The demand for international reserves in emerging market countries: The role of domestic financial markets

Emerging market countries have been accumulating international reserves at an extraordinary pace since the early 1990s. This paper explores the trends in international reserve holdings over the past 30 years, the potential driving factors, associated costs, and policy implications. The contribution of this paper is the analysis of the role domestic financial markets may play in determining the demand for international reserves in emerging market countries. Both theoretical and empirical analyses are used to investigate the following research hypothesis – To the extent that efficient and developed domestic financial markets provide an alternative source of financing to international markets, policy makers in emerging economies may choose to hold fewer international reserves as insurance against international capital flow volatility. A theoretical model is developed for international reserve demand in a representative emerging market economy in which the primary role of international reserves is self-insurance against international capital volatility. The model predicts that optimal reserve holdings decline as domestic financial markets become more efficient. This result is tested empirically using a panel dataset comprised of annual data from 1980-2009 for 73 countries, both emerging and advanced. In addition to standard variables that measure economic development, export volatility, trade openness, financial integration, and exchange rate volatility, the data includes measures of banking system efficiency. The theoretical and empirical findings suggest that financial market reforms that promote improved efficiency may be a potential alternative to costly reserve accumulation in the long-run.