Academic journal article Journal of International Business Research

Demand for Foreign Currency Reserves: Impact of Size and Rank

Academic journal article Journal of International Business Research

Demand for Foreign Currency Reserves: Impact of Size and Rank

Article excerpt


Over the past couple of decades, there has been an increase in the stock of reserves of most countries (especially those of emerging market countries) beyond established benchmarks. The benchmarks are considered by global financial institutions such as the International Monetary Fund (FMF) as optimal to cushion economies against destabilizing terms of trade shocks. Figure 1 shows the growing trend in reserves of the 116 countries in this study by three country classifications-advanced countries; emerging market/developing countries (EMDC); and Asia-Pacific countries (APC).

On Table 1, we ranked the top ten reserve holders in 2014 and compared them to optimal levels as prescribed by two well-known benchmarks-4% of GDP and 100% of short-term debt. We find all the countries on the list holding reserves well above the 4% of GDP optimal levels. Using the World Bank's 100% of short-term debt benchmark, we observe the same trend with most of the countries holding reserves beyond proposed levels (except for Japan, Korea and Singapore). We also observed that the countries in Asia dominate the list with the highest levels of reserves amongst the countries in the sample (i.e., they hold 77% of the reserves on the top ten list).

Theoretical Foundation

Traditionally, reserve accumulation was justified as necessary to insure trade imbalances, support the exchange rates and cushion the sudden stops in capital inflow which plagued emerging market countries post debt and financial crisis. The buffer stock model for example, views the accumulation of foreign currency reserves as a cushion for current account imbalances. Frenkel and Jovanovic (1981) suggest that foreign currency reserves serve as a buffer stock with optimal reserves balancing the adjustment costs with the opportunity cost of holding reserves.

In line with the buffer stock model, is the precautionary motive for holding foreign currency reserves as self-insurance against sudden stops of capital inflow (Aizenman and Lee, 2008). The monetary policy view on the other hand (Mundel 1971) point out that, in an open and integrated world economy, fluctuations in central bank reserve holdings are bound to occur as a result of changes in the money market and such imbalances should be corrected using appropriate monetary policy (Frenkel and Johnson, 1976). Deatte and Fouquar (2012) and Aizenman and Lee (2008) argue that the widening deviation of the reserves of emerging market countries from the mean are based more on mercantilist strategies. The mercantilist motive for holding foreign currency reserves argues that these strategies are employed to keep the country's exchange rate with its major trading partners depreciated to facilitate export led growth. In fact, empirical analysis by Deatte and Fouquar (2012) using a time-varying panel smooth transition model finds that the weights of the traditional variables (precautionary motive) have faded away in favour of mercantilist motives. Pringle (2012) adds that in the case of China for example, reserve accumulation is motivated not only by economic factors but also by political factors. China's accumulation of reserves has provided the country with political clout, respect and security internationally (Williams, 2005).

The problem with holding a valuable resource such as foreign currency reserves at excessively high levels is the welfare loss suffered by society from the alternative productive uses of reserves especially in the areas of healthcare, education and infrastructure. Another cost of excess reserves comes from the lost interest income for the central bank as reserves are usually held in short term liquid assets (such as currency or money market deposit accounts) that yield little or no interest payments (Higgins and Klitgaard, 2004). Scrichander (2008) adds that in many emerging economies, the interest on domestic currency liabilities tends to be higher than that earned on the central bank's foreign currency assets, causing central banks to incur a running loss from carrying low-yielding foreign currency reserves on their balance sheets. …

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