Undervaluation Through Foreign Reserve Accumulation: Static Losses, Dynamic Gains

42 Pages Posted: 20 Apr 2016

See all articles by Anton Korinek

Anton Korinek

University of Virginia; National Bureau of Economic Research (NBER)

Luis Servén

CEMFI

Date Written: March 1, 2010

Abstract

This paper shows that real exchange rate undervaluation through the accumulation of foreign reserves may improve welfare in economies with learning-by-investing externalities that arise disproportionately from the tradable sector. In the presence of targeting problems or when policy choices are restricted by multilateral agreements, first-best policies such as subsidies to capital accumulation, or subsidies to tradable production are not feasible. A neo-mercantilist policy of foreign reserve accumulation "outsources" the targeting problem or overcomes the multilateral restrictions by providing loans to foreigners that can only be used to buy up domestic tradable goods. This raises the relative price of tradable versus non-tradable goods (i.e. undervalues the real exchange rate) at the static cost of temporarily reducing tradable absorption in the domestic economy. However, since the tradable sector generates greater learning-by-investing externalities, it leads to dynamic gains in the form of higher growth. The net welfare effects of reserve accumulation depend on the balance between the static losses from lower tradable absorption versus the dynamic gains from higher growth.

Keywords: Economic Theory & Research, Debt Markets, Currencies and Exchange Rates, Access to Finance, Emerging Markets

Suggested Citation

Korinek, Anton and Servén, Luis, Undervaluation Through Foreign Reserve Accumulation: Static Losses, Dynamic Gains (March 1, 2010). World Bank Policy Research Working Paper No. 5250, Available at SSRN: https://ssrn.com/abstract=1579213

Anton Korinek (Contact Author)

University of Virginia

1400 University Ave
Charlottesville, VA 22903
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Luis Servén

CEMFI ( email )

Casado del Alisal 5
28014 Madrid
Spain

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