September 29, 2004

Can Developing Countries Afford to Hold Dollar Reserves?

IMF Warnings of Dollar's Overvaluation Should be Heeded, Say Economists

For Immediate Release: September 29, 2004

Contact: Debbi Karr, 202- 387-5080   

When the G-7 finance ministers meet in Washington later this week, followed by the IMF and World Bank meetings, exchange rates will be on the agenda. In a new Center for Economic and Policy Research (CEPR) report, "Going Down with the Dollar: The Cost to Developing Countries of a Declining Dollar " by Mark Weisbrot, David Rosnick, and Dean Baker, the authors find that developing countries can be expected to incur substantial losses from holding dollar reserves. These losses are comparable with the gains that developing countries would get from complete trade liberalization by the rich countries, including the removal of all rich country barriers to developing countries' merchandise exports.

"The IMF has been warning that the dollar is overvalued, but they should do more," said CEPR co-Director Mark Weisbrot, a co-author of the report. "The institution was established 60 years ago to manage global exchange rates, and these are seriously out of alignment right now."

Developing countries now hold an amount of reserves that is on average more than 10 percent of their GDP, and in many cases exceeds 20 percent of GDP. The current overvaluation of the dollar, and thus its impending decline, means that those countries that hold large amounts of dollar reserves will not see the expected return from holding those reserves.

The dollar is widely recognized to be seriously over-valued. The United States current account deficit expanded to $660 billion in the second quarter of 2004, or 5.7 percent of GDP. This deficit can only be brought down to a manageable level through a sharp decline in the value of the dollar.

Looking at a sample of reserve holdings among developing countries, the authors find that the drop in the dollar will lead to a loss in the value of reserve holdings of between 1.8 percent and 5.6 percent of GDP, for the typical country examined.

These are enormous potential losses, but easily preventable. If developing countries simply traded the bulk of their dollar reserves for a currency more likely to maintain its value, such as the euro or the Japanese yen, they could insulate themselves from the effects of a falling dollar.