BIS Review 119/2007  3  Moreover, precautionary savings may be compounded in emerging economies that are characterised by greater macroeconomic instability. In addition, when the private sector has limited access to credit, agents have to rely on self-financing, whether for household purchases of durable goods or for corporate sector investment. What are the underlying mechanisms that cause these private savings to end up in public balance sheets? Such a substitution of public savings for private savings in emerging countries results from the interaction of two basic ingredients: incomplete financial markets and inflexible exchange rate regimes. Beyond credit constraints, a key feature of financial market incompleteness in emerging economies is the lack of domestic financial assets, such as fixed-income securities. As a consequence, a large share of these savings ends up in bank deposits. The other key ingredient is of course the exchange rate regime. In many emerging economies, trade surpluses reflect net foreign currency revenues. Capital account regulations sometimes involve surrender requirements of such currency-denominated income but more importantly, in a fixed or a pegged exchange rate regime, the central bank purchases foreign currency to prevent appreciation. The capital account regime and financial constraints of developing economies result in the central bank “borrowing” from the private sector as a domestic counterpart to the hoarding of international reserves. Banks naturally play a central intermediation role in this mechanism by taking deposits of private savings and purchasing sterilisation bills. That completes the mechanism of excess private savings being diverted into public holding of excess reserves.

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 .