The High Demand for International Reserves in the Far East: What's Going On?

Joshua Aizenman and Nancy Marion ()

No 9266, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper explores econometric and theoretical interpretations for the relatively high demand for international reserves by countries in the Far East and the relatively low demand by some other developing countries. Using a sample of about 125 developing countries, we show that reserve holdings over the 1980-1996 period seem to be the predictable outcome of a few key factors, such as the size of international transactions, their volatility, the exchange-rate arrangement, and political considerations. The estimating equation does a good job of predicting reserve holdings in Asia before the 1997 financial crisis. After the crisis, the estimating equation significantly under-predicts the reserve holdings of several key Far East countries, as one might expect from the Lucas Critique. This under-prediction is consistent with models explaining reserve demand in developing countries. Specifically, we show that sovereign risk and costly tax collection to cover fiscal liabilities lead to a relatively large precautionary demand for international reserves. In the aftermath of a crisis, countries that have to deal with higher perceived sovereign risk and higher fiscal liabilities (both funded and unfunded) will opt to increase their demand for reserves. The models also help us understand why some developing countries do not hold large precautionary reserve balances in the aftermath of crises. Countries with high discount rates, political instability or political corruption find it optimal to hold smaller precautionary balances. We also show that models that incorporate loss aversion predict a relatively large demand for international reserves. Hence, if a crisis increases the volatility of shocks and/or loss aversion, it will greatly increase the demand for international reserves. Consequently, we conclude that the puzzling' pattern in international reserve holdings is reasonably explained by the extended models described in this paper.

JEL-codes: F31 F32 (search for similar items in EconPapers)
Date: 2002-10
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-sea
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (28)

Published as Aizenman, Joshua, and Nancy P. Marion. "The high demand for international reserves in the Far East: What is going on?" Journal of the Japanese and International Economies, September 2003, 17(3): 370-400.
Published as Joshua Aizenman & Nancy P. Marion, 2002. "The high demand for international reserves in the Far East: what's going on?," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.

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Journal Article: The high demand for international reserves in the Far East: what's going on? (2002)
Working Paper: The high demand for international reserves in the Far East: what's going on? (2002)
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