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Holding International Reserves in an Era of High Capital Mobility
... It is seen that four groups of independent variables are used in the empirical literature to explain the reserve holding behavior of countries (Mwase, 2012): a) Variables reflecting current account risks: Import and export items are the most used variables in measuring the impact of external shocks on the current account balance. Studies in the literature reveal that import and export volatility are positively related to prudential reserve demand (Cheung and Ito, 2009;Aizenman and Marion, 2003;Flood and Marion, 2002). In addition, openness of countries was used as an independent variable in some studies (Aizenman et al., 2004). ...
... d) Opportunity cost: Although the studies in the literature reveal that reserve demand is negatively related to the opportunity cost of the reserve holding, it is argued that this effect is small. On the other hand, it is difficult to accurately calculate the opportunity cost of reserve holding (Flood and Marion, 2002;Dabla-Norris et al., 2011). ...
In this study, with the help of panel data analysis, the determinants of
reserve accumulation behavior were estimated for different developing
country groups. According to the findings, the channels leading to prudential
reserve holding differ between country groups. Based on these findings, it is
assessed that the IMF metric, which is frequently used in measuring the
reserve adequacy of developing countries and comparing these countries, can
be revised. The IMF metric is a general measurement that was built in 2011
by combining traditional metrics. Developing countries are advised to revise
the metric, considering their own risk channels. In this context, the empirically
revealed risk channels in the study will help to reassess the IMF metric and to
measure the reserve adequacy of the country groups more confidently.
Other external debt, representing foreign debt with a maturity of more
than one year, is an important channel in the IMF metric, and has become
more important after the 2008 global financial crisis. However, it has not been
considered as an explanatory variable in empirical studies on reserve holding.
In this study, it has been revealed that this channel is statistically significant
and also its effect on country groups has been compared. Considering this
channel in future studies will provide a more accurate estimation of the
dynamics of reserve accumulation.
Considering the opportunity cost of reserve holding, developing
countries may prefer to control their risk channels after identifying their
specific risk channels for reserve demand, instead of being in a competition to
accumulate reserves. In this case, by using their reserves in more productive
areas, they can affect their growth rates positively and avoid incurring
unnecessary costs.
... Though these countries gradually amassed enormous reserves with time, all economies including those in the SADC have become more market-oriented than centrally regulated. This has defied key tenets of the central bank intervention model which postulates that the wish to hold international reserves is justified only when countries pursue fixed exchange rate regimes in which case central banks are expected to intervene in the market to counteract any speculative attacks and defend parities (Bastourre, Carrera & Ibarlucia, 2009;Batten, 1982;Flood & Marion, 2002). This means that as SADC countries become more liberalized, other things held constant, stocks of reserves are expected to decline as shocks will be self-absorbing and hence there will be little or no need for market intervention. ...
... It was observed that opportunity cost must be defined as the spread between the interest rate at which countries can borrow from abroad and the London Interbank Offered Rate (LIBOR). Later studies include Flood and Marion (2002) who presented a comprehensive extension of Frenkel and Jovanovic's (1981) study by modifying not only how volatility is measured, but also incorporating financial crises. Volatility was found to have a significant positive impact on reserve hoardings from this study. ...
What explains the unprecedented high levels of foreign reserves accumulated in the Southern African Development Community (SADC)? This study seeks to econometrically establish the key determinants of such high levels of reserves. To do so, the study adopts two panel estimation techniques: the Blundell-Bond System Generalized Method of Moments (GMM) and the Bias-Corrected Least Squares Dummy Variable (LSDVC). The regression results show evidence of precautionary (mainly reserves volatility) but not mercantilist motives in the SADC region. Inertial and opportunity cost elasticities of reserves demand are observed to be inelastic in both econometric models at about 0.85 and-0.70 respectively. The GMM identifies membership to the Common Monetary Area (CMA) as a significant factor, as member countries of these sub-groupings demand more reserves to meet subsequent reserve targets. In addition, while GMM results reveal a U-shaped relationship between reserves hoarding and national income, the LSDVC finds income to have no influence on demand, an observation attributed to strength of instruments within the GMM. From the regression results, the study finds that empirical works on demand for reserves need to clearly distinguish between the alternative measures of reserves-either including or excluding gold; a measurement difference that has typically been ignored in the literature. Various policy implications are drawn from the results.
... In particular, the rate of return from holding IR should be lower than investing in other financial tools, including domestic investment, especially for developing countries. Economic theory generally suggests that IR should be negatively correlated with the opportunity cost of holding it; however, the empirical evidence is scant, due to the difficulty in assigning a single interest rate for IR holding while accounting for the associated risks (Flood and Marion 2002;Dabla-Norris et al. 2011). One study found the correlation between IR holding and its opportunity cost insignificant for advanced economies but relevant for emerging markets in the past; however, the rise in reserve holding in recent years has essentially eliminated this effect (IMF 2017). ...
We evaluate the change in international reserves in the aftermath of significant external shocks by using a quasi-experimental setup and focusing on earthquakes. Our objective is to understand the macroeconomic dynamics of quake-affected countries ex-post, and their ex-ante disaster risk mitigation strategies. The estimation is done on a panel of 103 countries over the period 1979–2016. We find that in the five years following a large earthquake: (i) Countries exposed to it accumulate reserves ex-post for precautionary reasons, supported by the inflows of foreign assistance and money expansion; (ii) Quake-prone countries tend to hold fewer reserves relative to the non-prone countries, suggested by the richer set of other disaster preventive measures in place for the former; (iii) The patterns of reserves holding post-earthquake vary with a country’s income level and other macroeconomic fundamentals.
... Departing from the previous literature, Lizondo and Mathieson (1987) show that the difficulties of external payments and diminishing access to international financial markets accompanies the variations in the estimated demands of forex reserves. Flood and Marion (2002) investigates the reasons of reserve accumulation and studied that the need of forex reserves holdings against the backdrop of increase in financial volatility and diminished faithfulness to fixed exchange rates. The key findings suggest that the efficacy of exchange rate stability, nation's financial openness, and opportunity cost explains around 40 per cent of the discrepancy in the countries' forex reserves holdings. ...
In this study, we examine whether foreign currency borrowings by the corporate sector acts as a determinant of international reserves holdings by the central bank of India and discuss on the adequacy of forex reserves. Departing from the previous studies, we employ the ARDL model, we show that forex reserves accumulation by the RBI is because of mercantilist motives and there is no evidence that such accumulation of forex reserves provides implicit guarantee for the firms to borrow in foreign currency. The central bank will accumulate forex reserves keeping in view the money circulation in the economy, current account and capital account volatility. These results endorse the existing policy framework of the central bank on the reserves accumulation and external commercial borrowings by the corporate sector.
The Reserve Bank of India often claims that the official intervention in the foreign exchange market primarily aims at minimizing undue fluctuations in the exchange rate and this study is an attempt to explore the success story of such interventions. Although the stylized facts seem to indicate that maintaining adequate amount of official reserves help reduce the volatility, the marginal benefit of adding reserves in terms of containing excessive volatility declines as the level of reserve holding increases beyond certain threshold level. The evidence from a threshold vector autoregression model suggest that the response of exchange rate volatility is conditional upon the size of intervention and whether the level of reserve holdings is above or below certain threshold level. While the official purchase of foreign exchange reduces the variability of exchange rate, official sale seems to trigger volatility irrespective of whether reserve holding is above or below the threshold level. Further, a positive shock to absolute official sale (purchase) could reduce the pace of depreciation (appreciation) although it could not revert the direction of exchange rate. These evidences exemplify the fact that intervention cannot prevent exchange rate volatility from rising rather it can only moderate.
This paper analyzes the effect of remittance inflows on external debt in developing countries, by identifying international reserves as a potential transmission channel. Using panel data over the period 1970–2017 and covering 50 low-and middle-income countries worldwide, we find a positive and significant effect of remittance inflows on the external debt-to-GDP ratio. We also find a negative and significant effect of international reserves on external debt. After controlling for international reserves, the effect of remittance inflows on external debt increases; it remains positive and significant. The results suggest that the role of international reserves as a self-insurance mechanism, and the Dutch disease effect related to remittance inflows are at play. In addition, we find negative and significant effects of economic growth and savings-investment gap on external debt. We also find positive and significant effects of the nominal exchange rate and the United States lending interest rate on external debt. We discuss the policy implications of these findings, while highlighting factors that policymakers should focus on for containing external debt in developing countries in the post-COVID-19.
The steady depletion of Nigeria's foreign reserves has raised serious concerns for economic blueprints and policy interventions for economic prosperity. With the autoregressive distributed lag technique, we interrogated foreign reserves effects of different interest rates using time series data for the period 1990 to 2020. Results show that effects of monetary policy rate on foreign reserve were not significant though it was negative in the short run but turned positive in the long run. Bond rate effect on foreign reserve was positive but not significant in the short run and negative but significant in the long run. Treasury bill rate and US federal fund rate had positive but no significant effect on foreign reserves in both long run and short run. We found interest rate differential to have positive and significant effects on foreign reserves both in the long and short run. We recommend that Nigeria's monetary authority should ensure a significant interest rate differential among similar interest rates with considerations for monetary policy and treasury bill rates if the intention is to increase foreign reserves in the long run, while considerations should be for government bond rate if the intention is to increase foreign reserves in the short run.
In the context of a managed float regime, we adopt the portfolio balance view to show the effects of the net foreign assets of an economy and its gross international reserves level on interest rate differentials. We argue that the interest rate differential can be explained by three components, where the components are the expected depreciation of the domestic currency, a default risk premium, and a portfolio balance premium. Our theoretical analysis suggests that the interest differential is a convex function of the level of gross international reserves. In particular, the differential and gross reserves are inversely related at low levels of reserves, but positively at higher levels. We evaluate our framework for the case of Lebanon. We find that the differential is inversely related to both net foreign assets and gross international reserves. These findings are then confirmed with data from Indonesia and Mexico.
Financially closed economies insure themselves against current-account shocks using international reserves. We characterize the optimal management of reserves using an open-economy model of precautionary savings and emphasize several results. First, the welfare-based opportunity cost of reserves differs from the measures often used in the literature. Second, under plausible calibrations the model is consistent with the rule of thumb that reserves should be close to three months of imports. Third, optimal linear rules can capture most of the welfare gains from optimal reserve management, but significantly differ from certainty equivalence. Fourth, policymakers should place more emphasis on how to use reserves in response to shocks than on the reserve target itself.
This paper investigates the drivers of reserves in emerging markets (EMs) and small island (SIs) and develops an operational metric for estimating reserves in SIs taking into account their unique characteristics. It uses quantile regression techniques to allow the estimated factors driving reserves holdings to vary along the reserves’ holding distribution and tests for equality among the slope coefficients of the various quantile regressions and the overall models. F-tests comparing the inter-quantile differences could not reject the null that the models for the different quantiles of SIs reserve distribution were similar but this was rejected for EMs distribution suggesting that models explaining drivers of reserve holdings should take into account the country’s reserve holdings. Empirical analysis suggests that the metric performs better than existing metrics in reducing crisis probabilities in SIs.
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