Managing Foreign-Currency Reserves in Emerging Markets

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In the past 15 years, a number of emerging nations have gained the ability to borrow abroad in their own currency. Historically, borrowing in foreign currencies created problems when unexpected shocks hit, as in the Latin American crisis in the 1980s or the Asian financial crisis in the late 1990s. Emerging nations prefer to borrow in their local currency because it reduces their exposure to risk. If an adverse shock hits the domestic economy, the currency can depreciate and the government’s debt burden will not increase. The problem is that risk-averse international investors charge a premium for debt in local currency.

Pursuit of a credible monetary policy is often cited as a key factor behind foreign investors’ increasing acceptance of local-currency borrowing by emerging-market nations. In Foreign Reserves Management and Original Sin (NBER Working Paper 30418), Michael B. Devereux and Steve Pak Yeung Wu find that accumulation and smart management of foreign-currency reserves also contributes to this acceptance. The combination of inflation-fighting monetary policy from central banks and foreign-currency reserves has given foreign investors increasing confidence in the stability of local currencies.


Emerging market governments that purchase foreign currencies when times are good can reduce overborrowing in good times and reduce the risk of currency depreciation following global shocks.

For decades, emerging market countries could only borrow in foreign currency, a risky move that was sometimes called “original sin.” In 2005, for example, the median country in the researchers’ 24-country sample had only 5 percent of its external sovereign debt denominated in its own currency. The data sample includes nations in Asia, Europe, the Middle East, and Latin America. By 2018, that median share in this group had increased to 38 percent. 

Consider Peru. Its central bank began targeting inflation in 2002. In 2004, the share of government borrowing in local currency began to rise. In 2006, Peru began dramatically boosting its reserves of foreign currency. By the end of 2019, the local currency share of government borrowing was 30 percent.

By building a small open-economy model and calibrating it using Brazil’s borrowing history, the researchers conclude that two-thirds of the rise in emerging markets’ local-currency borrowing can be attributed to inflation targeting, while the other third is due to foreign-reserve accumulation. And there are additional benefits of holding large reserves of foreign currencies that inflation targeting cannot achieve.

To secure the full benefits of reserve accumulation, emerging market governments must lean against the global wind. In calm periods, private households may overborrow in foreign currency. When a negative global shock hits, they cut back, causing exchange-rate depreciation. By buying foreign currencies when times are good and private households are overborrowing, the government can prevent the economy from becoming too leveraged. By spending down those reserves when households are cutting back on borrowing, the government keeps the economy from becoming too constrained during global shocks. This smoothing strategy reduces the risk of currency depreciation and explains why the economies of nations with large foreign currency reserves are less sensitive to global forces and pay less of a premium when they borrow in local currency.

— Laurent Belsie