The task might however be easier for commodity exporters: their macroeconomic risks are clear, highly concentrated and hedging products are readily available on financial markets. Issues Impact on asset prices Under what conditions can sovereign asset management go hand in hand with orderly functioning of the financial markets? Large foreign reserve holdings are already seen to have an impact on asset prices. The strong preference for safety and liquidity in official reserves, combined with the fast increase in reserve assets, has often been given as an explanation for what Alan Greenspan first called a conundrum, namely the persistently low level of long-term interest rates. For instance, Warnock and Warnock 5 estimated that, under the hypothesis of “no foreign official flows into U.S. government bonds in 2005”, the 10-year Treasury yield would have been 90 basis points higher. Several alternative estimates exist and there are significant differences between them. But they consistently conclude at least some impact on long-term interest rates. As SWFs hold portfolios with higher risk/return profiles than the usual FX reserve management funds, many market economists predict that their development will result in additional demand for high-risk asset classes like equities and lower demand for low-risk assets classes like short-term government securities. This could in theory lead to an increase in bond yields (partly reversing the prior impact of official reserve accumulation) as well as a decrease in the equity risk premium.
Recently, Jeanne and Rancière 2 provided a “quantitative normative framework” to infer an optimal level for foreign exchange reserves in order to mitigate the impact of sudden stops of capital inflows. Their model, based on welfare criteria, suggests that the build-up of reserves has been excessive in Asian countries since 1997-1998. To be sure, the Asian crisis may have prompted emerging economies to reassess the magnitude of potential sudden stops and the subsequent output loss. Under widespread uncertainty, assessing an optimal level for foreign reserves confronts us with the problem of catastrophic events. In other words, even if the likelihood of a financial crisis may be very small, the potential consequences may be so dramatic that emerging countries could rationally accumulate very large reserves. 1  Dooley, M., Garber, P., and Folkerts-Landau, D. (2003) – An Essay on the Revived Bretton Woods System, NBER working paper ; (2007) – The Two Crises of international Economics, NBER working paper. 2  Jeanne, O. and Rancière, R. (2006) – The Optimal Level of International Reserves For Emerging Market Countries : Formulas and Applications, IMF working paper. 2  BIS Review 119/2007  Nonetheless, Jeanne and Rancière’s standard approach suggests that the level of reserves is in some countries excessive with respect to the self-insurance motive. Domestic monetary implications Excessive accumulation of foreign assets may lead to domestic financial imbalances. These can be caused by incomplete or ineffective sterilisation 3 .