Foreign exchange reserves and financial crises in emerging economies
Date
2021
Authors
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Publisher
University of Delaware
Abstract
In this dissertation, I study the relationship between foreign exchange reserves and financial crises in emerging economies. The ratio of foreign exchange (FX) reserves to output has been increasing in emerging economies since the 1980’s. Reserves are costly to the countries accumulating them since these are resources that could be invested in the private sector and earn higher returns. They are also costly to the world; the resulting excess demand for safe assets depresses safe-countries interest rates, which can be problematic at the effective lower bound inducing a downward adjustment of output instead. It is then essential to understand the rationale behind the increasing trend in reserves. ☐ First, I develop a theoretical 2-period, 2-good, open-economy general equilibrium model with a banking sector in a global games framework. Consistent with the empirical literature, I show that increasing foreign exchange reserves, while not necessarily eliminates the possibility of a double drain (that is bank runs plus sudden stops of foreign lending), leads to a decrease in the probability of the occurrence of such an event, under certain conditions. I also prove that higher foreign exchange reserves lead to a downward shift of the (infinitely elastic) supply curve of foreign debt and a possible rightward shift of the supply curve of domestic deposits. ☐ Second, I develop an infinite-horizon small open economy DSGE model that elucidates the mechanisms behind double drains, providing insights into the precautionary motivation behind reserve holdings. The model is calibrated based on aggregate data from East Asian economies. I find that, in economies characterized by an already high average ratio of reserves to GDP, increasing the ratio of reserves to foreign debt by one percentage point decreases the probability of double drains from 0:1756 to 0:0676. I also find that economies with marginally higher ratios of FX reserves to GDP are more resilient to banking crises and enjoy a slightly larger social welfare.
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Keywords
Foreign exchange reserves, Infinite-horizon small open economy, Emerging economies