Cambridge Journal of Economics 2008, 32, 665–681

doi:10.1093/cje/ben028
Advance Access publication 27 June, 2008

Is the accumulation of international

reserves good for development?
Moritz Cruz and Bernard Walters*

International reserves accumulation has been the preferred policy recently adopted

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by developing economies to achieve financial stability. The aim of this policy is to
increase liquidity and thus reduce the risk of suffering a speculative attack. The main
concern expressed in the literature has been related to its cost. Most of the studies
conclude that the opportunity cost of international reserves accumulation is around
1% of GDP. However, these studies have not analysed whether this strategy is, or
could be, more broadly supportive of development, an issue that must be of central
interest for developing economies. The aim of this paper is to show that the
stockpiling of international reserves is not optimal for developmental purposes and
that there exist alternative policies that can be applied to achieve financial stability,
policy autonomy and a better performance in terms of development.

Key words: International reserves, Financial stability, Speculative attacks, Capital

management
JEL classifications: O11, O16, E12, E63, F41

1. Introduction
The factor identified by most commentators as triggering recent financial crises across the
developing world has been illiquidity in the wake of an interruption and/or reversal of
capital inflows (see Allen, 2004, Calvo, 2001, Feldstein, 1999, 2002). The sequence has
been of speculative attacks inexorably exhausting international reserves, forcing countries
to increase their domestic interest rate and eventually to float their foreign exchange rates.
The economic policy response to forestall this cycle of speculative attack–capital flight–
financial crisis, adopted by both crisis-affected and other non-affected emerging economies
since Mexico’s 1994–95 financial crisis, but particularly since the 1997–98 East Asian
crisis, has been simply to increase liquidity through the accumulation of international
reserves. In 2001, the Report of the High-Level Panel on Financing for Development to the
United Nations stressed that since the Asian crisis international reserves in emerging

Manuscript received 13 October 2006; final version received 6 May 2008.

Address for correspondence: Moritz Cruz, Universidad Nacional Autónoma de México (UNAM), Instituto
de Investigaciones Económicas, Circuito Mario de la Cueva s/n, CU 04510, México; email: aleph3_98@
yahoo.com
* Universidad Nacional Autónoma de México, Mexico and University of Manchester, UK, respectively.
The authors are very grateful to two referees for their comments, which have improved the paper
substantially. The usual disclaimers apply.
Ó The Author 2008. Published by Oxford University Press on behalf of the Cambridge Political Economy Society.
All rights reserved.
666 M. Cruz and B. Walters
economies had increased by around 60%. Furthermore, developing countries’ interna-
tional reserves ‘have risen from 6–8 percent of GDP during the 1970s and 1980s to almost
30 percent of GDP by 2004’ (Rodrik, 2006, p. 255).
Earlier concerns about the issue of reserve accumulation focused on their optimum size.
More recent concerns have addressed the cost of excess reserves in terms of the difference
between the market return and the much lower return from holding reserves in (typically)
US treasuries. On this basis, some studies suggest that the excess of international reserves
has a cost of around 1% of gross domestic product (GDP) (Bird and Rajan, 2003; Rodrik,
2000, 2006). This is, as Rodrik (2006, p. 262) states, ‘a large number by any standard. It is
a multiple of the budgetary cost of even the most aggressive anti-poverty programs
implemented in developing countries.’ Other studies, moreover, have identified potential
costs in terms of detrimental effects on the financial sector of either moral hazard
problems, created by very liquid banking systems channelling excess credit to overheated

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asset markets and/or domestic macroeconomic risks such as inflation, high intervention
costs and monetary imbalances (Garcı́a and Soto, 2004; Mohanty and Turner, 2006;
Schiller, 2007).
The dominant explanation for the build-up of reserves, and therefore for accepting their
associated cost, is that it represents precautionary behaviour designed to provide insurance
against the far higher output and other costs associated with earlier crises (see Cerra and
Sexena, 2008). Countries following this strategy are evidently hoping to emulate those
economies that escaped speculative attacks and/or capital flight (e.g. Chile, Columbia,
China and India) and maintained policy autonomy, thereby providing ‘a way of reducing
the risks of future crises and of minimising the need to turn to the IMF [International
Monetary Fund] if crises occurred’ (Bird and Mandilaras, 2005, p. 85). Another
alternative but not exclusive, explanation for reserves accumulation identifies it with an
active policy of export-led industrialisation characteristic of several countries in East Asia
(especially China). This is the mercantilist interpretation of reserve accumulation, in which
increased reserves are a by-product of maintaining a competitive exchange rate designed to
expand tradable production. In summary, as well as insurance against the opportunity
costs associated with crises, there are benefits claimed for the policy of international
reserves accumulation in terms of the policy autonomy necessary to pursue independent
industrialisation strategies.
However, this justification is not entirely compelling. A large literature demonstrates
that it was not international reserves accumulation per se that deterred speculative attacks
and provided policy autonomy for the countries that avoided the earlier crises; these aims
were attained through the implementation of capital controls (see Agosin and Ffrench-
Davis, 1996; Athukorala, 2003; De Gregorio et al., 2000; Doraisami, 2004; Edwards,
1999, 2003; Joshi, 2003; Ocampo, 2002; Palma, 2002). Furthermore, the export (and
growth) record of the more successful of these economies (particularly their export-led
growth success) has not been primarily the result of a short term competitiveness strategy
based on the maintenance of a competitive real exchange rate (RER) through the
accumulation of international reserves. On the contrary, it has been the result of a long
term strategy that has included supply side policies such as the building of technological
capabilities. Thus, as Aizenman (2006, p. 2) observes, ‘the mercantilist case for hoarding
international reserves, as an ingredient of an export led growth strategy, is lacking empirical
evidence.’
In addition, for most countries the adoption of a reserve accumulation strategy was
taken in the context of the decision to adopt or reinforce the neo-liberal strategy of rapid
 Effect of accumulation of international reserves on development 667
financial liberalisation, unrelated to the development of either deep financial markets or
mature and effective regulatory structures. The evidence suggests that this, in fact, leads to
a reduction in policy autonomy, a high degree of financial instability and very little (if any)
contribution towards development (see Chang and Grabel, 2004; Grabel, 1995; Kose
et al., 2006). Governments are evidently in a position where they see little alternative to the
world of increased financial liberalisation but have no faith in the insurance provided by the
IMF. In this context, the policy of reserve accumulation is seen as providing the only option
to navigate between the Scylla of a financial crisis and the Charybdis of an IMF package.
The justification for the policy of reserve accumulation is, therefore, bounded by the
acceptance of the liberalised financial architecture with a narrow interpretation of the
opportunity costs and benefits available from its pursuit. A full evaluation should address at
least two further questions. First, whether this strategy, through the policy autonomy it
provides by preventing financial crises and the consequent involvement of the IMF,

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contributes to development in the sense of aiding the process of industrialisation.
Strikingly, the studies that have addressed the question of reserves accumulation have
not analysed this question. Second, whether there are alternative policy options able to
provide financial stability at a lower opportunity cost than stockpiling international
reserves. The aim of this paper is to argue precisely that the policy of amassing reserves is
misguided and developing countries should (re)consider alternative policies that are
feasible and effective, which might provide financial stability while maintaining the policy
autonomy necessary to pursue growth and industrialisation goals.
The paper is set out as follows. Section 2 explains why developing countries accumulate
international reserves. Section 3 considers whether this strategy is worthwhile and argues
that at least three important issues need to be considered before embarking on this course
of action: the tradeoffs involved in the stockpiling of international reserves; the factors that
predispose an economy to financial crisis; and finally, whether there are policies better
suited to the promotion of financial stability and policy autonomy that also allow sufficient
space to promote industrialisation. Section 4 argues, based on historical evidence, that
such alternatives exist and have been successfully used in the past to achieve and maintain
financial stability, which, in turn, has allowed the pursuit of active policies supporting
industrial development, with fewer costs associated with their implementation. Finally,
Section 5 presents the concluding remarks.

2. What is driving developing countries’ international reserve

accumulation? Precautionary, policy autonomy and mercantilist motives
The issue of the accumulation of international reserves has regained relevance and interest1
(see Aizenman, et al., 2004; Aizenman and Marion, 2002; Bird and Rajan, 2003;
Mendoza, 2004; Wijnholds and Kapteyn, 2001) since the mid 1990s because of the
‘boom’ in financial crises in the developing world, notably in Mexico, Thailand, Korea,
Malaysia, Philippines, Indonesia, Brazil, Turkey, Russia and Argentina. The majority of
these crises were associated with the adoption of the neo-liberal financial liberalisation
strategy of free mobility of capital (for further discussion see Allen, 2004; Arestis and

1
In an earlier period, during the 1960s, as a consequence of the plans to provide the international financial
system with greater liquidity, the debate focused on defining the optimal level of international reserves
necessary to maintain the value of a currency within the fixed exchange rate system. A decade later, during the
1970s, when most countries adopted freely floating foreign exchange rate regimes, international reserves were
seen as a buffer to absorb a transitory current account shock (see Edwards, 1983; Garcı́a and Soto, 2004).
668 M. Cruz and B. Walters
Glickman, 2002; Cruz et al., 2006; Grabel, 1996; Palma, 2003; Singh, 2003), which
increased the vulnerability of the capital account of the balance-of-payments, a source
ignored during the earlier era of capital controls.
The observed increased vulnerability in the modern era of financial liberalisation has
meant, first and foremost, that stockpiling international reserves has been seen as the
central policy option that a country can pursue to avoid a financial crisis and its high
economic costs (Bird and Rajan, 2003). This choice is reflected in the evolution of world
international reserves. Data from the World Development Indicators indicate that world
wide accumulation of international reserves registered a marked break in 1994–95, in the
aftermath of Mexico’s financial crisis. From that year, international reserves sharply
increased, with an increase of 19.4% in 1995. Interestingly, if Organisation for Economic
Cooperation and Development (OECD) countries1 are eliminated from the sample, given
that their liberalisation occurred (long) after the development of mature economic and

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financial structures, the pattern described becomes more marked, with an increase in
foreign exchange holdings in 1995 of 22.1%. In fact, around two thirds of international
reserves are currently held by developing countries (Aizenman, 2007). Thus, as Rodrik
(2006) stresses, developing economies are deeply involved in international reserves
accumulation.
The evidence therefore suggests that the accumulation of international reserves was seen
initially as a source of protection or insurance, and more recently as a permanent buffer
stock against the total or overall vulnerability of the balance-of-payments, arising from both
the capital and the current accounts. Of course, in the current era of free mobility of
capital, much more attention has been placed on the vulnerability arising from the capital
account. A ‘developing country’s reserves is related to changes not in real quantities (such
as imports or output) but in financial magnitudes’ (Rodrik, 2006, p. 257, emphasis in
original).
The results reported by Mendoza (2004), for a sample of 65 developing economies, are
consistent with the hypothesis that, since the boom in financial crises, the strategy of
reserve accumulation has been linked to the pursuit of financial stability. In addition, the
econometric work of Aizenman and Lee (2005) supports the view that developing
countries mainly demand and accumulate foreign exchange for precautionary reasons.
Notwithstanding the financial stability that international reserves might provide, it is
also clear that developing countries consider the increase in international reserves holdings
as having other, non-precautionary purposes. These can be categorised as the policy
autonomy and mercantilist motives for holding reserves.
The policy autonomy argument is straightforward: avoiding financial crises avoids the
interference of and dependence on international agencies. The eruption of financial (but
also debt and political) crises has led to the involvement of international multilateral
institutions, mainly the IMF (but also the World Bank), and their conditional assistance
packages, with an inevitable loss of policy autonomy. Countries judge that by preventing
a crisis through the accumulation of liquidity, they will also minimise IMF conditional
assistance and gain policy autonomy, even in the event of a crisis actually occurring (see
Bird and Mandilaras, 2005). Therefore, developing countries see in a strategy of reserve
accumulation a source of policy independence or sovereignty.
An alternative but not exclusive motive is provided by the mercantilist approach. This
centres on the maintenance of a competitive RER as a form of active industrial strategy.

1
Except, for obvious reasons, Mexico, Korea and Turkey.
 Effect of accumulation of international reserves on development 669
The aim is to achieve and then maintain a RER that is sufficient to promote a high export
growth rate (see Aizenman 2006; Aizenman and Lee, 2005); the accumulation of
international reserves is an inevitable counterpart to such a strategy. The mechanism is
explained in a recent study of Frenkel and Ros (2006). They argue that if the rate of
accumulation in the tradable goods sector is a positive function of profitability, and
profitability in that sector is a positive function of the RER, then a competitive RER will
lead to faster growth of the traded goods sector. And they further note that a competitive
RER operates as an industrial policy designed to distort relative prices in favour of tradable
goods activities (like any industrial policy, such as export promotion industrialisation). In
this sense, a more depreciated currency is equivalent to a uniform tariff on imports, with
the advantage that a depreciated currency does not distort relative prices against exports
because it simultaneously implies a ‘subsidy’ (an income transfer) of the same size (p. 636).
Thus, by maintaining a competitive RER with the concomitant reserve accumulation, the

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profitability of the tradable sector can be promoted and, in turn, firms will invest and
expand production.
It is important to mention, finally, that additional benefits may attach to the
accumulation of international reserves. For example, large stocks of reserves may reduce
the volatility of the foreign exchange rate (see Aizenman, 2006; Aizenman and Riera-
Critchton, 2006; Cady and Gonzalez-Garcia, 2006). In addition, the cost of foreign
borrowing may also be reduced.
In summary, the precautionary, mercantilist and policy sovereignty motives are the
driving forces behind developing countries’ hoarding of international reserves. The
benefits claimed for this strategy, which can be classified with respect to development
purposes, policy autonomy and financial stability, seem, at least at first glance, very
attractive. Furthermore, there appears to be a presumption that the costs associated with
the policy are small compared with the cost of being less liquid. Accordingly, this policy is
seen as the best means to achieve financial stability, provide policy autonomy and aid
industrialisation.
However, this impression is deceptive. First, there are large direct and potential
opportunity costs inherent to the adoption of this policy. Second, some of the benefits
enumerated may not be achieved, or even be achievable, in practice. Third, there are policy
alternatives available to pursue these targets. When the proposed benefits are set against
a fuller analysis of all the opportunity costs in terms of development purposes, policy
autonomy and financial stability the policy of reserve accumulation, particularly in the long
term, loses much of its attractiveness. The next section presents a more complete analysis
of the wider costs associated with this strategy.

3. The drawbacks of pursuing a policy of international reserves

accumulation
3.1 Direct and potential costs
It is clear that following the strategy of reserves accumulation comes with considerable
direct costs. Holding reserves incurs an opportunity cost, which is the difference between
what the reserves could have earned and what they actually earn (Ramachandran, 2004,
p. 365). This opportunity cost has been estimated for the Report of the High-Level Panel
on Financing for Development to the United Nations in 2001 to be of the order of 8%,
which represents the differential between the yield on the reserves and the marginal cost of
borrowing.
670 M. Cruz and B. Walters
In addition to establishing the differential, estimating the cost also requires identifying
the size of the excess holdings relative to some optimum level. So far, international reserves
accumulation seems unrelated to any clear notion of what might constitute an optimal level
of reserves. The so-called Guidotti–Greenspan rule,1 which proposes ‘the maintenance of
reserves equivalent to 12 months of a country’s total foreign obligation, which includes but
is not limited to imports’ (Mendoza, 2004, p. 76) does not adequately explain the recent
evolution of international reserves. This is unsurprising as this sort of criterion is based on a
rule-of-thumb,2 rather than any formal theory.3 Nevertheless, as we have already stressed,
there are clear precautionary reasons to hold reserves but ‘quantifying optimum reserves
is. . . not straightforward since it is difficult to estimate the adjustment costs and output
losses that reserves may enable a country to avoid’ (Bird and Mandilaras, 2005, p. 86).4
In the absence of a robust definition of the optimum level of reserves a number of ad hoc
ratios have been used. Rodrik (2000) and Bird and Rajan (2003), for example, have

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estimated that the excess of reserves holdings above the level defined by the conventional
ratio R(reserves)/M(imports), to be around 1% of GDP, a result confirmed by Rodrik
(2006). Cruz and Walters (2007), applying the notion of a maximum sustainable external
threshold,5 estimate this cost at around 0.19% of GDP for the Mexican economy during the
1996–2004 period. Mendoza (2004), on the other hand, estimates that the quarterly cost of
reserves accumulation, for a sample of 65 developing economies during the 1998–2001
period, was approximately US$450 million.6 In summary, it is clear that, based even on
a narrow criteria defining excess and cost, as Rodrik (2006, p. 261) observes, ‘developing
countries are paying a very high price to play by the rules of financial globalization.’
In addition to these considerable direct costs, it is important to note that reserve
accumulation can actually be counterproductive, potentially generating further long term
problems. For example, ‘large reserves stocks may create moral hazard problems that could
weaken the financial system of a country. This, in turn, could make crises to be deeper. . .’
1
Proposed initially by Pablo Guidotti (then deputy finance minister of Argentina) and then refined by
former US Federal Reserve Chairman Alan Greenspan in 1999.
2
The same can be said about the ratio of international reserves to imports (R/M), which suggests that an
adequate level of reserves can be established as that level of reserves which are able to cover at least 3 or 4
months of imports. More importantly, however, the criterion suggested by the ratio R/M became
inappropriate when most economies moved to a freely floating exchange rate regime and/or when they
could borrow foreign currency in the international markets. In a freely floating system, the need to keep
reserves is reduced considerably (even for fully open economies) because, in theory at least, the external
imbalances can be corrected through adjustments of the exchange rate or, in the last resort, through the
ability to borrow from the international markets.
3
Despite the lack of a theory for reserve adequacy, there are studies that have applied econometric
techniques to try to determine it. These include, among others, Ben-Bassat and Gottlieb (1992) for a selected
group of 13 economies, Ramachandran (2004) for the case of India and Garcı́a and Soto (2004) for Chile and
other Asian economies.
4
In the absence of consensus about the optimal level of reserves, the data is best characterised as following
what has come to be called Mrs Machlup’s wardrobe theory (Machlup, 1966). According to Bird and Rajan
(2003, p. 877), this suggests that the ‘acquisitive characteristics of monetary authorities in terms of adding to
their reserves resembled those of Mr. Machlup’s wife in terms of clothes. According to this idea no level of
reserves was ever enough.’
5
The central idea of this threshold comes from the fact that during the boom of crises in the 1990s, both
the current account deficit and the short term external debt, each expressed as a fraction of GDP, reached
levels beyond which the historical record indicates financial markets start to get nervous and, on that basis,
decide to withdraw their capital out of a country. In this sense, the authors suggest that a level of reserves that
could maintain calm amongst financial investors would be of an order of around 5–6% of GDP. Any level of
international reserves in terms of GDP above that threshold can be considered an excess and this, in turn,
allows an estimate of its cost.
6
A cost that, as Mendoza himself stresses (p. 73), needs to be taken in the proper context. For example, for
a large country like Brazil or Malaysia it may be infinitesimal, but large for a small country like Uganda.
 Effect of accumulation of international reserves on development 671
(Garcı́a and Soto, 2004, pp. 17–18). This is because currency intervention injects liquidity
into domestic money markets producing very liquid market systems that can spill over into
overheated assets markets and perhaps distort the banking system (see Schiller, 2007). In
addition, according to Mohanty and Turner (2006, p. 40), large and prolonged reserve
accumulation aimed at resisting or delaying currency appreciation can create a range of
domestic macroeconomic risks through its effects on the balance sheets of the central bank
and the private sector. These risks include near-term inflation, high intervention costs and
monetary imbalances. In their study, the authors argue that these potential risks have been
controlled so far only because many countries accumulating reserves over the past few
years have faced conditions of substantial excess capacity and low inflation, which has
meant that policy could be eased in the face of upward pressure on the currency. In these
circumstances, reserve accumulation did not create the dilemma for policymakers of
choosing between their inflation and their exchange rate objectives.

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3.2 Does international reserves accumulation promote development?
The logic of accumulating large amounts of any resource, like reserves, when a country is
most in need of them for alternative productive projects, is questionable.1 This is
particularly true when the economy has suffered a deep economic slowdown as a result
of a crisis and thus the need for rapid and sustained growth is more urgent than ever. There
is evidence that crisis-affected economies suffer not only large and persistent output losses,
but they never recover from such negative shocks in the sense of output losses being
reversed (Cerra and Sexena, 2008). Thus, the broadest interpretation of the opportunity
cost of holding excess reserves should allow the cost of reserves to be considered in terms of
foregone developmental projects. Although the approach is contentious,2 in a recent study,
Cruz (2006) estimated that, had the excess of international reserves been absorbed by the
Mexican economy during the 1996–2004 period (either through investments in in-
frastructure or in sectors with a high rate of return), the upper bound of Mexico’s growth
would have been 4.3% per year instead of the 3.7% observed.
In addition to the various costs enumerated above, the empirical significance of using
international reserves to promote growth (the mercantilist view) is contested. The
econometric analysis of Polterovich and Popov (2002) suggests that countries with
growing foreign exchange reserve ratios to GDP, all other things being equal, exhibit
higher investment/GDP ratios, higher trade/GDP ratios, higher capital productivity and
higher rates of growth. However, the results of Aizenman and Lee (2005) indicate that
although the variables associated with the mercantilist motive are statistically significant
their economic importance in accounting for reserves hoarding is close to zero and is
dwarfed by other variables. In a similar vein, Aizenman (2006) concludes that the
management of international reserves should not be seen as a panacea, particularly for an
export-led growth strategy. Furthermore, as previously highlighted, large and prolonged
1
In this respect, for example, the Bank of England highlights (p. 10) that ‘even a positive return may not be
optimal; the key question is whether higher returns, after allowance for risk, could be made elsewhere (e.g.
through investment in the country’s domestic infrastructure).’ See Handbooks in Central Banking No. 19 of
the Bank of England, available at: http://www.bankofengland.co.uk/education/ccbs/handbooks/ccbshb19.
htm#top
2
According to Rodrik (2006, p. 8) ‘the process of accumulating international reserves. . . makes clear that
the relevant counterfactual in most instances is not one dollar of additional public investment, but one less
dollar of short-term foreign debt.’ Also, so far, there is no evidence that international reserves have been used
to finance infrastructure projects, especially when the aims of reserves accumulation are liquidity and
protection (see Singh, 2006).
672 M. Cruz and B. Walters
reserve accumulation aimed at delaying currency appreciation can create a range of
domestic macroeconomic risks.
It is also important to emphasise that, if it is to promote growth and development
effectively, a policy of maintaining a competitive RER through reserves accumulation
needs to be coupled with appropriate long-run supply side policies, while a competitive
RER can only be a short term policy. Japan, Korea, Singapore and China [according to
Polterovich and Popov (2002), examples of successful development strategies using
growing foreign exchange reserves], are manufacturing export leaders. However, this is an
outcome that has involved much more than a non-appreciated currency strategy. They
have, in fact, long since developed an export structure that allows them to enjoy the
benefits of trade. Their superb export performance is not something recent that has
occurred since the boom of financial crises. It is rather the story of East Asian economies
during the last 50 years. The corollary is that adopting a large reserves holdings strategy

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will not, on its own, deliver the benefits of export-led growth from a developmental point of
view.1 Thus, it is not appropriate to embark on reserves accumulation and its effects on the
foreign exchange rate and export promotion, especially in the long term, without other
complementary policies aimed at creating the supply side structures that are needed for
(high value added) export growth.

3.3 Do international reserves guarantee financial stability and policy autonomy?

Even though the balance of the discussion so far might suggest that ‘prevailing patterns of
reserve holdings are far from crazy in view of the significant costs of being less liquid’
(Rodrik, 2006, p. 10), at least two further questions should be considered before deciding
to embark on a strategy of stockpiling reserve holdings.
In the first place, the factors that open the door to financial crises, or, in other words, to
a rapid drain of liquidity, should be considered. The empirical evidence indicates that there
are two main routes by which an economy can suffer a financial crisis. Directly, by opening
the capital account of the balance-of-payments and simultaneously deregulating domes-
tically, i.e., by implementing the neo-liberal strategy of financial liberalisation. And
indirectly, via contagion, which is, however, to a considerable extent an inevitable
consequence of the increasingly tight commercial and financial links between countries.2
The implication, therefore, is that only if policymakers are planning to implement (or
reinforce) the neo-liberal financial integration strategy3 will it be worth considering the
strategy of international reserves accumulation.
1
Mexico, for example, has increased reserves by around 300% since the 1994–95 peso crisis. However,
manufactured exports have risen, on average, at a 12% rate during 1996–2005, which is much lower than the
20% rate achieved during the 1981–94 period.
2
Recall that the danger of the contagion risk, defined as ‘the threat that a country will fall victim to
financial and macroeconomic instability originat[ing] elsewhere’ (Grabel, 2003, p. 320), will depend upon
the vulnerability of the recipient emerging economy (i.e. its current levels of flight, currency and fragility risk)
relative to the specific form and size of the shock (trade, foreign income or financial, i.e. cost of finance,
investor herd behaviour) as well as any responses by policymakers and investors (see Chui et al., 2004 and
ECLAC, 1998). Additionally, the effect of the contagion risk will vary in duration and intensity according to
the linkages that the country under consideration maintains with the country (or region) where the crisis
originates.
3
Recall, however, that the neo-liberal strategy of financial liberalisation is growth-distorting because it
promotes the creation of new opportunities for risky investment practices and a corresponding misallocation
of credit toward speculative activities, with destabilising macroeconomic effects (Grabel, 1995, p. 129).
Furthermore, abandoning financial repression may lead to an explosion of government debt, economic
instability and lower economic growth (Fry, 1997, p. 768).
 Effect of accumulation of international reserves on development 673
As we have stressed, however, a large body of literature suggests that, among other
things, financial liberalisation has preceded financial crises with the associated huge costs
and that it has reduced significantly the space for and the autonomy to formulate policies in
the pursuit of national development objectives. In this sense, neo-liberal financial
liberalisation is not supportive of industrialisation, while it sharply increases financial
instability.1 Furthermore, it is important to stress that ‘even an emerging-market economy
with an idealized external position would remain highly exposed to the punishing
vicissitudes of liberalised financial flows’ (D’Arista, 2000, p. 3). In other words, there is
no guarantee for a poor economy that even holding large amounts of international reserves
will completely eliminate the risks that emanate from hot money because it has proved
impossible to identify either exactly what moves international liquidity holders to attack
a currency or what determines their timing. International reserves holdings can be seen,
therefore, as simply an ad hoc protection against speculative attacks.

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The second question that needs to be asked when considering a strategy of reserve
accumulation is whether there are feasible policy alternatives that can allow countries the
policy space to apply their own approaches to development, understood as the structural
transformation of their economies in the direction of a modern, industrialised state.
Fortunately, the historical evidence of both developed and newly industrialised economies
shows that there are indeed several alternatives that have proven to be effective in these
common aims, among which are restrictions on currency convertibility and the famous
(Chilean) management of capital controls (see Grabel, 2003).2 These policies are
addressed in the next section.
Table 1 summarises the costs and benefits of the strategy of international reserves
accumulation with respect to development purposes, policy autonomy and financial
stability. As can be seen, the benefits of this strategy are very attractive but, as we have
argued, they can only be enjoyed on a short term basis: as soon as the neo-liberal strategy of
financial liberalisation is applied, financial stability is subject to the vicissitudes of hot
money and policy autonomy for development purposes disappears. Also, the competitive
RER policy can only be sustained as long as monetary and macroeconomic imbalances can
be managed and, in the same vein, long term export promotion depends on supply side
policies. In this sense the costs, especially the long term costs, outweigh the benefits of the
reserves accumulation strategy. Finally, the need to hold extremely large international
reserves can be reduced substantially if alternative policies that can provide policy
autonomy, financial stability and the space to support industrialisation are implemented.

4. Financial stability, policy autonomy and development: the alternative

strategies
Recent financial crises are strongly associated with the degree of freedom with which
capital is able to leave the country given an economic or political change. This suggests that
any strategy that aims at reducing financial vulnerability without trying to reduce agents’
1
Only the most optimistic studies emphasise the fact that, despite currency crises, financial liberalisation
can be linked to boom–bust cycles (see Tornell et al., 2004) or argue that developing countries can benefit
from financial liberalisation, but with many nuances (see Kose et al., 2006).
2
It is important to mention that Grabel (2003, 2004) also proposes the trip wires and speed bumps
approach as a policy alternative that can also offer financial stability and aid the attainment of development
goals. The idea consists of providing policymakers (and investors) with measurable variables that can indicate
if the country is approaching dangerous levels of risk of suffering capital flight or a speculative attack, and
tools to reduce such risks.
674 M. Cruz and B. Walters
Table 1. Costs and benefits of the international reserve accumulation strategy

Benefits Costs

Forgone resources for

Development purposes Foreign exchange stability.
Export growth (through a
competitive RER).
Increased creditworthiness.
Avoid reliance on the IMF in
Policy autonomy the case a crisis occurrs.
developmental purposes.
Moral hazard problems.
Macroeconomic risks (inflation,
high intervention costs,
monetary imbalances).
No room for industrial and
growth policies.
The economy remains highly
exposed to hot money,

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Financial stability Prevents speculative attacks. particularly to capital outflows.

RER, real exchange rate; IMF, International Monetary Fund.

financial freedom to transfer funds across borders is likely to fail. As Keynes (quoted by
Davidson, 2002, p. 214) warned ‘loose funds may sweep round the world disorganising all
steady business. Nothing is more certain than that the movement of capital funds must be
regulated.’ Moreover, ‘it is easy to forget that the Golden Age was, among other things, an
era of effective national economic regulation’ (Crotty and Epstein, 1996, p. 118). It is clear
that only strategies aimed at controlling the flow of capital and thus the behaviour of agents
provide options that are likely to offer greater financial stability.
In addition, reducing the freedom of capital can increase policy autonomy because
‘freedom to [move money across the borders] is one of the main sources of capitalist
political power’ (Crotty and Epstein, 1996, p. 120). Policy autonomy cannot be trimmed
to avoid IMF assistance when collapses occur; it needs to be broader and should imply,
among other things, the capacity of the authorities to address monetary and fiscal policy
towards industrialisation and growth goals and also be able to smooth business cycles. In
other words, ‘. . . countries must be allowed to impose capital controls in the interest of
demand management’ (Bhaduri, 2002, p. 45). Furthermore, there is evidence that such
measures have also contributed in the process of development through, amongst other
channels, subsidising imports, stabilising the exchange rate and improving the allocation of
investments. For these reasons, here we focus on presenting and analysing the feasible
alternative proposals, summarised by Grabel (2003), which can be applied by domestic
policymakers to achieve financial stability. They include the management of capital flows (à
la Chile) and restrictions on currency convertibility.
Before discussing these options, it is important to make two important observations.
First, conclusions from the literature, both for and against capital controls, suggest that
they involve tradeoffs. Thus, the issue is not whether the policies have costs but whether
policymakers can ensure that these costs do not offset the benefits. In addition, although
these policies may have been proven to offer financial stability and policy autonomy in the
past, this need not imply that they will now operate as they were originally applied; they
need to be adjusted to the present context of globalisation. This raises the question of
which policy or combination of policies are most appropriate. Evidently this depends on
the particular circumstances of the economy (such as the level of development) and the
prevailing external conditions.
 Effect of accumulation of international reserves on development 675
Second, a growing body of literature has suggested an alternative approach to achieve
financial stability, and thus promote development, through the involvement of the
international community.1 These proposals essentially view financial stability as a global
public good (see Kaul et al., 1999, for a definition of global public goods). The idea is that
poor people may lack income and barely participate in financial markets. Yet financial
crises, through multiple transmission channels, can hurt them badly. Thus, international
financial stability is important for all people (Griffith-Jones, 2003). However, notwith-
standing the remarkable value of this insight, our emphasis in this paper is on policies that
are feasible in the sense that they can be applied by domestic authorities. If developing
countries really want to protect themselves and accelerate industrialisation they need to
apply, sooner rather than later, policies that are effective but which are under their control.
In this sense, they cannot depend on ‘. . . international organizations nor expect that a new
financial international architecture that will make the world less dangerous’ (Feldstein,

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1999, p. 1). This does not mean, of course, that they should stop the search for
mechanisms to attain global financial stability.

4.1 The management of capital flows (the Chilean model)

The so-called management of capital flows is one of the strategies that have been shown to
be effective in reducing speculative attacks and capital flight and provide policy autonomy
whilst contributing to development goals.2 This is because, as Thirlwall (2003, p. 95)
points out, ‘capital controls, in whatever form. . . allow countries to manage their exchange
rate effectively and provide a greater degree of monetary independence’ (cf. Joshi, 2003,
for the case of India). In other words, capital controls provide a solution to the policy
dilemma of reconciling internal and external equilibrium.
Although there may be some national differences in design, the mechanisms by which
capital controls operate are to ‘lengthen the maturity structure and stabilise capital inflows,
mitigate the effect of large volumes of inflows on the exchange rate and exports, and protect
the economy from the instability associated with speculative excess and the sudden
withdrawal of external finance’ (Grabel, 2003, p. 326). Moreover, capital controls insulate
a country’s financial system from the contagion effects of financial crises and enhance the
autonomy of pro-growth and social policy (Epstein et al., 2003). They also promote
development by attracting favoured forms of foreign investment and by maintaining
foreign exchange stability, which is crucial to subsidise capital imports. In other words, the

1
See, for example, Eichengreen, 1999, and Davidson, 2002, for proposed changes in the international
financial architecture; Mendoza, 2004, and Bird and Rajan, 2003, for strategies that involve measures to
redefine and readjust international financial instruments (like the SDRs) to the needs of emerging economies;
Bird and Mandaliras, 2005, for mechanisms to achieve global balance-of-payments equilibrium; see also
Griffith-Jones, 2003, for a review about why global financial stability has not been achieved and what needs to
be done.
2
The management of capital flows was applied successfully in Chile and Colombia during the 1990s (see
Agosin and Ffrench-Davis, 1996; De Gregorio et al., 2000; Edwards, 1999, 2003; Palma, 2002), in India and
China and, for a short period during the East Asian crisis, in Malaysia (see Athukorala, 2003; Doraisami,
2004; Joshi, 2003). The strategy allowed these economies to pass through the era of financial crises with low
levels of financial and macro instability (see David, 2007; Ocampo, 2002). Also, in the early post-war years
capital controls for macroeconomic reasons were generally imposed as part of policy packages dealing with
balance-of-payments difficulties so as to avoid, or at least reduce, the need for devaluations. Rich and poor
countries alike used controls on capital inflows for long term development reasons. When freer capital
movements were allowed from the 1960s onwards, rich countries, such as Germany, Holland and
Switzerland, when destabilised by large capital inflows, imposed controls such as limits on non-residents’
bank deposits and their purchase of local securities (Khor, 2001).
676 M. Cruz and B. Walters
risk of currency collapse is reduced through the adoption of a crawling band exchange rate
regime coupled with capital inflows control1 and the probability of a sudden exit of
investors is reduced by allocating investment towards longer term activities.2
In summary, the management of capital flows has proved to be a highly effective strategy
to mitigate speculative attacks and capital flight and to enhance policy autonomy for pro-
growth goals (see David, 2007; Epstein et al., 2003). Furthermore, it is evident that those
economies that have managed capital inflows and outflows have recorded more stable
growth and a marked move towards further industrialisation.
The main cost stressed by critics is that their adoption could inhibit access to financial
resources as well as investment, thereby reducing economic growth. However, there is little
evidence supporting the view that portfolio investment encourages productive investment
and growth (through financing productive projects). On the contrary, there is empirical
evidence suggesting that foreign direct investment does not necessarily promote growth; it
is not, as Chang and Grabel, 2004, point out, the Mother Theresa of capital flows.3 In

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addition, the volume of capital inflows does not necessarily decrease in the face of capital
controls. In fact, evidence suggests that the only change is a positive one, with a larger share
of capital going to longer term activities (for evidence in the case of Chile, Colombia,
Taiwan, Singapore, Malaysia in 1998, India and China see Chang and Grabel, 2004, and
Epstein et al., 2003). This suggests that resources can indeed be efficiently allocated. Other
emerging economies recently seem to have realised the benefits of this strategy. For
example, in June 2005, Argentina decided to apply measures to retain 30% of portfolio
capital inflows, with the specific aim of stabilising the exchange rate. More generally,
capital management should represent a developmental option for developing economies as
it did in the past for today’s industrialised ones; it cannot be accepted, as Chang (2002)
stresses, that in the name of market efficiency the same state action could be considered an
‘intervention’ in one society and not in another.
Finally, many criticisms of capital management arise from their potential microeco-
nomic costs. The argument is that capital controls have the potential to harm medium
sized enterprises because the strategy forces domestic lenders to raise domestic costs
during the economic boom (see Forbes, 2003, 2004). However, severe limitations on data
availability in these studies suggest that the results be treated cautiously. In addition,
neither study presents their analysis in the necessary comparative context, nor do they
show clear evidence that the microeconomic costs are likely to offset the macroeconomic
benefits of capital management.

4.2 Restrictions on currency convertibility

The management of foreign exchange currency transactions provides another feasible
policy measure to achieve financial stability, increase policy autonomy and support
development goals. Free currency convertibility allows investors to move their money

1
According to Thirlwall (2003, p. 79), the historical experience of the last 30 years or so points to an
important exchange rate regime policy conclusion: ‘intermediate positions between rigidly fixed rates (or
hard pegs) and floating (what might be called ‘soft’ pegs) are not sustainable without capital controls.’
2
Edwards (1999) provides evidence that these goals were achieved in the case of Chile and Ocampo
(2002) illustrates their successful application in Colombia and other emerging economies. Importantly,
Feldstein (1999) highlights this policy as a means of increasing liquidity, thus further improving policy
autonomy.
3
See Singh (2003) for a comprehensive exposition of the disadvantages of foreign direct investment and
why it should be regulated.
 Effect of accumulation of international reserves on development 677
freely from one financial centre to another regardless of the purpose of the conversion or
the identity of the holder. It is this capability that allows investors to put the domestic
currency under pressure cheaply and easily, further decreasing the value of assets and
potentially causing a financial crisis. The corollary is that currencies that cannot be
exchanged freely for other currencies or assets denominated in them cannot be put under
such pressure (Chang and Grabel, 2004).
Thus, the greater the restrictions on exchanging the currency, for both national and
foreign residents, the lower is the chance of the currency being subject to a speculative
attack. Furthermore, capital flight is also reduced because restricted convertibility
discourages investors from acquiring the kind of domestic assets that are more prone to
flight because they cannot be easily and quickly converted to their own currency
(particularly portfolio assets). These effects translate into a reduction in foreign exchange
pressures, thus increasing policy autonomy and the ability of the authorities to pursue
development goals.1

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It is worth highlighting that, as with the management of capital flows, there is
considerable evidence to show that restrictions on currency convertibility are capable of
providing financial stability and improving policy autonomy. The experiences of Taiwan,
China and India demonstrate that such measures support the process of industrialisation
by allowing the subsidy of capital imports, implementing counter cyclical fiscal and
monetary policies and directing resources towards the development of a productive
structure. Equally striking is the fact that many of today’s industrialised economies only
removed restrictions on full exchange convertibility for capital movements very recently:
the USA, Canada, Germany and Switzerland in 1973, while Britain and Japan only did so
in 1979 and 1980, respectively, and France and Italy made the transition as late as 1990
(Nayyar, 2003, p. 66). Importantly, these economies not only made this transition when
they considered that their currencies (and their economies) were strong enough to resist
foreign exchange pressures, but also only after this strategy had fulfilled its function within
the development process.
The debate about the likely effectiveness of this policy measure have emphasised the
Achilles’ heel of restrictions on currency convertibility: leakages between the commercial
and the financial rate, after a dual exchange rate system has been set up. According to
Eichengreen and Wyplosz (1996), experience suggests that dual exchange rates work well
when the gap between the commercial and financial rates is small—meaning that they work
least well during crises. Furthermore, the IMF has traditionally been hostile to these sorts
of exchange rate practices, seeing them as an interference with the free market in goods and
1
Among the mechanisms that a government can apply are restrictions on capital account transactions,
particularly restrictions on both domestic residents and foreigners and on on the form of foreign direct or
portfolio investment in national assets. This measure can decrease abrupt capital flight. Alternatively,
charging a higher domestic price for foreign currencies than the official rate for investing abroad in capital
assets such as shares and properties might inhibit flight risk (see Thirlwall, 2003).The authorities can also
authorise currency convertibility for trade transactions, repayment of loans or profits repatriation previously
authorised. This mechanism is similar to the adoption of a dual exchange rate system, where a specific
exchange rate is set up for capital account transactions and another, cheaper exchange rate, is set up for the
current account. Multiple exchange rate systems, of which the dual is a special case, imply different exchange
rates for different transactions on either the current or financial account (see Mikesell, 2001; Thirlwall,
2003). Importantly, according to the IMF Articles of Agreement (specifically Article 8) this kind of selective
exchange rate convertibility is allowed (Chang and Grabel, 2004). For a more complete discussion
concerning the benefits of the dual exchange rate system see Mikesell (2001). Moreover, the government
could manage convertibility by requiring that investors apply for a licence that entitles them to exchange
currency for a particular reason. This mechanism would allow the government to influence the pace of
currency exchanges.
678 M. Cruz and B. Walters
capital. This view is consistent with studies suggesting that low levels of restriction on
currency convertibility (and capital controls) are associated with higher levels of economic
development, efficiency and integration of the financial sector (see Johnston, 1999).1
Edwards (1999, p. 69), points out that these types of outflow controls have been largely
ineffective, particularly because the market finds ways of evading them; he also stresses that
evidence has shown that in almost 70% of the cases where controls on outflows have been
used as a preventive measure a significant increase in ‘capital flight’ has been detected after
the controls had been put in place. Finally Eichengreen (2000, p. 1110) has also stressed
that ‘not too much should be expected of outflows controls in times of crisis, given the
strong incentives that then exist for avoidance.’
However, Chang and Grabel (2004, p. 173) stress that critics of this type of policy
generally focus on their high costs, ‘[B]ut they overlook the fact that the resources devoted
to these wasteful activities are generally dwarfed by the resources wasted in the currency

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speculation that frequently occurs in liberal financial environments. Moreover, the
economic and social costs of financial instability and crisis tend to be much greater than
the economic costs of convertibility restrictions.’
In summary, the balance of the argument and evidence supports the view that, despite
evident costs, alternative policies to maintain financial stability, policy autonomy and the
pursuit of national developmental objectives exist and are feasible.

5. Concluding remarks
This paper has considered whether the widespread policy among developing economies of
amassing large amounts of foreign exchange reserves is, in any sense, optimal from the
perspective of supporting the process of industrialisation, achieving financial stability and
extending policy autonomy. It argues that this policy cannot be justified in these terms,
particularly in the long term. This is because, even when the policy of reserve accumulation
can be, and has been, defended as being legitimate relative to the enormous costs
associated with financial crises and their aftermath, this defence fails to take account of
a number of issues.
First, it accepts, albeit reluctantly, the necessity and, indeed, inevitability of neo-liberal
financial liberalisation of both domestic and capital markets. The paper points out that this
is contestable and that the evidence shows that the neo-liberal financial liberalisation
strategy is deeply implicated in precipitating such crises (and their associated output costs)
and reducing policy autonomy.
Second, it is possible to defend such a strategy as a reflection of an active export growth
policy of maintaining a competitive exchange rate. However, it was argued that the
empirical evidence does not unambiguously support this conclusion and even in situations
where this strategy appears to have worked, this has been accompanied by a range of
complementary, supply-side policies to promote the long term expansion of exports. It was
concluded, therefore, that no general endorsement of the policy was provided by these
examples.
Finally, it might be argued that the costs of such a reserve accumulation strategy would
be acceptable if there were no feasible alternatives available to governments. However,
both current and historical evidence suggests that a range of policies based on controlling
the free flow of capital are, as a matter of fact, both feasible and effective, allowing the

1
However, these studies do not show causality.
 Effect of accumulation of international reserves on development 679
achievement of financial stability, policy autonomy, and the promotion of industrialisation
and growth. These policies include: the management of capital flows according to the
Chilean model and a variety of restrictions on currency convertibility. It was accepted that
these policies were not without cost and would need to be consistent with the new context
of increasing globalisation. However, it was argued that they provided an effective
alternative to holding large reserves while providing financial stability, increasing policy
autonomy and supporting the industrialisation process.
In summary, this paper has argued that the policy of amassing large foreign exchanges
reserves is not consistent with developmental goals. Countries seeking financial stability
and an autonomous financial strategy should resist full capital account liberalisation and
impose restrictions on the ability of capital holders to liquidate their positions without cost
or delay. In other words, developing countries need the freedom of action that developed
countries allowed themselves when they were in their earlier stages of development.

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