Domestic financial instability and foreign reserves accumulation in China

Abstract

AbstractUsing a time series analysis, this paper argues that domestic financial instability, which increases the potential for resident‐based capital flight from the domestic currency, provides an incentive for China to hold more foreign reserves in the short run. To measure its domestic financial conditions, we construct a monthly Chinese financial stress index, which is used as a proxy for the possibility of capital flight. The empirical results show that this index is a significant determinant of the movements of China's foreign reserves around its trend and that using M2 as a proxy for domestic financial instability as suggested by previous studies is not a valid strategy for China. It is suggested that greater attention should be given to the role of domestic financial conditions in explaining China's short‐run demand for foreign reserves.