Do oil endowment and productivity matter for accumulation of international reserves?

Abstract

Motivated by the observation that a country tends to have more official foreign reserves if its crude oil endowment is large (small) but its productivity is low (high), we develop and estimate a dynamic stochastic optimization model to show that precautionary incentives against oil price shocks can account for a substantial part of the effects of productivity and oil endowment on a country’s foreign reserves. We demonstrate how oil price shocks are absorbed by changes in foreign reserves which, in turn, leads to less variation in aggregate consumption. Along with productivity and oil endowment, we also consider as determinants of foreign reserves conventional variables such as trade-to-GDP ratio and capital openness. Overall, our results suggest that ignoring productivity and oil endowment may lead to large bias in the estimates of some conventional determinants of a country’s foreign reserves.