Insuring against Neighboring Crises: International Reserves in Latin America

This paper revisits the traditional literature on optimal demand for international reserves by exploring the possibility that perceived contagion risk originating from neighboring countries influences a country’s own demand for reserves. In addition, it highlights another reason why the mechanisms of local coordination and support within the framework of regional integration might be desirable additions to the current international financial structure. Using a sample of the seven largest Latin American economies, the empirical evidence presented here suggests that countries take into consideration the volatility conditions of their neighbors when determining their own optimal level of reserves. Moreover, given that countries in Latin America appear to purchase insurance against contagion risk, this paper argues that a mechanism of reserve pooling that increases the protection of all members of the pool might reduce the risk of contagion and thereby also reduce the opportunity cost faced by individual countries.