economic growth and a little less weight on avoiding a financial crisis."

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