# **1 Introduction**

Over the past decades, a number of emerging economies, notably in Asia, have experienced fierce economic growth, while also accumulating large amounts of foreign reserves.<sup>1</sup> These observations contrast with standard neoclassical open economy growth models in which economies with rapid productivity growth are predicted to run current account deficits so as to import capital and accelerate the buildup of the domestic capital stock (see e.g. Gourinchas and Jeanne, 2007, for a critical analysis).

The literature has proposed two main categories of explanations for these facts: First, reserve accumulation might be a form of precautionary savings to insure against future country-specific adverse shocks.<sup>2</sup> However, it has been difficult to reconcile the massive amounts of reserves observed in the data with realistic magnitudes of shocks that a country might want to insure against.<sup>3</sup> According to a second category of explanations, much of the recent reserve accumulation in Asia results from a form of “neo-mercantilist” policy to increase net exports so as to enhance economic growth, as argued for instance by Dooley et al. (2003) or Rodrik (2008).<sup>4</sup> These papers argue that developing countries might enjoy learning-by-doing externalities in the spirit of Arrow (1962) and Romer (1986). A policy of fostering exports by undervaluing the real exchange rate through foreign reserve accumulation would increase domestic production and lead to dynamic welfare gains due to these externalities.

The subject of our paper is to develop a formal dynamic model of the welfare effects of real exchange rate undervaluation and to assess the desirability of reserve accumulation and real exchange rate undervaluation as a second-best instrument to internalize such learning-by-doing externalities.<sup>5</sup> Our setup is based on the notion that reserve accumulation and undervaluation solve a targeting problem: In a first-best world with a full set of instruments, government would like to subsidize investment to induce agents to internalize their learningby-doing externalities. However, if policymakers face difficulties in targeting productive investment opportunities, an alternative mechanism is needed. By lending to for-

> 1China, for example, was sitting atop of USD 2.4 trillion of official foreign reserves by early 2010 - a whopping 49% of its GDP, and experienced growth of more than 9% on average over the past decade (data from the People’s Bank of China). Its performance on both measures was followed closely by other Asian tiger economies such as Taiwan and South Korea.

> 2See e.g. Aizenman and Marion (2003), Durdu et al. (2009), Mendoza et al. (2009) or Carroll and Jeanne (2009) for proponents of this view.

> 3This is discussed e.g. in Jeanne and Ranci`ere (2009). However, see Carroll and Jeanne (2009) for a more positive assessment.

> 4Mercantilism was a widespread view among economic thinkers in Europe during the period of 1500 – 1750 and is still a frequent argument in the public discourse among non-economists.

> 5For the purposes of this paper, we equate the term “reserve accumulation” to “real exchange rate undervaluation,” since reserve accumulation in our model of closed capital accounts requires that more tradable goods are exported, which makes tradable goods in the domestic economy scarcer and depreciates the real exchange rate.

2