Insurance underwriter or financial development fund: what role for reserve pooling in Latin America?

Abstract

Abstract The unprecedented accumulation of international reserves by emerging markets raises the question of how to best utilize these funds; in particular if they should be held as a war chest to guard against the risk of financial crisis or if they should be used to recapitalize and strengthen weak banking systems. A third issue is if the resource cost could be limited by pooling the holdings of different central banks and if so, to what objectives should this reserve pool be put. This paper considers these questions with reference to the countries participating in the Latin American Reserve Fund (FLAR). It explores two routes through which the pooling of reserves through FLAR could enhance stability and welfare in Latin America. First, the reserve pool could be used for emergency lending in response to sudden stops. Insofar as the incidence of sudden stops differs across countries, pooling would allow the same reserves to support a larger volume of emergency lending. However, the paper discusses how such a scheme would face significant obstacles due both to the bunching of sudden stops temporally and regionally and to moral hazard problems which are stronger in the case of self-regulating entities like FLAR. The second, more promising alternative that the paper analyses, is the use of a portion of the reserve pool, along with borrowed funds, to purchase contingent debt securities issued by Latin American governments and corporations: domestic-currency inflationindexed bonds, GDP-indexed bonds, commodity-price-indexed bonds. This would help to solve the coordination/first-mover problem that limits the liquidity of markets in these instruments and hinders their acceptance by private investors. In any case, the idea is that neither initiative should be thought of in stand-alone terms. In addition to creating an expanded reserve pool for use in emergency lending, governments could also push ahead with issuing contingent debt securities that reduce their vulnerability to disturbances.