Developing Nations to Boost ‘Defensive’ Reserves, Spence Says

By Bob Chen

Aug. 12 (Bloomberg) -- Developing countries are likely to focus on increasing their foreign-currency reserves, an “element of self-insurance,” in the aftermath of the financial crisis, said Nobel Prize-winning economist Michael Spence.

Nations will look to protect themselves from money outflows by building up reserves after emerging markets saw their currencies weaken due to a “rapid exodus of capital” as developed economies withdrew funds amid the slump, Spence said in a commentary posted on the Web site of Pacific Investment Management Co.

“The use of reserves to stabilize the net capital flows is the most important domestically controlled circuit breaker,” Spence, professor emeritus of management in the Graduate School of Business at Stanford University, said in the article. “Countries without reserves had few options and remain highly vulnerable and dependent on a recovery of the international system.”

China and Russia have put forward the idea of replacing the dollar as the world’s reserve currency because of concern the value of their investments in U.S. assets will fall. The U.S. Treasury is selling record amounts of debt to fund its stimulus spending and rescue the economy from recession.

The People’s Bank of China suggested the option of expanding the use of the International Monetary Fund’s special drawing rights, a unit of account based on a basket of currencies. Premier Wen Jiabao said in March that he was concerned U.S. borrowing would erode the value of the $801.5 billion in Treasuries held by his nation’s investors.

‘Defensive Weapon’

The dollar accounted for 64 percent of the world’s reserves at the end of 2008, down from 73 percent in 2001, according to the IMF.

The U.S. dollar is unlikely to be replaced by a “super- sovereign currency,” according to Spence.

The global financial crisis caused South Korea’s reserves to drop to the lowest levels in almost four years in November as the won fell 12 percent that month. Russia spent more than a third of its foreign-exchange holdings to help stem a 35 percent devaluation in the ruble from last August to January.

“The importance of reserves as a defensive weapon will be elevated,” Spence said. “Management of the current and capital account will be carried out in such a way as to include or expand this element of self-insurance.”

To contact the reporter on this story: Bob Chen in Hong Kong at bchen45@bloomberg.net