External Shocks and the Adequacy of Foreign Reserves: The Case of Mexico

Abstract

Recent research highlights the presence of significant increases in reserves accumulated by emerging market economies in the last decade and half. This is often viewed as the result of deliberated policies by governments wishing to insure themselves against the risk of balance of payments (hereafter, BOP) crises. Using Mexico as an example, this paper (i) explores the relative importance of external shocks as key determinants of the increase of foreign reserves accumulated since the 1990s, (ii) generates an empirical method aimed at assessing the adequacy of reserve holdings, and (iii) predicts BOP crises forced by external shocks. Using the returns on a set of international financial securities and oil variables to identify exogenous shocks to Mexico, I decompose foreign reserves into those driven by external shocks and those driven by policy targets. I argue that foreign reserves can be approximated as stationary functions of external shocks. In particular, I find that about 70% of the variation in foreign reserves can be replicated by a linear combination of the external shocks. Taking into account the effects of the exogenous shocks on reserves buildup, I develop a new approach to evaluate the adequacy of reserves policy, based on a concept of BOP sustainability that can accommodate a variety of future policy patterns, and allows the stock of reserves to influence the likelihood of BOP crises. According to this approach, aside from 1994, historically Mexico held an adequate level of reserves. However, although the reserves policy in place is adequate (i.e., effective) in the short run, a BOP crisis is more likely in the long run.JEL Classification: F31, F34, F37, G12, G15.