NEW YORK – A remarkable feature of the international financial system in the last decade has been the rapid and vast accumulation of foreign-exchange reserves by developing countries. World foreign reserves tripled from $2.1 trillion in December 2001 to an unprecedented $6.5 trillion in early 2008, according to IMF data.
Developing countries as a whole accounted for more than 80% of global reserve accumulation during this period, and their current level of reserves approaches $5 trillion. Half of this volume is concentrated in developing Asia, but Latin America and Africa have also been amassing international assets at a remarkable pace. This pool of reserves surpasses developing countries’ immediate liquidity needs, leading to their increased creation and expansion of sovereign wealth funds, which have an additional level of assets of more than $3 trillion.
The unprecedented increase in developing countries’ foreign exchange reserves is due both to their current-account surpluses and large net capital inflows. Practically all developing countries’ reserves are invested in developed countries’ assets, leading to an increasing net transfer of resources from the developing to the developed world, which, according to UNDESA estimates, reached $720 billion in 2007 alone.
Although economic growth and poverty reduction in many developing countries has been impressive in recent years, a significant increase in investment in areas such as infrastructure is required to sustain such growth in the future. We propose that a very small portion of developing countries’ total foreign-exchange reserves – say, 1% – be channeled to the expansion of existing regional development banks or the creation of new ones that would invest in infrastructure and other crucial sectors.
Indeed, infrastructure investment is recognized as a key ingredient in sustaining and accelerating growth. However, there is a large financing gap. According to the World Bank, developing countries spend an average of 3-4 % of GDP on infrastructure every year, compared to an estimated 7% of GDP required to meet existing infrastructure needs for maintaining rapid growth. This translates into an annual gap of at least $300 billion at current prices.
High expectations for private-sector financing of infrastructure have gone largely unmet. Private investment remains limited and concentrated by both country and sector. National governments still account for the large majority of financing. Official development assistance and multilateral bank lending, though valuable, remain insufficient. In particular, there are large gaps in the provision of crucial regional and cross-border investments, for example in energy and roads.
Multilateral financial institutions must maintain their central function in the international development architecture, and in particular in financing infrastructure investment. But regional and sub-regional financial institutions owned by developing countries can and should play an important and valuable complementary role. These institutions give a greater voice and sense of ownership to developing countries, are more likely to rely on moral suasion rather than conditionality, and tend to benefit from smaller information asymmetries.
Moreover, regional and sub-regional development banks are particularly suited to provide regional public goods. The growing importance of trade integration and regional trade flows makes the provision of regional infrastructure urgent. The European experience offers valuable lessons in this regard. Trade integration was initially supported by massive investments in regional infrastructure, financed to an important extent by a large, specifically created institution, the European Investment Bank.
If developing countries allocate only 1% of their foreign exchange reserves to the paid-in capital of regional and sub-regional institutions, this would amount to $50 billion at current levels of reserves. Assuming a ratio of loans-to-capital of 2.4 times – an estimate based on the ratio of the successful and financially sound Andean Development Corporation – the expanded regional and sub-regional development banks or new ones could generate additional lending of approximately $120 billion.
With time, they could leverage retained earnings, increasing their lending potential without additional paid-in capital. This would imply the ability to finance an important proportion of unmet needs for infrastructure financing.
Based on these initial calculations, the additional lending capacity generated would be significantly larger than total disbursements currently made by existing multilateral development banks. Obviously, more detailed calculations and analyses are required, along with discussions with governments, existing institutions, rating agencies, and other stakeholders.
By expanding or creating new regional and sub-regional financial institutions, developing countries could lay the basis for their own current and future lending capacity, which would eventually help them meet their development goals. Given their large foreign-exchange reserves, we believe the time to begin such an initiative is now.