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.

Macro Prudential Supervision in the Open Economy, and the Role of Central Banks in Emerging Markets

“…Final output is produced at period 2. The second period output finances the repayment of outstanding debt left to maturity, 18 Our model extends Aizenman and Lee (2007). It follows the tradition of Bryant (1980) and of Diamond and Dybvig (1983) in that the source of liquidity shock lies with the lender, rather than the borrower (Holmstrom and Tirole 1998).…”

“…The fear of floating may also provide an interpretation for the massive hoarding of IR during the last 10 years by EMs and other developing countries. Alternative explanations of IR hoarding however include the precautionary and/or mercantilist motives (Aizenman and Lee 2007), as well as the reincarnation of the Bretton Woods system (Dooley et al 2009). The present crisis imposes daunting challenges to EMs.…”

“…However, financial integration added the need to self-insure against volatile financial flows. By the nature of financial markets, the exposure to rapidly changing demands for foreign currency triggered by financial volatility exceeds the one triggered by trade volatility [see Aizenman and Lee (2007)]. 8 Estimating the benefits of hoarding IR between 2000 and 2005 in terms of crisis prevention, Jeanne (2007) concluded that, on average, the cost of IR accumulation exceeded the benefits by a factor of three.…”

Sovereign Default, Debt Restructuring, and Recovery Rates: Was the Argentinean “Haircut” Excessive?

“…); z t is the stochastic component of income, and depends on the state of the world (see below for details); and s t is debt service in period t. It is assumed that s t ≥0; that is, the 39 SeeAizenman and Lee (2007) for an analysis of the role of international reserves in debt crises. See, also,Reinhart and Rogoff (2010).…”

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

“…3 The existent studies claim that this accumulation is motivated by a large precautionary demand, providing self-insurance against the adverse output effects of sudden stops and capital flight shocks. For instance, Aizenman and Marion (2003), Bird and Rajan (2003), Aizenman, Lee, and Rhee (2004), Gosselin and parent (2005), Aizenman and Lee (2005), Jeanne (2007), and Cheung and Ito (2007) argue that developing countries opted for new policy in the aftermath of 1990s crises consisting in accumulating international reserves. This argument is based on econometric evaluations suggesting several structural changes in the patterns of reserves hoarded by developing countries.…”