Commentary: Emerging markets drive forex reserves

Last week, The Economist published a survey of the world economy, confirming what many economists have been arguing for years- that emerging markets will provide most of the world’s economic growth going forward. Led by the BRIC nations (Brazil, Russia, India, and China), emerging markets are projected to grow by 6.8% this year. These nations already consume half of the world’s energy, produce half of all exports, and contain 2/3 of the world’s population. Now, you might be wondering: what are the implications of this phenomenon for forex markets.

A few weeks ago, I argued that emerging market currencies are currently undervalued and represent attractive alternatives to the world’s major currencies. This week, I would like to explore a different effect of the rise of emerging markets: surging forex reserves. The world’s developing countries currently hold $2.7 trillion in foreign exchange reserves, the majority of which is held in USD-denominated assets. The ultimate cause of this surge is clearly strong economic fundamentals. The proximate causes, however, are more complicated.
First, the members of OPEC and other nations rich in natural resources have found themselves inundated with cash due to soaring commodity prices. However, the capital markets in these countries provide few opportunities to invest these proceeds, so countries have turned around and reinvested their windfall into American assets, notably equities and government securities. Second, since developing countries run a combined $500 Billion current account surplus, they have found themselves awash in foreign currency. In order to prevent their currencies from appreciating, they prevent this currency from circulating by holding it in reserve.
Now that we understand why the global stock of forex reserves is expanding, let’s explore why it matters. One of the only reasons that the USD has not plummeted in value as its current account deficit has ballooned is that foreigners largely remain willing to finance the deficit. If countries suddenly decide that they either want to inject their foreign currency into their economies (which would deplete their reserves) or if they decided to diversify their reserves by holding a larger fraction of them in non-USD-denominated assets, the USD would certainly suffer.