In view of the relatively low levels of foreign equity assets and non-reserve foreign debt assets, the foreign assets of China and India are highly concentrated in official reserves, which respectively represent 67 percent and 82 percent of their total foreign asset holdings. As noted in earlier, these countries rank highly in the global distribution of official reserves – at the end of 2004 China and India were second and sixth, respectively, and together accounted for about 20 percent of global reserve holdings.

At the economic level, the rapid pace of reserve accumulation can be interpreted as the byproduct of a development strategy that seeks to promote export-led growth by suppressing appreciation of the nominal exchange rate. For the rest of the world, this has represented a beneficial terms of trade shock, with the increase in manufacturing exports from China leading to a reduction in relative prices and helping to moderate global inflation. For suppliers of inputs to China, the increase in export activity has generated an increase in demand, aiding producers of components in other Asian countries and commodity producers around the world.

On the financial front, the high level of reserves acts as a subsidy that lowers the cost of external finance for the issuers of reserve assets – primarily, the United States. In turn, this helps to keep interest rates lower than otherwise in these economies. For example, a careful empirical study by Warnock and Warnock (2006) estimates that the foreign official flows from East Asia kept U.S. interest rates about 60 basis points below normal levels during 2004-05. This also feeds into higher asset and real estate prices and a reduction in the domestic savings rate, helping explain the large U.S. current account deficit. Regarding the impact on other developing countries, the low global interest rates associated with high reserve holdings also have translated into a compression of spreads on emerging market debt, with the “search for yield” raising the attractiveness of emerging market destinations to international investors (IMF 2006).

There are several reasons to believe that the pace of reserve accumulation will start to decelerate. First, the accumulation of reserves comes at a significant opportunity cost in terms of alternative uses for these funds. For instance, Summers (2006) estimates that the opportunity costs for the world’s 10 largest reserve holders amount to 1.85 percent of GDP; Rodrik (2006b) calculates that the cost is near 1 percent of GDP for developing countries taken as a whole.<sup>28</sup> Because these countries comfortably exceed the reserve levels that are required to cover imports and debt obligations, the opportunity cost may be high relative to the insurance gains from building up reserves as a precaution against financial risks. Second, to the extent that inflows are not sterilized, the increase in domestic liquidity (shown in Figure 7) associated with reserve accumulation threatens the possibility of an asset and real estate price boom and misdirected lending in the domestic economy. Third, it is increasingly appreciated in China that rebalancing output growth toward expanding domestic consumption is desirable to raise living standards even faster and avoid the external protectionist pressures that have been building up in Europe and the United States. Fourth, the move to a more flexible exchange rate system might reduce

> 28 As an illustration, Summers (2006) assumes that these countries could earn a 6 percent social return on domestic investments; Rodrik (2006b) compares the yield on reserves to the borrowing costs faced by these countries.

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