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The authors would like to thank Mohsin S. Khan and David Owen for their valuable comments and suggestions, and Petya Koeva for sharing an extensive cross-country data set on reserves.
Crises in emerging market economies provoked by “sudden stops” of capital inflows have become more prevalent since the 1990s. Typically, these crises result in large currency devaluations and severe output losses (Calvo, 2006).
Our analysis does not incorporate other benefits of reserves sometimes acknowledged in the literature. For example, Christofides, Mulder, and Tiffin (2003) cite reduced borrowing costs as a benefit to increased reserve holdings, and Hviding, Nowak, and Ricci (2004) find that reserves can curb currency volatility. These factors are, however, not that important for Jordan, a country with an exchange rate peg and little international borrowing on commercial terms.
This remains true even if we exclude the Asian sample countries.
Even in first generation models, such as Krugman (1979), additional reserves affect the timing of a crisis.
In the Jeanne and Ranciere (2006) model, the probability of a sudden stop is assumed to be constant and exogenous. However, Jeanne and Ranciere’s (2006) empirical calibration of the model includes an estimation where the probability of sudden stop actually changes period over period. Assuming the government debt to be short term simplifies the analysis where sudden stop probabilities are not constant.
With this framework, the cost of holding reserves is explicit. Although the government earns a return of r on its reserves, it pays its creditors a return of
We assume that the government takes the prices of its bonds as given.
Of course, a decline in reserves can also be a symptom of a sudden stop which would overstate our estimates. Most specifications, including ours, add several lags to address this problem.
These countries are Argentina, Bolivia, Botswana, Brazil, Bulgaria, Chile, China, Colombia, Costa Rica, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Guatemala, Honduras, Hungary, Jamaica, Jordan, Korea, Malaysia, Mexico, Morocco, Paraguay, Peru, Philippines, Poland, Romania, South Africa, Sri Lanka, Thailand, Tunisia, Turkey, and Uruguay.
Data are taken from the International Financial Statistics, World Development Indicators, and Global Development Finance.
This excludes two outlier countries, Botswana and Morocco. Botswana had very low amounts of short-term debt during the sample period, pushing average reserves to short-term debt to several hundred standard deviations higher than the mean of the rest of the sample. The sudden stop episode for Morocco in 1995 was coupled with a drastic contraction of short-term debt pushing reserves to short-term debt to more than 16 times the standard deviation of the rest of the sample.
We have also clustered the standard errors at the country level. This assumption allows for covariance in the error terms within each country. The assumption of homoskedasticity and White’s correction for heteroskedasticity are special cases where this covariance term is zero. Results are robust to just using White’s correction for heteroskedasticity.
We attempted using a few instrumental variables, including broad money and errors and omissions, the results were not conclusive.
Although equation (8) is not strictly scale-invariant, we find that changing the scale has minimal effect on the results. Calibrations are denominated in billions of U.S. dollars.
The results in Table 2 are simply coefficients in the probit regression and not marginal probabilities. Marginal probabilities are calculated from these coefficients to give
J-R use a figure of 6.5 percent since they assume that trend growth is about 3.3 percent.
To extend the sample period for calibration purposes, we assume that the effect of reserves on crisis probabilities is concurrent rather than lagged.
Trend real GDP growth during periods that are not a sudden stop or periods immediately after a sudden stop was about 3.5 percent.
We note that during this sudden capital reversal, Jordan actually experienced high real GDP growth.
In the case of Jordan, if reserves are held solely to finance short-term external debt (the Greenspan-Guidotti criterion), then one might claim that reserves are excessive since they cover more than seven times maturing external debt. But if reserves are also held to avoid interruptions in the domestic payments system or to insure import viability—both legitimate aims—then the ratio to money stock (M2) or import cover may perhaps be more relevant criteria.