Current account surpluses and growth: The role of foreign exchange reserves

Elitza Mileva, Fordham University

Abstract

The observation that developing countries which are net capital exporters tend to grow faster than developing countries that are net capital importers is an empirical puzzle in international economics. This paper's contribution is twofold. First, it addresses the capital flows and growth puzzle by showing that the accumulation of foreign exchange reserves has a statistically robust positive impact on growth. Second, the paper contributes to the policy debate on reserve hoarding by providing empirical evidence for three of the benefits of reserves for developing countries. ^ Chapter 2, which includes the preliminary work for a paper co-authored with Darryl McLeod, deals with the first one - reserve accumulation as a by-product of an active exchange rate policy. The study uses a variant of Matsuyama's (1992) two sector growth model to illustrate how a weaker real exchange rate can lead to productivity growth. With learning by doing in traded goods production, a weaker real exchange rate can lead to higher TFP growth as workers move into the traded goods sector. Based on TFP estimates for 58 countries, prepared by Bosworth and Collins (2003), the empirical estimates suggest that a weaker real exchange rate does raise TFP growth. In addition, I show that real depreciation raises domestic investment and, for countries with relatively underdeveloped financial markets, real exchange rate stability is also important for investment. ^ The second mechanism links foreign exchange reserve accumulation to higher domestic investment rates in developing countries. A large external debt burden (debt overhang) reduces the incentives to allocate more resources to future output and consumption. This paper demonstrates empirically that reserves help to reduce the debt overhang problem. Finally, I also show that reserves enhance domestic and foreign investor confidence, which in turn translates into higher domestic credit, to the private sector, larger foreign capital inflows, and lower sovereign spreads, all of which contribute to higher domestic investment. ^

Subject Area

Economics, General

Recommended Citation

Elitza Mileva, "Current account surpluses and growth: The role of foreign exchange reserves" (January 1, 2011). ETD Collection for Fordham University. Paper AAI3452801.
http://fordham.bepress.com/dissertations/AAI3452801

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