Recently, Jeanne and Rancière 2 provided a “quantitative normative framework” to infer an optimal level for foreign exchange reserves in order to mitigate the impact of sudden stops of capital inflows. Their model, based on welfare criteria, suggests that the build-up of reserves has been excessive in Asian countries since 1997-1998. To be sure, the Asian crisis may have prompted emerging economies to reassess the magnitude of potential sudden stops and the subsequent output loss. Under widespread uncertainty, assessing an optimal level for foreign reserves confronts us with the problem of catastrophic events. In other words, even if the likelihood of a financial crisis may be very small, the potential consequences may be so dramatic that emerging countries could rationally accumulate very large reserves. 1  Dooley, M., Garber, P., and Folkerts-Landau, D. (2003) – An Essay on the Revived Bretton Woods System, NBER working paper ; (2007) – The Two Crises of international Economics, NBER working paper. 2  Jeanne, O. and Rancière, R. (2006) – The Optimal Level of International Reserves For Emerging Market Countries : Formulas and Applications, IMF working paper. 2  BIS Review 119/2007  Nonetheless, Jeanne and Rancière’s standard approach suggests that the level of reserves is in some countries excessive with respect to the self-insurance motive. Domestic monetary implications Excessive accumulation of foreign assets may lead to domestic financial imbalances. These can be caused by incomplete or ineffective sterilisation 3 .

While theoretically feasible through issuance of central bank bills, large-scale sterilisation proves problematic in practice, especially in emerging economies, which are not always fully equipped with market-based policy instruments. In order to effectively control exuberant credit expansion, emerging economies have often had to recourse to large increases in reserve requirement ratios or even non-market policy instruments such as the rationing of credit. In a context in which credit and interest rates are largely administered, the fiscal cost of sterilisation can effectively be transferred to the banking sector, and ultimately to bank customers and stockholders; but that does not remove the opportunity costs of sterilisation for the private sector or the monetary risks of incomplete sterilisation. The bottom line is that in economies where largescale foreign asset accumulation needs to be sterilised, it is very likely that capital allocation efficiency will be reduced, especially if non-market instruments have to be used. Foreign reserves and international competition A second risk is that reserve hoarding may exacerbate trade competition and emphasise regional tensions. Emerging economies compete in their exports towards developed economies, as much as they compete with developed economies. As noted by Aizenman 4 “in a world with symmetric emerging markets competing in similar industries, competitive [reserve] hoarding tends to dissipate most competitive gains, leading to a “beggar-yourself” [outcome] and excessive hoarding”. By contrast “in an asymmetric world, an emerging market with low enough cost of sterilisation may win the hoarding war […] akin to the “beggar-thy-neighbor” outcome of asymmetric Tariff Wars”.