International Reserves and Underdeveloped Capital Markets

Abstract

International reserve accumulation by developing countries is just one example of the puzzling behavior of international capital flows. Capital should flow to where its return is highest, which ought to be where capital is scare. Yet recent data suggest the opposite – net capital flows from developing countries to industrialized countries. This paper examines the role of financial market development in the accumulation of international reserves. In countries with underdeveloped capital markets the government’s accumulation of reserves may substitute for what would otherwise be private sector capital outflows. Effectively, these governments are acting as financial intermediaries, channeling domestic savings away from local uses and into international capital markets, thereby offsetting the effects of domestic financial constraints that lead to excessive private sector exposure to potential capital shortfalls.