International Reserves, Effective Demand and Growth

Abstract

During the last decade, developing (and some developed) economies have accumulated large amounts of international reserves, mainly for precautionary reasons. This phenomenon has been coupled with insufficient economic growth. The resources being amassed largely overwhelm protective needs, there is an excess of resources that is being wasted, and which could be utilised for alternative productive projects, namely to promote growth. If insufficient aggregate demand can largely explain low growth, it is clear that this excess of international reserves can be used to stimulate aggregate demand. This paper argues that the excess of international reserves represents a potential resource to boost growth.

Acknowledgments

Moritz Cruz is grateful for financial support from research project UNAM-PAPIIT IN-306809.

Notes

¹In some cases, reserves accumulate as a result of intentional policy decisions that reduce domestic growth and increase net exports. When one country increases its reserves, effective demand is reduced elsewhere. As a result, a general build-up of reserves will be associated with lower levels of global demand and, therefore, lower levels of world economic activity. So, the build-up of reserves is associated with lower levels of both domestic and international demand.

²Globalisation has increased this tendency; see Kriesler & Nevile (2003).

³The rule was initially proposed initially by Pablo Guidotti, deputy finance minister of Argentina in the 1960s, and then refined by US Federal Reserve Chairman Alan Greenspan in 1999.

⁴In fact, the phenomenon of foreign reserves accumulation is strongly associated with financial crises over the developing world. The tendency to accumulate large amounts of international reserves started in the aftermath of the Mexican peso crisis of 1994–95. To this crisis others ensued in the developing world, notably in South East Asia in 1997, Russia in 1998, Brazil in 1998–99, Turkey in 2001 and Argentina in 2001–02, and the accumulation of foreign exchange followed suit.

⁵These results are consistent with the findings reported by Jeanne (2007) and Jeanne & Rancière (2006) that Asian economies have the largest excesses of international reserves.

⁶The exception in this regard is the Chinese economy, which has been both hording international reserves and growing at an extraordinary rate.

⁷The idea that demand leads growth can be summarised as follows. Low levels of aggregate demand will lead to a build-up of inventories, causing a slowdown in production and investment, which will further reduce employment and consumption. It will also translate into declining profits, leading to an increased inability of firms to service and discharge outstanding debts and, importantly, in the generation of negative expectations that this cycle, ceteris paribus, will perpetuate itself, inhibiting future investments and thus reducing income expansion.

⁸In the analysis that follows we do not consider exports as the component of aggregate demand that can fulfil this role, as they are not readily subject to control by domestic policymakers, particularly in the long run. In the short run, the only policy to promote exports is to devalue the exchange rate, but this alternative, depending on the size of the devaluation, might produce negative effects for the economy (i.e. inflation).

⁹There is, however, evidence that unemployment in developed economies (mainly Europe) during the 1970s to the 1990s was the result of capital shortages (see Alexiou & Pitelis, 1994). Hence, policies to expand capital accumulation should not be dismissed.

¹⁰Rostow (1956, p. 25) defines the take-off ‘as the interval during which the rate of investment increases in such a way that real output per capita rises and this initial increase carries with it radical changes in production techniques and the disposition of income flows which perpetuate the new scale of investment and perpetuate thereby the rising trend in per capita output.’ Most studies, including those we have cited in the text, assume that higher investment was the result of higher levels of savings. For a contrasting view that emphasises the role of aggregate demand in the process of growth in some Asian economies see Halevi & Kriesler (1998, 2007) and Kriesler & Halevi (1996).

¹¹It is important to mention that monetary policy, in the form of reduced interest rates, is unlikely to provide any effective stimulus to demand, as neither consumption nor investment is likely to be interest-elastic during a contractionary period (Kriesler & Nevile, 2003).

¹²Of course, as Chang (2003, p. 112), among others, has observed, investment should be part of a coherent and a well designed strategy of industrialisation aimed ‘at particular industries … to achieve the outcomes that are perceived by the state to be efficient for the economy as a whole’ (emphasis in the original).

¹³The logic of using the excess of international reserves for growth purposes might apply even for economies whose growth rates recovered after a crisis (namely Argentina, Turkey, Russia and some East Asian economies).