  as precaution against possible abrupt capital outflows (the “sudden stop” syndrome)    and, finally, to provide liquidity to domestic financial institutions. (Obstfeld et al. 2009). That use of foreign exchange reserves was especially apparent in 2008 when Central Banks in many emerging (and some industrialized) countries put those reserves at work to ease domestic tensions created by dollar liquidity shortages. The costs of holding reserves are also well identified:   intermediation of national savings by a public entity is never neutral. By nature, those entities don’t have the same risk appetite and liquidity preference as private agents. A significant part of national savings (up to 30% in some countries) might find itself subject to a “directed” allocation towards liquid instruments denominated in foreign currency.   as a consequence, there is a direct opportunity cost because foreign exchange reserves’ risk / return profile may be lower than for other, alternative, investments.   finally, as reserves accumulate, countries are getting increasingly exposed to exchange rate risk and face the possibility of significant valuation losses. This kind of cost / benefit analysis seems less and less able, however, to account for the true behavior of reserve holders. First there may be immeasurable, but very powerful, benefits such as increased security, lower external interest rates and lower exchange rate variability over the long run. Second, part of the costs may be borne by the system itself and not fully internalized by each individual country.

Rather, they would be “frozen” and unblocked only in pre – specified circumstances (Landau, 2009). Criteria for use would not be defined on the basis of individual countries’ situations, but on consideration of the conditions prevailing in the global economy and international capital markets. If properly constructed, such a scheme may provide, for no cost, the kind of insurance that countries are currently seeking by building excess reserves. How would countries access to this new source of liquidity? The traditional approach would allocate contingent liquidity to countries according to their quota shares in the IMF. However, those are very imperfect representations of countries’ liquidity needs especially in times of crisis. Taking inspiration from the contingent capital literature, one could imagine that countries could “buy” the access to contingent liquidity in crisis times by paying, in normal times, a premium to the issuer (the IMF?). This could prove less costly than accumulating excess reserves. Going one step further, and transposing an idea from Caballero and Kurlat (2009), the IMF could issue tradable instruments giving access to contingent liquidity once it has been activated. If broadly traded between public entities, the price of such instruments would give a useful indication of underlying systemic tensions in international financial markets. Regional arrangements Another approach would privilege regional arrangements either for pooling reserves or redistributing them though permanent swap agreements. Asian countries, especially, are working on and implementing progressively such schemes through the Chiang Mai initiative.