This is one of the hot topics being discussed all around the world (others are sub-prime, global imbalances, sovereign wealth funds etc).
For a recent summary of the capital inflows read chapter 3of IMF’s recent global financial stability report. It has some good summary of how each country has responded to the increasing capital flows. The idea is the same – improve domestic financial systems so that they could absorb capital flows.
I have read number of papers and explanations on the relation between rising capital inflows and forex reserves but this one by Joshua Aizenman is quite good.
The general idea is that these countries are shoring upon their reserves to safeguard themselves from future crisis. He says:
While not a panacea, international reserves help by providing self insurance against sudden stops; mitigating REER effects of TOT shocks; smoothing overtime the adjustment to shocks by allowing more persistent current account patterns; and possibly even export promotion, though this mercantilist use of reserves remains debatable due to possible coordination issues. Countries following an export oriented growth strategy may end up with competitive hoarding, akin to competitive devaluations. The sheer size of China, and its lower sterilization costs suggests that China may be the winner of a hoarding game. Hoarding international reserves may also be motivated by a desire to deal with vulnerability to internal and external instability, which is magnified by exposure of the banking system to non performing loans. Testing the self insurance and precautionary motives in the context of China may be challenged by a version of the ‘peso problem.’ Hoarding international reserves and sterilization have been complementing each other during the last ten years, as developing countries have increased the intensity of both margins.
It has lots of insights on rising forex reserves in asian economies. Read on.