The cost of reserves: developing countries pay the price of global financial instability

Added 14 Jan 2010

Eurodad has published this week a report on the current flaws and proposals for reforming the international monetary system, “The cost of reserves: developing countries pay the price of global financial instability”.

The report highlights the lack of appropriate regulation and the global monetary (dis)order that have been at the heart of the current financial crisis. The absence of appropriate coordination and adjustment mechanisms of global monetary policies, and the unfettered liberalisation of global financial markets led to dramatic global imbalances and global economic disaster. The report summarises key existing proposals to reform the global monetary system in the short term, as well as deeper reforms of the global financial architecture that give a stronger voice to developing countries.

The global paradox in which the South finances the North

Since the end of the 1990s we have witnessed the paradox of developing countries lending their vast surpluses to the United States and, to some extent, to other developed countries. At the end of 2007 developing countries held more than three quarters of the world’s total reserves – some $4.9 trillion (figure 2).[1] Although this increase can be partially explained by commercial reasons – that is, to the increasing share of emerging economies’ world trade – the growth of developing countries’ reserves has been heavily influenced by their precautionary desire to avoid future financial crisis.

Although reserves provide a comfortable insurance against financial flows and aid volatility, they come at a very high price. The cost for developing countries is estimated at $300 billion a year. But this is calculated strictly as the difference between investing reserves in lower yielding US treasury bonds and higher yielding investments.[2] It does not include the opportunity costs of not investing a share of reserves in boosting domestic economic growth, neither the costs of borrowing reserves in international capital markets, which are estimated to carry an average annual cost of $130 billion.[3]

If combined, these conservative estimates account for more than four times annual Official Development Assistance (ODA), and more than 2% of the combined Gross Domestic Product (GDP) for all developing countries. This constitutes a massive transfer of financial resources from developing to developed countries. Even more troubling is the fact that the poor are actually paying the price for financing the spending habits of the rich.

Proposals for reformng the global monetary and reserves system

Proposals call for: 

-a supranational reserve currency that substitutes the US dollar and which is not linked to the creation of a spiral of deficits of the reserve currency issuing country, and thus of destabilising global imbalances;

-a global system of symmetric coordination to allow for equitable adjustments of global imbalances between surplus and  deficit countries. This would effectively remove the pressure on deficit countries to adjust by cutting their aggregate demand and the so-called “deflationary bias” of the system which undermines the possibility to guarantee full employment and equitable growth;

-an efficient mechanism to create global liquidity. This mechanism should be counter-cyclical so that increased liquidity can be provided in times of crisis to support counter-cyclical fiscal policies;

-policy space for developing countries to implement capital management mechanisms. This should enhance exchange rate stability, curbing speculative attacks on currency and other kind of speculative capital flows. This should also be made possible through the provision of capital management mechanisms within World Trade Organisation (WTO) agreements and General Agreements on Trade in Services (GATS) and also in bilateral and regional investment agreements with developing countries.

However, the above measures must go hand in hand with broader and deeper reforms of the global financial architecture that give a stronger voice to developing countries.

Global institutional arrangements should complement enhanced regional cooperation, such as initiatives in Asia and Latin America to move towards a more balanced and stable regional financial architecture.

The G20 has failed to address these fundamental issues so far. But developing countries are increasing their calls for a new global reserve system. As pointed out by UNCTAD, all countries need “a combination of financial stabilisation with expansive monetary and fiscal policies. In the absence of such a policy mix more and more countries will quickly end up on the verge of collapse.”[4] 

Download the full report below.

The cost of reserves: Developingcountries pay the price of global finacial instability


[1] Report of the Commission of experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System. June 2009.
[2] Cho, Youngwon: “Capital Account Liberalisation in the Developing World and the Global Reserve Sytem: Imbalances and Inequities,” International Studies Association, New York, February 2009.
[3] Akyuz Yilmaz “Policy response to the global financial crisis: key issues for developing countries” May, 2009.
[4] UNCTAD 2009, op. cit. p. 54