Foreign reserve accumulation, foreign direct investment, and economic growth

Abstract

This paper develops a quantitative small-open-economy model to study the determinants of the optimal pace of foreign reserve accumulation by developing countries. In the model, reserve accumulation depreciates the real exchange rate and attracts foreign direct investment (FDI) inflows, which promotes productivity growth through endogenous firm dynamics. The economy is also subject to sudden stops in the form of an occasionally binding constraint on foreign borrowing, and accumulated reserves are used to prevent severe economic downturns. The model shows that two factors are the key determinants of the optimal pace of reserve accumulation: the elasticity of the foreign borrowing spread with respect to foreign debt and the entry cost for FDI. The model suggests that these two factors can explain a substantial amount of the cross-country variation in the observed pace of reserve accumulation.