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The high demand for international reserves in the Far East: what's going on?

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  • Joshua Aizenman
  • Nancy Marion

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 also 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 the demand for international reserves by developing countries. Specifically, we show that sovereign risk and costly tax collection to cover fiscal liabilities lead to a relatively large 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 much 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 in 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

Paper provided by Federal Reserve Bank of San Francisco in its series Pacific Basin Working Paper Series with number 2002-08.

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Date of creation: 2002
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Handle: RePEc:fip:fedfpb:2002-08

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  1. 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.
  2. Francis E. Warnock & Hali J. Edison, 2001. "A Simple Measure of the intensity of Capital Controls," IMF Working Papers 01/180, International Monetary Fund.
  3. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  4. Aizenman, Joshua & Marion, Nancy P., 2003. "International Reserve Holdings with Sovereign Risk and Costly Tax Collection," Santa Cruz Department of Economics, Working Paper Series qt9s7978n1, Department of Economics, UC Santa Cruz.
  5. 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.
  6. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  7. Joshua Aizenman, 1995. "Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion," NBER Working Papers 5361, National Bureau of Economic Research, Inc.
  8. 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.
  9. Hausmann, Ricardo & Panizza, Ugo & Stein, Ernesto, 2001. "Why do countries float the way they float?," Journal of Development Economics, Elsevier, vol. 66(2), pages 387-414, December.
  10. repec:fth:inadeb:418 is not listed on IDEAS
  11. 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.
  12. 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.
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