How Central Banks Prepare for Financial Crises - An Empirical Analysis of the Effects of Crises and Globalization on International Reserve Holdings

Abstract

Central banks’ international reserve holdings have increased significantly in the recent past. While traditional models fail to explain this accumulation of reserves, the more recent literature argues that reserves are used as a lifejacket against currency crises. However, research so far has neglected the question whether and how central banks change their precautionary reserve holdings after the country was affected by a currency crisis. This paper tests the hypothesis that central banks revise their reserve policy in the aftermath of currency crises. A dynamic panel data model is estimated for developing and industrial countries covering the period from 1975 to 2003. The evidence suggests that currency crises induce a permanent increase of reserves. This effect is particularly strong for recent currency crises since the Asian financial crisis of 1997-98.