The World Bank fires a warning shot across the dollar’s bow

Andrew Balls reports in the Financial Times that the World Bank ain’t too comfortable with the developing countries’ accumulation of dollar-denominated assets:

Developing countries that have amassed large US dollar reserves face a growing threat of big losses from a sudden decline in the dollar, the World Bank warned yesterday. In its 2005 Global Development Finance Report, the bank identified the “gravest risk” for emerging markets as a deep and disorderly dollar decline. This could create volatility, including a dollar collapse below what the bank’s economists see as its long-term equilibrium level. The result, it said, could be “a costly restructuring of world industry that would have to be undone in following years as the dollar returned to its equilibrium level”. But even in the event of a continued steady decline in the dollar the bank warned that countries with big dollar reserves faced capital losses, continuing the pattern of the past 2½ years. Foreign reserves held in developing countries rose from $292bn (€227bn) in 2003 to $378bn last year, the bank said in the report. Asia, and particularly China, accounted for much of this, but 101 of 132 developing countries increased their reserves last year. The report’s warning was echoed by the International Monetary Fund, the bank’s sister organisation, yesterday. Rodrigo Rato, IMF head, said: “A sharp increase in US interest rates would adversely affect the expansion and lead to a significant deterioration in emerging market financing conditions.”

The World Bank press release contains more direct warnings shots than those quoted in the FT:

[Uri] Dadush [Director of the Bank’s Development Prospects Group] says the US current account deficit is likely to hit six percent of GDP in 2005. “This is an unsustainable current account deficit level. The phasing out of that deficit will take forms that are very difficult to evaluate in advance. It will require some adjustment in interest rates. It will require some adjustment in exchange rates,” he says. Overall, Dadush says it could lead to a “significantly more turbulent financial environment for developing countries.” … But [François] Bourguignon, [the Bank’s senior vice president for Development Economics and Chief Economist], too sounds a warning about the risks facing developing countries. “We should also keep in mind that current global financial imbalances pose risks—of disorderly exchange rate movements, or of interest rate increases—that could threaten these gains. Developing countries need to prepare themselves for adjustments, some of which could be sudden,” he says. Dadush says it’s vital for developing countries to be ready to act. “History shows again and again that policy makers have been surprised by financial crises when they arise,” he says. “There is a tendency for financial markets and policymakers to miss the warning signs and overshoot, making the necessary adjustment larger when it does occur.”

Click here for the Bank’s full report, Global Development Finance 2005: Mobilizing Finance and Managing Vulnerability. Brad Setser has further thoughts on this topic as well:

The Bretton Woods 2 system of Asian reserve financing of the US continues, no doubt. But I also think it is fair to say that many — both in Asia and in the World Bank — are beginning to reassess the cost/ benefit ratio of this system.

Developing…. UPDATE: Last month Stefan Karlsson provided a nice backgrounder on the trade deficit for those who need a refresher. An the Economist has a nice backgrounder as well.