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The high demand for international reserves in the Far East: What is going on?

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  • Aizenman, Joshua
  • Marion, Nancy

Abstract

This paper explores econometric and theoretical interpretations for the relatively high demand for international reserves by countries in the Far East and the relatively low demand by some other developing countries. Using a sample of about 125 developing countries, we show that reserve holdings over the 1980-1996 period seem to be the predictable outcome of a few key factors, such as the size of international transactions, their volatility, the exchange-rate arrangement, and political considerations. The estimating equation does a good job of predicting reserve holdings in Asia before the 1997 financial crisis. After the crisis, the estimating equation significantly under-predicts the reserve holdings of several key Far East countries, as one might expect from the Lucas Critique. This under-prediction is consistent with models explaining reserve demand in developing countries. Specifically, we show that sovereign risk and costly tax collection to cover fiscal liabilities lead to a relatively large precautionary demand for international reserves. In the aftermath of a crisis, countries that have to deal with higher perceived sovereign risk and higher fiscal liabilities (both funded and unfunded) will opt to increase their demand for reserves. The models also help us understand why some developing countries do not hold large precautionary reserve balances in the aftermath of crises. Countries with high discount rates, political instability or political corruption find it optimal to hold smaller precautionary balances. We also show that models that incorporate loss aversion predict a relatively large demand for international reserves. Hence, if a crisis increases the volatility of shocks and/or loss aversion, it will greatly increase the demand for international reserves. Consequently, we conclude that the puzzling' pattern in international reserve holdings is reasonably explained by the extended models described in this paper.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of the Japanese and International Economies.

Volume (Year): 17 (2003)
Issue (Month): 3 (September)
Pages: 370-400

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Handle: RePEc:eee:jjieco:v:17:y:2003:i:3:p:370-400

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Web page: http://www.elsevier.com/locate/inca/622903

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  1. Hali J. Edison & Francis E. Warnock, 2001. "A simple measure of the intensity of capital controls," International Finance Discussion Papers 708, Board of Governors of the Federal Reserve System (U.S.).
  2. Kahneman, Daniel & Knetsch, Jack L & Thaler, Richard H, 1990. "Experimental Tests of the Endowment Effect and the Coase Theorem," Journal of Political Economy, University of Chicago Press, vol. 98(6), pages 1325-48, December.
  3. Joshua Aizenman, 1995. "Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion," NBER Working Papers 5361, National Bureau of Economic Research, Inc.
  4. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  5. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  6. Robert P. Flood & Nancy P. Marion, 2002. "Holding International Reserves in an Era of High Capital Mobility," IMF Working Papers 02/62, International Monetary Fund.
  7. Martin Feldstein, 2002. "Economic and Financial Crises in Emerging Market Economies: Overview of Prevention and Management," NBER Working Papers 8837, National Bureau of Economic Research, Inc.
  8. Ricardo Hausmann & Ugo Panizza & Ernesto H. Stein, 2000. "Why Do Countries Float the Way They Float?," Research Department Publications 4205, Inter-American Development Bank, Research Department.
  9. Joshua Aizenman & Nancy P. Marion, 2002. "International Reserve Holdings with Sovereign Risk and Costly Tax Collection," NBER Working Papers 9154, National Bureau of Economic Research, Inc.
  10. repec:fth:inadeb:418 is not listed on IDEAS
  11. Tversky, Amos & Kahneman, Daniel, 1991. "Loss Aversion in Riskless Choice: A Reference-Dependent Model," The Quarterly Journal of Economics, MIT Press, vol. 106(4), pages 1039-61, November.
  12. Menzie D. Chinn & Hiro Ito, 2002. "Capital Account Liberalization, Institutions and Financial Development: Cross Country Evidence," NBER Working Papers 8967, National Bureau of Economic Research, Inc.
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