Foreign Reserve Holdings Research Articles

The Role of Macro‐Economic Policy in Explaining China's Current Account Surplus

AbstractI assess how much of China's current account surplus can be explained by government policy of capital controls and foreign reserve accumulation during a period of rapid productivity growth. My model can generate an increase in China's current account surplus and foreign reserve holdings. I find that half of the peak in China's current account surplus can be explained by its capital control policies and half by its foreign reserve accumulation policies. Under an open capital account and floating exchange rate, China would have run a current account deficit of 6.5% of GDP.

What Determines Egypt’s Demand for Foreign Reserves?

Objective: The main objective of this paper is to identify the determinants of the demand for foreign reserves in Egypt. Methods: The buffer stock model, quarter-century data spanning over the past 20 years, and Auto-Regressive Distributed Lag (ARDL) regression are all employed to estimate Egypt's demand function for foreign reserves, assess its stability, and predict how swiftly it may change if the underlying Cointegrated connection is disturbed. Results: The results reveal that exports and imports have elasticities of demand for foreign reserves of 1.16 and -3.69, respectively. Moreover, Egypt's foreign reserve assets have notably increased due to foreign direct investment and foreign portfolio investment growth. Lastly, the demand function for foreign reserves is steady, and in the event of a shock, it returns to its steady state in less than two years. Conclusion: To improve Egypt's foreign reserve holdings, policymakers should concentrate on measures encouraging exports and attracting foreign investment.

A Statistical Study of Price of Gold

Gold has long been considered one of the most precious metals, and its value has been used as the standard for many currencies (known as the gold standard) in history. Ancient India accumulated gold through trade of Indian spices with Roman Empire and by gold mining operations, predominantly in the regions of Hatti and Kolar of modern-day Karnataka. 1. There has been drastic increase in the prices of gold since 2001. Gold prices have been increased by 90% during last 10 years. 2. The Bank of India has one of the largest stores of gold in the world. India is the second largest consumer of gold in the world and is one of the most reliable drivers of global demand. Gold accounts for nearly 5.5% of the total foreign reserve holdings of India. India’s festival and wedding season, which runs from October to December, has historically been a huge boon to gold trade. 3. Gold has always been used as a monetary standard. Gold has a profound impact on the value of world currencies. Even though the gold standard has been abandoned, gold as a commodity can act as a substitute for fiat currencies and be used as an effective hedge against inflation. There is no doubt that gold will continue to play an integral role in the foreign exchange markets. Gold consumption observed a sharp acceleration during the 1990s amidst liberalization of gold import policy, strong economic growth and favourable movements in gold prices. Gold is now being used as an alternative for dollar since its collapse. Monetary and Non- Monetary demand for gold is steeply rising. It has been demanded by individual buyer, institutional buyer as well as he Countries too.

Factors Responsible for Movements in Real Effective Exchange Rate of Selected African Countries

The study examined the determinants of real effective exchange rate on selected African countries, namely, Nigeria, Libya, Angola, Egypt, Gabon, Ghana, and Chad over the sample period of 1980 to 2023. The vector error correction methodology was used in the study. The results suggest the following findings; In Nigeria, variations in the real effective exchange rate responded significantly and positively to Brent crude oil prices, domestic inflation rate, external debt burden, the volume of foreign exchange reserves, and prices of primary export. It also responded negatively to foreign investment flows. Whenever the real effective exchange rate deviated from its equilibrium, 74% of its disequilibrium was restored in Nigeria. In Libya, the response of real effective exchange rate was positive and significantly related to commodity prices of primary export but responded negatively and significantly to Brent crude oil prices, foreign investment inward stock, and foreign reserve holdings. In addition, 57% of the disequilibrium in the real effective exchange rate of the Libya currency was restored to the long-term value. In Angola, it was found that the variations in the real effective exchange rate had a positive and significant response with Brent crude oil prices and foreign investment inflows. It however responded negatively with a significance balance of payments and the volume of foreign reserves. About 60% of the disequilibrium in the real effective exchange rate was restored to the long-term value in Angola. In Egypt, the real effective exchange rate responded positively with significance to Brent crude oil prices, foreign investment inflows, and prices of primary export. Additionally, it responded negatively and significantly to the domestic inflation rate and external reserve holdings. Within the period of study in Egypt, 53% of the disequilibrium in the real effective exchange rate was restored to equilibrium. In Gabon, variations in the real effective exchange rate had a positive and significant response with Brent crude oil prices, real interest rate, external debt burden, and the volume of foreign exchange reserves. Also in Gabon, the real effective exchange rate responded negatively and significantly to the inflation rate and prices of primary export. Accordingly, 82% of the disequilibrium in the real effective exchange rate was restored to equilibrium. The Ghanaian real effective exchange rate relative to the dollar responded significantly and positively to Brent crude oil prices, domestic inflation rate, foreign debt burden, and foreign investment flows while it negatively responded to the Ghanaian balance of payment position. Each time the real effective exchange rate of the Ghanaian cedi deviated from its equilibrium value, 79% of its disequilibrium was restored. In Chad, variations in the real effective exchange rate responded significantly but negatively to the domestic inflation rate while it positively and significantly responded to Brent crude oil prices, external balance position, the volume of foreign reserve holdings, and foreign direct investment inflows. Also, whenever the real effective exchange rate deviated from its equilibrium value in Chad, 65% of its disequilibrium was restored in the long run. Based on these results, policymakers should focus on addressing structural constraints, commodity price fluctuations, and improve the business environment by anchoring policies of economic stability to boost competitiveness in trade and industry. There is also the need for policymakers to consider country-specific factors when formulating exchange rates.

Sudden stops and reserve accumulation in the presence of international liquidity risk

We propose a small open economy model where agents borrow internationally and invest in liquid foreign assets to insure against liquidity shocks, which temporarily shut out the economy of short-term credit markets. Due to a pecuniary externality, individual agents overborrow and hold too little liquid assets relative to a social planner. This inefficiency rationalizes macroprudential policy intervention in the form of reserve accumulation at the central bank to stabilize trade and the real exchange rate. Our model quantitatively matches the depreciation of the real exchange rate and contractions in output, gross trade flows, and foreign reserve holdings during Sudden Stops.

Exchange Rate Regimes, Import Prices and Foreign Reserve Holdings in Africa

In this study, we examined dynamic interaction between exchange rate regimes, import prices and foreign reserve holdings in developing countries. Monthly data for the study were obtained on five African countries from 1980M1 to 2020M12. Recognizing that our sample of nations may not be homogenous due to unobserved characteristics of the individual countries such as, economic size, or differences in financial strength, we modelled reserve holding following P-ARDL specifications of Pesaran, Shin & Smith (1995) which recognizes the MG and PMG modeling in error correction configurations. The Hausman test reveals that MG was more efficient compared to PMG. To check robustness of our MG estimates, we had an alternative GMM specification. The GMM estimation was also necessitated to overcome simultaneity biases and endogeneity problems that characterized OLS estimation of our P-ARDL model. Findings showed that exchange rate regime is a significant positive contributor to the volume of reserve holdings while import prices negatively influences reserve holdings. Relatively, study reveals negative contributions of cost of holding reserves, and inflation towards declining reserve holding in selected countries of Africa is highly significant in both SR and LR. Nevertheless, significant heterogeneity exists amongst countries as regards speed of adjustment following disturbances in SR reserve holding to LR convergence. Nigeria had the fastest speed of 61% compared to Angola, Kenya, South Africa, and Egypt with 49%, 20%, 50%, and 19% respectively. Differences in economic strength, economic size (GDP), government factor, political size, financial depth, etc. of countries could have accounted for the difference in adjustment speed. Our MG estimates were found robust to a GMM specification. The study concludes that there is a dynamics interaction between exchange rate regime, import prices and foreign exchange reserves holding. We so recommended that African countries should strategically implement policies to reduce their inflation rates, dependence on import, effectively manage exchange rate regime so that they can achieve higher volume of external reserve holdings that will lead to a reduction in their import prices.

Mars or Mercury? The geopolitics of international currency choice*

SummaryWe assess the role of economic and security considerations in the currency composition of international reserves. We contrast the ‘Mercury hypothesis’ that currency choice is governed by pecuniary factors familiar to the literature, such as economic size and credibility of major reserve currency issuers, against the ‘Mars hypothesis’ that this depends on geopolitical factors. Using data on foreign reserves of 19 countries before World War I, for which the currency composition of reserves is known and security alliances proliferated, our results lend support to both hypotheses. We find that military alliances boost the share of a currency in the partner’s foreign reserve holdings by about 30 percentage points. These findings speak to the implications of possible US disengagement from global geopolitical affairs. In a hypothetical scenario where the United States withdraws from the world, our estimates suggest that long-term US interest rates could rise by as much as 80 basis points, assuming that the composition of global reserves changes but their level does not.

Monetary Regime Choice in China: Policy Rules for Navigating in Dark Corners

This paper examines the performance of monetary policy rules when the economy finds itself in dark corners. An economic dark corner can occur when the real sector experiences a sequence of negative shocks from world demand, while the central bank faces prolonged low world interest rates on its foreign reserve holdings. We examine variations of the current policy rules, based on variations of the Taylor rule with interest-rate instruments, in the context of strong restrictions on capital flows and a fixed exchange rate, and in the context of less restricted capital flows and a more flexible managed exchange rate. Our results show that a more flexible exchange-rate system with a more open capital account acts as a shock absorber when the economy is in a “dark corner”, thus reducing the fall in real GDP and consumption. However, this benefit comes at a cost. Under the more flexible exchange-rate regime with the more open capital account, during dark corner episodes, employment is much lower than in the more restricted fixed-rate environment. In the more open environment, the real exchange rate appreciates, with an increase in imported inputs, leading to a large loss of foreign exchange reserves and lower employment.

A theory of rollover risk, sudden stops, and foreign reserves

Emerging economies have accumulated very large foreign reserve holdings since the turn of the century. We argue that this policy is an optimal response to an increase in foreign debt rollover risk. In our model, reserves play a key role in endogenously reducing debt rollover crises (“sudden stops”) by allowing governments to be solvent in more states of the world. Using a dynamic multi-country environment with learning, we find that a relatively small unanticipated increase in rollover risk jointly accounts for (i) the outburst of sudden stops in the late 1990s, (ii) the increase in foreign reserves holdings, and (iii) the subsequent reduction of sudden stops in emerging economies. We also show that a policy of pooling reserves may substantially reduce reserves because mutual insurance across countries dampens rollover risk.

The ‘trilemma’ hypothesis and policy implications for Fiji

type=main> This paper examines the trilemma constraint for Fiji; that is, we investigate how trilemma policy variables were used to address policy trade-offs among the three objectives of exchange rate stability, monetary autonomy, and financial openness. Fiji makes an interesting case because of its policy orientation towards a stable exchange rate and adequate foreign reserves. Our results suggest that the trilemma constraint is binding for Fiji and policy priority is given to exchange rate stability and monetary policy independence, while less emphasis is placed on financial market openness. We also find that the actual policy levels do not deviate substantially from optimal levels, which evidences that Fiji's policy management has been efficient under the trilemma constraint. Finally, we also study the effects of various trilemma policy combinations and foreign reserve holdings on output growth and inflation.

Le dollar à l’épreuve de la crise financière

Le creusement du déficit courant américain dans les années 2000, puis le fait que la crise financière est née aux États-Unis laissaient présager une poursuite de la dépréciation de la devise américaine. Sept ans après la faillite de Lehman Brothers, le dollar est au contraire au plus haut en termes effectifs depuis plus de dix ans. Si le mouvement d’appréciation récent est à rapprocher du décalage des cycles économiques, la bonne tenue du dollar depuis le début de la crise financière tient aussi au statut de valeur refuge de la devise américaine. Le dollar est en effet resté prédominant dans le système monétaire international, comme l’illustre la part de la devise américaine dans les détentions de réserves, les paiements internationaux ou les émissions de dette, dans les pays avancés comme dans les pays émergents. Classification JEL : E58, F31, F33, G01.

In search of an optimal strategy for yuan’s real revaluation

International commentators seem to have a consensus view that the Chinese yuan is substantially undervalued and the Chinese monetary authority must take speedy actions to redress the currency misalignment by rapid nominal revaluation. This paper argues for a gradualist but comprehensive strategy for adjusting the renminbi’s exchange rate. Taking into consideration the facts that the yuan’s undervaluation is caused by an array of domestic and international factors and that the Chinese central bank cannot effectively invest its growing holdings of foreign reserves, we develop a framework to provide a theoretical underpinning for the optimal strategy for the renminbi’s gradual revaluation. With this strategy, the renminbi undervaluation problem is gradually redressed through a combination of nominal appreciation and higher inflation plus some other structural and macroeconomic policies. This strategy can also allow absorption of external imbalances, hence strengthening the foundation of China’s long-term growth.

A Theory of Rollover Risk, Sudden Stops, and Foreign Reserves

Emerging economies, unlike advanced economies, have accumulated large foreign reserve holdings. We argue that this policy is an optimal response to an increase in foreign debt rollover risk. In our model, reserves play a key role in reducing debt rollover crises ('sudden stops'), akin to the role of bank reserves in preventing bank runs. We find that a small, unexpected, and permanent increase in rollover risk accounts for the outburst of sudden stops in the late 1990s, the subsequent increase in foreign reserves holdings, and the salient resilience of emerging economies to sudden stops ever since. Finally, we show that a policy of pooling reserves can substantially reduce the reserves needed by emerging economies.

Are reserve holdings in emerging Asian countries excessive? - The intertemporal balance perspective

Under the assumption of intertemporal balance, current foreign reserve holdings should equal the present value of the sum of future current account and financial account balances. To satisfy the intertemporal balance, a testable condition indicates that the change in foreign reserves needs to follow a stationary path. We employ variant unit root tests on nine Asian emerging markets for the time period of 1989.1 to 2008.12. The univariate unit root test shows that most countries have violated the intertemporal balance due to accumulating excessive reserves, while for the time period up to 1997.6, prior to the Asian currency crises, most countries deviated from the sustainable path due to deficient reserve holdings. However, results from the panel unit root test, which particularly considers the cross country correlation, show that except for China not being on a sustainable path, the other countries do not violate the intertemporal balance. The disparate results between univariate and panel unit root tests indicate interdependence among Asian emerging markets in the era of financial globalisation and vindicate the advantages from regional financial cooperation.

Threshold Effects of Foreign Reserve Holdings in Developing Countries

Foreign reserves play an important role in insuring developing countries against exogenous shocks and reducing the probability of panic driven crisis. While the literature on foreign reserves has so far focused on determining the ‘required’ or ‘optimal’ level of reserves based on various parameters such as volatility of export revenues, opportunity cost of holding reserves etc., little attention has been paid to the impact of reserve holdings in the event of shocks. This paper tries to bring some insight in to the role of reserves in shaping the response of developing countries to exogenous price and capital flow shocks. We find important threshold effects of reserves on the behavior of key macro variables in the face of exogenous shocks. Ignoring these effects would provide us with misleading results regarding the cost of exogenous shocks and adequacy of reserve levels.

Financial crisis and a transmission mechanism of external shocks: The signaling role of the Korean Monetary Stabilization Bond

This paper explores a transmission mechanism of an exogenous shock to domestic financial markets by investigating the potential signaling role of the Monetary Stabilization Bond (MSB) spread together with several financial variables in Korea. The MSB spread widened and became more volatile during the crisis period after the variance change point at the end of 2007, when the causality relationships between the key variables became apparent. The empirical results illustrate that a foreign shock, which directly leads to rapid short-term capital flow and foreign exchange rate fluctuation, is likely to have a significant contagion effect on domestic financial markets in the case where it has a sizable negative impact on national foreign reserve holdings. The MSB is a monetary policy instrument for foreign exchange reserve management, and the daily observable MSB spread is a timelier signal in this transmission channel.

Financial Crisis and a Transmission Mechanism of External Shocks: The Signaling Role of the Korean Monetary Stabilization Bond

This paper explores a transmission mechanism of an exogenous shock to domestic financial markets by investigating the potential signaling role of the Monetary Stabilization Bond (MSB) spread together with several financial variables in Korea. The MSB spread widened and became more volatile during the crisis period after the variance change point at the end of 2007, when the causality relationships between the key variables became apparent. The empirical results illustrate that a foreign shock, which directly leads to rapid short-term capital flow and foreign exchange rate fluctuation, is likely to have a significant contagion effect on domestic financial markets in the case where it has a sizable negative impact on national foreign reserve holdings. The MSB is a monetary policy instrument for foreign exchange reserve management, and the daily observable MSB spread is a timelier signal in this transmission channel.

How China's Holdings of Foreign Reserves Affect the Value of the US Dollar in Europe and Asia

AbstractBy January 2009, China held almost US$2tn in foreign reserves. The present paper estimates the marginal effect of China changing its holdings of foreign reserves on the value of the US dollar in Europe and Asia. Because using traditional techniques to find this estimate would be inappropriate due to severe problems resulting from omitted variables, the present paper uses a new approach, bidirectional‐reiterative truncated projected least squares, that has been proven to minimize problems associated with omitted variables. It is found that if China would sell 1 percent of its foreign reserves, then the value of the US dollar would fall by 0.44 percent. With such a large effect, China has an incentive to either not sell any of its US dollar reserves or sell all of its US dollar reserves.

Country Insurance and Corporate Risk-Taking

The paper presents a robust but previously undocumented data pattern: corporate risk taking is positively correlated with country-level foreign exchange reserve holdings (as a share of the GDP). With data on 5000 manufacturing firms in 24 emerging economies during 2000-2006, we show that foreign reserve accumulation is economically and statistically associated with higher leverage ratios, lower cash holdings, riskier investments, and higher total and idiosyncratic stock return volatilities. We further show that at least a part of the positive correlation is due to greater corporate risk taking in response to an improvement in a country’s ability to defend against macroeconomic risks associated with a sudden stop in international capital flows. The pattern is stronger for firms that are intrinsically more dependent on external finance for working capital and capital expenditure. It continues to hold when the foreign reserve is instrumented by cumulative trade surpluses. Our finding may provide an explanation for a puzzle during the 2008-2009 global crisis: that higher foreign reserve holdings before the crisis did not translate into less severe corporate difficulties across countries during the crisis.

Optimal reserve management and sovereign debt

Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the reserve accumulation does not play a quantitatively important role in this model. In fact, we find the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.