International reserves and domestic money market disequilibrium

Purpose - The purpose of this paper is to examine the likely determinants of the demand for official international reserves (hereafter reserves) for India and China in the long run in a basic buffer stock model. The paper also examines the role of domestic money market disequilibrium in the short-run demand for official reserves for both the countries in a dynamic synthesis model. Design/methodology/approach - The study used quarterly data for the time period 1993:Q1–2015:Q4. The long-run model is being estimated by following theFrenkel–Jovanovic (1981)buffer stock model and includes the determinants such as transaction motive variable (GDP or Imports), opportunity cost variable (domestic interest rate), precautionary motive variable (volatility of reserves) and exchange rate. The study also examined the role of domestic money market disequilibrium in addition to the above variables in the short-run reserve demand model. The money market disequilibrium term is expected to be negative and significant in the short run. The study employed autoregressive distributed lag bound testing approach to co-integration and unrestricted error-correction model (UECM) approach developed by Pesaranet al.(2001) for estimating the long-run and short-run models, respectively. Findings - The co-integration test suggests the existence of long-run relationship between international reserves and its determinants. In the long run, all the variables are statistically significant with expected sign, except domestic interest rate variable for China. It is also found that, the money market disequilibrium term in the short run is negative and significant which validates that an excessive money demand (supply) induces an inflow (outflow) of international reserves for both India and China with a lag of four quarters. The recursive residual tests (CUSUM and CUSUMSQ) confirm the stability of both long-run and short-run reserve demand models. Practical implications - The findings and policy implications of this study may be useful for the policy makers of the similar emerging economies for designing money and currency policies. Originality/value - This paper is a comparative study which systematically analyzed the reserve demand behavior of the two emerging economies India and China. The study integrates the domestic money market with the international reserve demand behavior for these two economies.