Demand For International Reserves: Theory Analysis And Empirical Study

The issue of demand for international reserves intrigues economists'interests for a long time. At first this thesis reviews the empirical literature of demand for international reserves and then offers a descriptive analysis of their definition, composition, functions as well as the motive of holding reserves. After that, it summarizes the theories of demand for international reserves. It investigates the Keynesian traditional model based on the model proposed by Clark (1970), then uses Girton and Roper (1977) as an example to evaluate the monetary approach. Next, it introduces the approach proposed by Edwards (1984) to incorporate the two ingredients into his empirical model.In the empirical section, this thesis first analyzes the trends and changes of China's foreign reserve holdings. Then it uses the quarterly data from 1994 to 2006 to test different theoretical models. The first model tested here is the Exchange Market Pressure model proposed by Connolly and Silveria (1979). The empirical results based on VAR methods confirm that the monetary approach correctly predicts the response of the central bank's foreign reserve holdings to domestic credit disturbances. After that, it applies VECM method to estimate China's demand for international reserves. It proves that the demand for international reserves in China is cointegrated with imports, variability of international payments, average propensity of imports and the opportunity costs. The result also demonstrates that transaction motive is the primary reason of holding reserves for the central bank. In addition, it reveals the monetary authority's high risk aversion and prudent attitude towards international reserve holdings—it focuses on the liquidity and stability of its reserves and seldom concerns with portfolio considerations. In the short run, the monetary disequilibrium enters the VECM as an exogenous variable with significant negative effects, which confirms the theoretical prediction of the monetary approach again.