real exchange rate to preserve export competitiveness<sup>4</sup> . The best way is to achieve this is by compressing domestic spending, particularly consumption, which inevitably leads to persistent current account surpluses and foreign reserve accumulation. This strategy defines the so‐called 'Bretton Woods II' system (see Dooley, Folkerts‐Landau and Garber, 2004), in which emerging Asian countries play the role of producers of last resort, and advanced countries – led by the United States– are the consumers of last resort whose current deficits are financed by capital inflows from Asia.

Under appropriate circumstances, the mercantilist strategy may succeed in accelerating economic growth. However, its merits from the welfare standpoint are questionable, because large‐scale accumulation of external (and typically low‐yield) assets involves major opportunity costs in terms of foregone consumption and investment; see Korinek and Servén (2010) for details. Nevertheless, as long as Asian emerging markets stick to the export‐led strategy, Bretton Woods II can remain in operation indefinitely.

Another variant of this argument justifies the accumulation of external assets as a precautionary policy<sup>5</sup> . In the absence of mechanisms for international diversification of aggregate risk, emerging countries integrated in the global financial system need to resort to self‐insurance against external shocks such as disruptions of international capital flows– of the kind observed in the crises of Asia and Russia in the 1990s. They accumulate external assets, preferably short‐term instruments, from which they can draw in the event of a ‘sudden stop’. Unless the global financial system generates new international diversification mechanisms, this precautionary foreign asset accumulation is unlikely to stop.

What does the evidence say about the empirical validity of these arguments? The massive accumulation of international reserves of emerging economies during the last decade seems to confirm that the policy of deliberate hoarding has played an important role. Figure 6 illustrates the evolution of the international reserves of industrial and emerging countries. Between 1998 and 2008, reserve holdings of the latter, measured at constant prices, increased fourfold, while those of industrial countries rose only 50 percent. As a result, the volume of international reserves held by emerging markets at present greatly exceeds that of industrial countries. For example, at the end of 2008, China’s foreign reserve stock was almost as large as that of all industrial countries combined. The rest of emerging Asia has also increased dramatically its

> 4 For example, for the case of China, Cline and Williamson (2008) survey existing estimates of the equilibrium value of the renminbi. Only one of the 18 studies in their survey concludes that the renminbi is overvalued. On average, the estimates indicate substantial renminbi undervaluation—on the order of 20 percent for the real effective exchange rate and 40 percent for the bilateral renminbi‐dollar exchange rate

> 5 This of course is closely related to the explanations based on asset demand of Mendoza, Quadrini and Rios‐Rull (2007) and Carroll and Jeanne (2009) summarized earlier. In both cases, the underlying force is the lack of adequate insurance mechanisms. The main difference is that now the focus is on country‐level insurance against external shocks, rather than individual insurance against idiosyncratic shocks.

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