How should developing countries with large reserve funds invest?

Abstract

Emerging economies on account of their sustained GDP growth hold a substantial amount of the world’s total reserves. The growth of developing countries’ reserves has been heavily influenced by their precautionary desire to avoid future financial crisis. Some of the countries have accumulated reserves to hedge against currency fluctuations and maintain the competitiveness of their external trade. These reserves are more than what is needed to provide a comfortable insurance against financial flows and manage volatility which comes at a very high price. In the context of US Debt rating downgrade by S&P, moral hazard issue in Europe, volatile European Union, deflation plagued Japanese economy and the economic axis shifting away from Atlantic, the question of “Where to invest the reserve funds?” assumes greater significance. There is an imminent need for emerging economies to take deeper reforms in their financial architecture to maximize the risk adjusted returns. Since the end of last decade, the world has witnessed the paradox of developing countries lending their vast surpluses to the United States and, to some extent, to other developed countries. Investing these resources at lower yielding treasury bonds incurs a huge cost which is estimated to be approximately $300 billion a year calculated as a difference of returns between high yielding instruments and low yielding treasury bonds. This constitutes a massive transfer of financial resources from developing to developed countries. Thus, developing countries bear the price of global financial instability in the form of cost of reserves. The worsening global imbalances that led to some recent crises have also revived the need for reforming global monetary system. Developing economies with large stock of reserves thus need to call for financial reforms i.e. investment strategy of their surplus reserves which would decrease their dependence on dollar. The reforms at the same time should be counter cyclical so that increased liquidity can be provided in the times of financial crisis. Keeping both of these perspectives in consideration, we through this project have tried to study possible investment alternatives with optimal risk returns for excess reserves in developing countries and have proposed a broad investment strategy for the same. First phase of the project involves identifying the target countries for investments of reserves. Presently used ‘Euromoney’ and ‘EIU’ rankings for country risk ratings have been analyzed and the underlying determining variables are consolidated. High correlation between the two ratings validates the underlying variables under each rating. Each rating was regressed against the consolidated variables to deduce the actual determining variables. Second phase of the project concentrates on identifying the instruments and optimum allocation of portfolio. Certain percentages of these reserves in emerging economies are already being channeled through Sovereign Wealth Funds (SWF). Hence, we have drawn some parallels from the study of investment strategies of these SWFs. Analysis of investment strategies and returns of some major and high performing SWFs leads to our recommendations for investment of reserves in developing countries.