STOCKPILING FOREIGN EXCHANGE RESERVES: A USEFUL PRECAUTION FOR COUNTRIES EXPOSED TO FINANCIAL CRISES

Since the 1997/8 Asian financial crises, the monetary authorities in East Asia’s emerging markets have more than doubled their stockpiles of foreign exchange reserves. Research by Professors Joshua Aizenman and Nancy Marion, published in the July 2004 Economic Journal, shows that such hoarding of foreign exchange reserves may have a useful role in dealing with exposure to possible future crises.

They note that one frequent by-product of countries’ financial opening has been financial crises. A possible reason for this outcome is that short-term capital – dubbed ‘hot money’ – often flows into the country once it opens up. These short-term flows are ‘footloose’, subject to abrupt reversal. They expose the developing country to a higher risk of a liquidity squeeze and occasionally lead to a full-blown financial crisis.

Aizenman and Marion begin by investigating the empirical determinants of the demand for reserves in developing countries over the last 20 years. As in past studies, they find that reserve holdings increase with volatility, trade openness, and country size, and decrease with greater flexibility of the exchange rate. The opportunity cost of holding reserves does not play a significant role.

They then extend the analysis by adding two political measures that may lower the demand for reserves. They find that an increase in an index of political corruption significantly reduces reserve holdings, as does an increase in the probability of a change in government leadership.

The researchers conclude that the recent large build-up of international reserve holdings in East Asia is motivated by the experience of the recent Asian financial crisis. Therefore, they examine the possibility that the build-up may represent ‘precautionary’ holdings.

They examine theoretically two situations that can influence the demand for international reserve holdings. The first is the government's desire to ‘smooth consumption’ – that is, to spread over time the costs of shocks. When a country’s continued access to capital markets is uncertain, and when it is costly to either raise taxes or cut government spending, that country will find it desirable to hold large precautionary reserve balances.

The analysis also helps to explain why some developing countries choose not to hold large precautionary reserve balances. Specifically, countries that strongly favour current consumption, that experience political instability, or that suffer from political corruption face a lower effective return on holding reserves and will accumulate more modest stockpiles.

While these findings are consistent with the view that hoarding foreign exchange reserves may serve a useful role, not all countries may benefit from adopting this strategy. In particular, the results suggest that the benefits accrue only when countries optimally control both the saving of precautionary reserves and external borrowing. Attempts to focus solely on the reserves side may disappoint if the borrowing side is abused as a result of political uncertainty or corruption.

ENDS

Note for Editors: ‘International Reserve Holdings with Sovereign Risk and Costly Tax Collection’ by Joshua Aizenman and Nancy Marion is published in the July 2004 issue of the Economic Journal.

Aizenman is at the University of California Santa Cruz; Marion is at Dartmouth College.

For Further Information: contact Joshua Aizenman on +1-831-459-4791 (email: jaizen@ucsc.edu; website: http://econ.ucsc.edu/Faculty/facAizenman.shtml); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).