WASHINGTON, Nov 12: Developing countries should use some of their foreign exchange stockpiles to help domestic savers invest some savings overseas without triggering massive capital flight, the International Monetary Fund’s top economist said in a recent paper.
The research paper, by IMF chief economist Raghuram Rajan and senior economist Eswar Prasad, said the plan would have several major benefits.
It would allow domestic savers to seek some higher returns abroad without triggering destabilizing capital flight often happens when exchange controls are abolished.
At the same time, by using the reserves to translate local currency funds into dollars, euros or yen for foreign investment, it would help remove inflationary, excess money from the banking system associated with currency intervention and reserve buildup in the first place.
Under their proposal, a central bank would license a private fund management company, or use a foreign fund manager, to start a closed-end mutual fund.
The fund would raise money by issuing shares to domestic investors in the local currency and then use the proceeds to purchase foreign exchange from the central bank for investing in overseas stocks and bonds.
Without mentioning countries by name — but alluding to Asia’s large build up of reserves — the economists said the proposal could apply to countries with closed or partly closed capital accounts looking for ways to use their reserves and avoid sudden capital flight.
Massive accumulation of foreign currency reserves, mainly by Asian central banks, is one reason for global imbalances in international accounts, reflected in the US current account deficit now at over 6 per cent of gross domestic product.
“While foreign reserves in reasonable amounts can help insulate a country against external shocks ... eventually reserves are enough to protect against everything except Armageddon,” Rajan and Prasad said.
A build-up of reserves could become a strain on government finances and create a perception of exchange rate manipulation in some cases, they said.
The economists argue their proposal could be seen as part of a “tool kit” that would allow a country to liberalize its capital account in phases, at the same time training domestic investors in the country to invest abroad.
Rajan and Prasad note the proposal would allow governments to control both the amount and timing of outflows.
“We emphasize that our proposal is not intended to be a substitute for other policies that developing economies should focus on, including strengthening of domestic financial markets and, in some cases, moving toward greater exchange rate flexibility,” they said.—Reuters
