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Almost a free lunch: Lawrence Summers at the World Bank

Ignacio Hernandez's picture

Lawrence Summers delivered today at the World Bank his presentation “Almost a Free Lunch: Investing Foreign Exchange Reserves in Global Equity Markets”, following similar presentations at the Reserve Bank of India in Mumbai or at the Center for Global Development in Washington DC.


Mr. Summers claims that the flow of capital today is exactly the opposite of what the “International Financial Architecture” had in mind after the World War. Today we see a net flow of capital from the poorer to the richer countries. In particular, large amounts from developing countries are being accumulated as reserves in US Treasury Bonds.


He sees two main problems here:

  1. The amounts that are being kept as reserves in developing countries are too big.

  2. These reserves in US Treasury Bonds have a very low real rate of return, close to zero.

The gap between the return obtained at a typical central bank or what could be obtained with a typical pension portfolio or in stock is around 4 % or 5 % respectively (this gap would be of around 10 % if compared to the return of Harvard’s endowment while he was President).


Therefore, we have some of the most rapidly growing economies in the world, with high percentages of their populations living in poverty, with a “fair amount of money deployed in clearly suboptimal investment”.


And what is the cost of this excess of reserves invested in low yielding US Treasury Bonds? The excess of reserves for the 121 developing countries is, according to Mr. Summers,  around $ 2 trillion, or 19 % of their combined GDP. If developing countries where able to deploy 10 % of their GDP in global equity markets that produced a 5 % extra return, the amount earned would clearly exceed the amount spent in foreign aid worldwide.


Food for thought …


Submitted by Oupoot on
CATCH-22 FOR DEVELOPING COUNTRIES I fully agree with Mr Summers' comment. However, developing countries face a catch-22 situation, especially China, Japan and other large foreign reserve accumulators. If they were to disinvest from US Treasury Bills, their own currencies would appreciate, reducing the value of their remaining reserves beyond just the value of reserves sold. Very much like a broker selling some of his/her equities in a company, which result in a lower stockprice and lower value of the remaining stocks. This is amplified if this triggers a run on the stock/currency, a very real possibility considering the precarious situation of the US economy. The appreciation of the local currency would also reduce the competitiveness and profits from their exports in local currency terms. This in turn would reduce employment growth if not turn it negative, and with that the return the society gets from economic and employment growth. Thus, though the country will get a higher return on their foreign reserves, they will get a lower domestic social return on those same reserves. What happened in South Africa between 2001 and 2005 is a case in point to a limited degree. So, it is true that developing countries need to seriously divest their foreign reserves to reduce the ever increasing risks that this is bringing, as well as earn a higher return on these investments. But the dynamic processes of the market requires them to walk a tight line, otherwise they may actually reduce the local social benefits of those reserves too much, below the private return on investment, resulting in slower economic growth and slower employment growth, if not an absolute decline. At the same time, they cannot let the risks increase so much that the only way out is a large crash. It is easier said than done Mr Summers. Economics is much more an art than a science.

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