Dilution of Opportunity Cost Effect on the Demand for International Reserves in the High Reserve Era

This study investigates the possible links between the international reserve accumulation by developing countries and an endogenous decrease in the magnitude of the opportunity cost effect. If the opportunity cost of reserve holdings is determined endogenously in relation to the reserve holdings themselves, the estimated coefficients of opportunity costs from a conventional OLS regression will be biased downward. An increase in the reserves decreases the risk of liquidity problems imposed by a sudden capital outflow, which results in a decrease in the opportunity cost of holding reserves. Thus, a high level of reserves may make the negative opportunity cost effect smaller. Generally, empirical results from pooled data for 17 developing countries covering the 1994 to 2002 time period support this interpretation.