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A Growth Perspective on Foreign Reserve Accumulation

  • Cheng, Gong

Based on a dynamic open-economy macroeconomic model, this paper aims at understanding the contribution of domestic financial under-development to foreign reserve accumulation in some emerging market economies, especially in China. It is argued that foreign reserve accumulation is a consequence of a growth strategy induced by strong capital investment in a financially constrained economy. It is further proved using a Ramsey problem that purchasing international reserves is a welfare-improving policy in terms of production efficiency gains when the domestic economy faces two sources of frictions: credit constraint and capital controls. In fact, when domestic firms are occasionally credit-constrained and they do not have a direct access to international financial market, they need domestic saving instruments to increase their retained earnings so that they can sufficiently invest in capital. The central bank/government plays the role of financial intermediary and provides domestic firms with a liquid public bond, thus relaxing the domestic credit constraint. The proceeds of domestic public bonds are then invested abroad due to the limited scope of domestic financial market and a depressed domestic interest rate, leading to foreign reserve stockpiling. The speed of foreign reserve accumulation will slow down with the domestic financial deepening and the development of the domestic financial market.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 46668.

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Date of creation: 09 Dec 2011
Date of revision: 01 Mar 2013
Handle: RePEc:pra:mprapa:46668
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