International Reserves: Precautionary Versus Mercantilist Views, Theory and Evidence

Abstract

This paper tests the importance of precautionary and mercantilist motives in accounting for the hoarding of international reserves by developing countries, and provides a model that quantifies the welfare gains from optimal management of international reserves. While the variables associated with the mercantilist motive are statistically significant, their economic importance in accounting for reserve hoarding is close to zero and is dwarfed by other variables.Overall, the empirical results are in line with the precautionary demand. The effects of financial crises have been localized, increasing reserve hoarding in the aftermath of crises mostly in countries located in the affected region, but not in other regions. We also investigate the micro foundation of precautionary demand, extending Diamond and Dybvig (1983)'s model to an open, emerging market economy where banks finance long-term projects with short-term deposits. We identify circumstances that lead to large precautionary demand for international reserves, providing self-insurance against the adverse output effects of sudden stop and capital flight shocks. This would be the case if premature liquidation of long-term projects is costly, and the economy is de-facto integrated with the global financial system, hence sudden stops and capital flight may reduce deposits sharply. We show that the welfare gain from the optimal management of international reserves is of a first-order magnitude, reducing the welfare cost of liquidity shocks from a first-order to a second-order magnitude.

What explains global exchange rate movements during the financial crisis?

“…A widespread fear was that such an adjustment may occur suddenly and be rather disruptive (Krugman 2007). 1 In short, there was a fairly widespread expectation that a US dollar depreciation would play an important if not central role in the global adjustment process. However, as we now know, the adjustment process has taken a very di¤erent path with a collapse in asset prices and a massive deleveraging process among …nancial institutions being at the core of the crisis.…”

“…Figure 1 indicates that this appreciation trend of the US dollar has been present equally against exchange rates of advanced economies and emerging markets, Figure 2 shows that nevertheless the heterogeneity in bilateral exchange rate movements against the US dollar has increased signi…cantly after July 2008, implying that countries have fared very di¤erently with regard to exchange rate movements. 2 1 Of course there are also dissenting voices, arguing that the large US current account de…cit is the result of a natural outcome of …nancial globalization in general and a preference for US …nancial assets in particular (e.g. Cabellero et al 2008, Cooper 2008).…”

Reserve Holdings and Macroeconomic Variables: An Empirical Dynamic Analysis in Egyptian Economy

“…However, Aizenman and Lee, recognized that variables associated with mercantilist motives are statistically significant, but economically not important in explaining the patterns of holding reserves. In contrast, variables associated with precautionary motives (openness and exposure to financial crises) are statistically and economically important in explaining the holding of international reserves [9].…”

12. The Real Exchange Rate and Economic Growth: Some Observations on the Possible Channels

“…Recent research seems to support this view. Aizenman and Lee (2007) find evidence suggesting that international reserve accumulation in emerging markets has been carried out as a self-insurance strategy to protect the economy from sudden stops. Polterovich and Popov (2002) and Levi Yeyati and Sturzenegger (2007) find a positive correlation between foreign reserve accumulation and RER levels, and also between reserve accumulation and economic growth.…”