The authors find that the pattern of accumulation of international reserves is not stable but instead shows large variations during different sample periods. Formerly significant variables lose their importance during the global financial crisis, whereas the post-crisis period is dominated by a number of newly identified factors. Emerging market economies with insufficient holdings of international reserves tend to experience exchange rate depreciation.
What’s Inside?
The authors study the patterns of accumulation of international reserves from 1999 to 2012 for a large sample of developing and developed economies. They confirm the instability of the demand for international reserves, which react dynamically to changes in the macroeconomic environment. During the global financial crisis in particular, formerly significant variables become insignificant or reverse signs, whereas the post-crisis period is dominated by previously overlooked factors. Newly identified factors include access to swap lines, implementation of macroprudential regulation, the presence of sovereign wealth funds, and the attitude toward outward foreign investment. A prediction exercise reveals that emerging market economies with insufficient holdings of international reserves tend to experience exchange rate depreciation.
How Is This Research Useful to Practitioners?
International reserve holdings can act as a buffer during times of global turmoil and are considered self-insurance against the volatility induced by financial globalization, especially for emerging economies. Thus, the stock of international reserve holdings can also help to explain the sustainable level of the exchange rate over time.
The authors break down the sample period into three subperiods—pre-crisis, crisis, and post-crisis—and confirm that the appropriate level of international reserves is indeed not constant but evolving with global developments. They also distinguish between developing and developed countries and confirm that these two groups of countries display fairly different patterns of demand for international reserves.
Finally, the authors consider the link between adequacy of reserve holdings and currency value. They find that countries with insufficient amounts of international reserves tended to experience depreciation in their currency value during the post-crisis period of 2010–2012.
How Did the Authors Conduct This Research?
The authors assemble a large database covering annual data from 1999 to 2012 for 22 developed and 73 developing countries. They implement their empirical analysis for three subperiods: 1999–2006, 2007–2009, and 2010–2012. They also distinguish between developed and developing countries.
The authors initially propose a comprehensive list of factors that are likely to influence the level of international reserve holdings. They group these factors into three broad categories: (1) traditional macroeconomic factors, (2) financial factors, and (3) recently discussed variables. Traditional macroeconomic factors include the propensity to import, the volatility of international reserve holdings, the opportunity cost of holding these reserves, and the exchange rate regime. Financial factors considered are domestic financial depth, external financing, cross-border capital flows, and capital controls. The third group includes national sovereign wealth funds, bilateral currency swap agreements, macroprudential supervision, gross savings, outward direct investment, the composition of trade, local rivalry in reserve holdings, and the history of prior exchange rate crises.
The dependent variable is the level of reserve holdings. Initially, the explanatory variables consist of only the traditional macroeconomic and financial factors but not the recently discussed variables. In a second set of regressions, these variables are added. A comparison of the results of these two specifications allows for an assessment of the relevance of the new elements.
The authors initially focus on developing countries. For the first regression specification, they find that the performance of the explanatory variables during the tranquil pre-crisis period differs substantially from their performance during the other two periods. When the recently discussed variables are added to the regression, the importance of savings for reserve accumulation stands out: The savings rate has the expected positive sign and is significant for all subperiods. All other variables again have different effects over different sample periods. Some change signs, whereas others lose their significance when moving from one regime to the next. In the post-crisis regime, such new institutional developments as swap agreements and sovereign wealth funds have explanatory power for international reserve holdings.
The same exercise is conducted for developed countries, and the authors again find large deviations from the earlier findings: The two lists of significant variables are quite different.
Recent institutional changes included in the third group of variables may lessen the need for international reserve holdings. Sovereign wealth funds could offer an alternative financial buffer, effective prudential regulation may reduce the need for self-insurance, and access to durable bilateral swap lines can be seen as an alternative insurance policy.
Abstractor’s Viewpoint
The authors conduct a thorough study of the determinants of international reserve holdings. Their empirical findings highlight the difficulties of tying down the factors that explain the accumulation of reserves. The results also suggest that recent institutional developments, which can be interpreted as alternative mechanisms to insure against financial turmoil, may have changed the demand for international reserves. Future research should take a closer look at possible links and the substitutability of sovereign wealth funds, prudential regulation, and swap lines for traditional reserve holdings as buffers against financial shocks.