Shifting Motives
Explaining the Buildup in official Reserves in Emerging Markets Since the 1980's
Author: Mr. Atish R. Ghosh, Mr. Jonathan David Ostry, and Mr. Charalambos G Tsangarides

Contributor Notes

Author’s E-Mail Addresses: aghosh@imf.orgjostry@imf.orgctsangarides@imf.org
Publication Date:
01 Jan 2012
eISBN:
9781463933197
Language:
English
Keywords:
WP; reserve holding; precautionary demand; short-term debt; currency undervaluation; current account variable; exchange rate regime variable; quantile regression; precautionary variable; undervaluation measure; EME capital account crisis
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Why have emerging market economies (EMEs) been stockpiling international reserves? We find that motives have varied over time?vulnerability to current account shocks was relatively important in the 1980s but, as EMEs have become more financially integrated, factors related to the magnitude of potential capital outflows have gained in importance. Reserve accumulation as a by-product of undervalued currencies has also become more important since the Asian crisis. Correspondingly, using quantile regressions, we find that the reason for holding reserves varies according to the country's position in the global reserves distribution. High reserve holders, who tend to be more financially integrated, are motivated by insurance against capital account rather than current account shocks, and are more sensitive to the cost of holding reserves than are low-reserve holders. Currency undervaluation is a significant determinant across the reserves distribution, albeit for different reasons.

Abstract

Why have emerging market economies (EMEs) been stockpiling international reserves? We find that motives have varied over time?vulnerability to current account shocks was relatively important in the 1980s but, as EMEs have become more financially integrated, factors related to the magnitude of potential capital outflows have gained in importance. Reserve accumulation as a by-product of undervalued currencies has also become more important since the Asian crisis. Correspondingly, using quantile regressions, we find that the reason for holding reserves varies according to the country's position in the global reserves distribution. High reserve holders, who tend to be more financially integrated, are motivated by insurance against capital account rather than current account shocks, and are more sensitive to the cost of holding reserves than are low-reserve holders. Currency undervaluation is a significant determinant across the reserves distribution, albeit for different reasons.

I. Introduction

Over the past few decades, despite greater exchange rate flexibility, emerging market economies (EMEs) have been accumulating large stocks of international reserves. Reserve holdings, which averaged about 5 percent of GDP in the 1980s, have been doubling every decade since, reaching some 25 percent of GDP by 2010. This has raised concerns that EMEs are uselessly stockpiling reserves, that they are deliberately maintaining undervalued exchange rates, and even that they are imperiling the stability of the international monetary system.1 Much of the policy debate naturally hinges on why EMEs are accumulating reserves—whether it is precautionary demand in an uncertain world, a by-product of mercantilist growth strategies, or some other motive.2 Despite a growing number of studies, the literature to date has yet to account for the average rise in EME reserves, let alone the widening dispersion among them. In this paper, therefore, we take a fresh look at what has been driving EME reserves accumulation over the period 1980-2010.

Our take is that several factors are—and have been—at play. Beyond the reserves required to back the operation of fixed exchange rate regimes, EMEs have accumulated reserves for precautionary purposes against both current and capital account shocks, and as a by-product of undervalued currencies. Through the 1980s and early 1990s, developing countries were counseled—by the IMF and others—to hold reserves equivalent to (at least) three months of imports. It took the financial crises of the 1990s (Mexico, 1994; East Asia, 1997/98; and others) to recognize the need to insure against capital account shocks, culminating in the Greenspan-Guidotti rule of holding reserves to cover all of the country’s short-term debt.3 Moreover, in the aftermath of these crises, EMEs with sharply depreciated real exchange rates found their exports booming, which may in turn have helped inspire mercantilist growth strategies. It seems plausible, therefore, that different motives for accumulating reserves applied at different times.

A similar logic may help explain the dispersion across EME reserves holdings at a given point in time. Insurance against current account shocks, for example, requires fewer reserves than capital account shocks as these are “flow” rather than “stock” shocks. While “low” reserves-to-GDP observations are concentrated in the earlier part of our sample, they are by no means exclusive to it: around 40 percent of the below-sample median reserves-to-GDP observations occur in the post-Asian crisis period. Even today, some countries may be primarily concerned about current account shocks because their capital account remains relatively closed, or because potential shocks (e.g., stemming from banking system liabilities) happen to be small. But as EMEs become more financially open, they will typically need to hold more reserves to buffer against capital outflows. Finally, accumulation that is a by-product of mercantilism potentially adds to the reserves held for precautionary purposes. Whether in the time series or cross-section, therefore, observed levels of reserves may well correspond to different motives for holding them.

Testing our hypothesis requires three elements: a nested model in which, in addition to the exchange rate regime, insurance against current and capital account shocks, as well as mercantilism can all play a role. Adequate proxies of these various motivations (particularly undervaluation) as well as an empirical strategy that allows the effect of the explanatory variables to vary systematically along the reserves distribution are also needed. Our sense of the existing literature is that while one study or another may incorporate each of these elements individually, none includes all of them. Thus, Obstfeld et al. (2010) make a convincing case that insurance against capital account shocks (specifically, a banking crisis) is an important factor, but only include trade openness for current account shocks, and do not consider mercantilist motives. Aizenman and Marion (2004) use the volatility of export receipts as their measure of current account shocks, and implicitly include external debt and broad money in their analysis, but do not account for possible mercantilism. Aizenman and Lee (2007) and Delatte and Fouquau (2010) try to capture possible mercantilist motives, but neither includes banking system liabilities, and both are constrained to rather crude PPP-based measures of undervaluation, which they do not find to be robust determinants of reserves.4 None of the above papers allows for the effect of regressors to vary according to the level of reserves.5

In our analysis, we put these elements together. First, we adopt a nested model in which each of the various motives for holding reserves is explicitly included. Second, to obtain better proxies for mercantilism, we estimate undervaluation following the methodology used by the IMF in its own assessments;6 this is based on three distinct approaches and provides a richer assessment of misalignment than simple PPP-based metrics. For robustness, we supplement this with a second proxy—the difference between actual exports and those predicted by a gravity model of trade (“excess” exports below). Third, we use quantile regressions to allow the estimated effect of regressors to vary along the reserves’ holding distribution.

These innovations turn out to be critical to gaining a more complete picture of EME reserve accumulation. Our analysis suggests that precautionary and mercantilist motives together can explain a large proportion of the sample variation, but that different motives apply at different points in time and at different points along the reserves distribution. Insurance motives for countries that hold low levels of reserves (in relation to GDP) center mainly on current account shocks, whereas those for higher reserve holders (again in relation to GDP) tend to center more on capital account shocks such as banking system liabilities. The carry cost of reserves, which is proportional to the amount of reserves held, is only pertinent for countries with relatively high reserves-to-GDP ratios. Currency undervaluation seems to be relevant across the reserves’ distribution, though we suspect that for some low-reserves holders this may be more a reflection of currency crises and collapsed real exchange rates than of deliberate mercantilism.

This pattern is mirrored in how motives for holding reserves have evolved over time. In the first part of the sample (pre-1997), when reserve holdings and financial integration were low, insurance against current account shocks was the most important determinant. Post-Asian crisis, insurance against capital account shocks gains greater importance. It is in this period also that mercantilist motives through undervaluation of the exchange rate becomes relevant.

The rest of this paper is organized as follows. Section II lays out some stylized facts and briefly surveys the literature. Section III describes the variables used to proxy for precautionary and mercantilist motives. Section IV reports our main empirical results, including those for different sub-periods and using quantile regressions. Section V discusses the role of different motives in accounting for the observed trends in EME reserve holdings.

II. Reserves Accumulation by EMEs and Some Stylized Facts

After largely depleting their reserves during the 1980s debt crisis, emerging market economies started accumulating reserves aggressively, doubling the reserves-to-GDP ratio every decade since the 1980s (Figure 1). The dispersion in reserve holdings across EMEs has also risen, with the difference between the top and bottom quartiles widening from 3 percent of GDP in 1990 to 13 percent of GDP by 2010. As such, there is considerable time series and cross sectional variation in reserve holdings.

Figure 1.
Figure 1.

International Reserves held by EME’s, 1980-2010

(in percent of GDP)

Citation: IMF Working Papers 2012, 034; 10.5089/9781463933197.001.A001

Source: WEO and authors’ calculations.

What accounts for this? Beyond the reserves required to operate a fixed exchange rate regime, the literature has identified two main motives: precautionary and mercantilist. Reserves held for precautionary purposes are intended to buffer absorption against current or capital account shocks. Traditionally, developing countries were counseled to hold reserves equivalent to three months of imports to insure against shortfalls in export earnings (or shocks to output that necessitated higher imports). As EMEs became more financially integrated, the need to buffer absorption against capital account shocks gained greater importance. A sudden net outflow of capital would reduce resources available to finance imports, hence the Greenspan-Guidotti rule of holding reserves against short-term debt.7 More generally, reserves can reduce both the likelihood and impact of a sudden stop in capital inflows or a sharp rise in outflows, for example, in a banking crisis that leads to currency flight (Ben-Bassat and Gottlieb, 1992). Optimizing models (Jeanne and Rancière, 2006; Jeanne, 2007; Caballero and Panageas, 2008) treat the decision to hold reserves as an explicit cost-benefit trade-off where the insurance gains of holding reserves must be weighed against their carry costs.8 Empirically, several studies, including de Beaufort Wijnholds and Kapteyn (2001), Cheung and Qian (2009), Bastourre et al. (2010), and Obstfeld et al. (2010) document the importance of precautionary motives.

A quite different explanation is modern mercantilism—reserves accumulation as a by-product of export-led growth strategies that rely on sterilized intervention to maintain an undervalued currency (Dooley et al., 2003). Ghosh and Kim (2009) consider an economy in which the government has an incentive to maintain an overvalued exchange rate because it is equivalent to an export subsidy (the cost of sterilized intervention being the analogue of the subsidy cost) in an economy where there are positive productivity spillovers, external to the firm, of output in the tradeable sector. Aizenman and Lee (2008) show that, in a two-country game, such mercantilism can lead to the inefficient accumulation of reserves as each country engages in beggar-thy-neighbor competitive depreciations. Durdu et al. (2009) and Bar-Ilan and Marion (2009) combine the precautionary demand for reserves with mercantilist motives, where the latter includes deliberate undervaluation both to boost aggregate demand and to build up reserves. Despite the theoretical plausibility, as well as growing suspicion in policy circles that some EMEs are deliberately undervaluing their currencies to gain competitive advantage, the empirical literature to date (notably Aizenman and Lee, 2007; and Delatte and Fouquau, 2010) has had little success in establishing this link robustly in the data.

Are precautionary and mercantilist motives reasonable explanations for the trends in reserves? Before turning to formal empirics, Figure 2 plots simple bivariate relationships between reserves and proxies of insurance against current account shocks (import of goods and services), capital account shocks (broad money and short-term debt), and mercantilism (undervaluation of the exchange rate). The relative importance of these determinants has clearly shifted over time. While the R-squared between imports and reserves declines only slightly over the three time periods (pre-Asian crisis; post-Asian crisis; emergence of global imbalances), the R-squared for the capital account shocks rises from 0-10 percent in 1980-97 to 11-26 percent in 1998-2004, and 14-38 percent in 2005-10. Likewise, the R-squared between reserves and our measure of currency undervaluation (a higher value indicates greater undervaluation) is close to zero in the pre-Asian crisis period, but rises to around 4 percent afterwards. Mercantilist motives and insurance against capital account shocks clearly grew in importance over time.

Figure 2.
Figure 2.

Bivariate Relationships by Period

Citation: IMF Working Papers 2012, 034; 10.5089/9781463933197.001.A001

In a similar vein, different motives might apply at different points along the sample distribution of reserve holdings; countries that hold low levels of reserves may do so because they are not very financially integrated and are mostly concerned about current account rather than capital account shocks. But once one recognizes that different motives may be at play, there is no reason to believe that the effect of various explanatory variables will be the same across the distribution of reserve holdings. There are two aspects to this: first, a variable may help explain why a country holds a high or a low level of reserves; second, it may help differentiate within the group of high- (or low) reserve holders (capturing both types of correlations requires quantile regression techniques that we adopt below). Of course, if different motives are not at play, and if the “homogeneity” assumption that underlies most studies is satisfied, then it should not make any difference—the same variable would explain both whether a country holds a high or low level of reserves, and its relative position within the relevant group, with an identical marginal impact regardless of the level of reserves.

Is this homogeneity assumption satisfied? Figure 3 plots the bivariate relationships between reserves and the same explanatory variables, but now segmented into quartiles of the reserves distribution rather than time periods. Again, some of the relationships look quite different at different levels of reserves. In particular, those related to capital account shocks (broad money and short-term debt), as well as currency undervaluation, are stronger for higher levels of reserves than for lower levels. In part, this is the same as the chronological story (i.e., in the early part of the sample, when countries worried mainly about current account shocks, they held lower reserves), but it is not the full story: about 40 percent of the below-median reserves-to-GDP observations occur in the post-Asian crisis sample; conversely, 44 percent of the above-median observations occur in the pre-Asian crisis sample. As such, it is important to go beyond OLS regressions that ignore these important features of the data.

Figure 3.
Figure 3.

Bivariate Relationships by Quantile

Citation: IMF Working Papers 2012, 034; 10.5089/9781463933197.001.A001

III. Data and Specification

Our sample consists of a panel of 43 emerging market economies over the period 1980-2010. The dependent variable is the logarithm of gross international reserves, end-period stock, expressed in percent of GDP. Following the discussion above, we include three sets of variables intended to capture: (i) precautionary demand for reserves against current account shocks; (ii) precautionary demand against capital account shocks; and (iii) reserve holdings as a by-product of export-led growth strategies.

A. Precautionary Motives

Current Account Shocks

We include three variables to proxy precautionary demand against current account shocks: imports of goods and services, Imports/GDP; the volatility of exports of goods and services, measured as the three-year moving standard deviation of the export-to-GDP ratio, σ(exports/GDP); and the volatility of trading partners’ real GDP growth, also measured by the three-year standard deviation, σ(Δypartner). Each of these is expected to be associated with higher precautionary demand because more reserves will be required to finance imports if the country’s normal imports are large, while the likelihood that a liquidity buffer will be required is increasing in the volatility of partner countries’ demand or of actual exports.

In addition, we include two variables related to the country’s exchange rate regime: a dummy for hard or soft pegs, Peg; and the nominal effective exchange rate volatility σ(ΔNEER). Since a country that has a truly floating exchange rate (and that is willing to let its exchange rate move to any level in the face of shocks) should never need foreign exchange reserves, the peg dummy variable is expected to be associated with greater demand for precautionary reserves while de facto willingness to tolerate greater exchange rate volatility should be associated with lower demand for reserves.

Capital Account Shocks

Turning to capital account shocks, crises in Mexico (1994), Argentina (1995), Indonesia (1997), Turkey (2001), Argentina (2002), and Uruguay (2003) showed how banking crises can spill on to the balance of payments as investors withdraw deposits and flee the currency, while the Mexican (1994), Korean (1997), and Thai (1997) crises also underscored the risks of short-term debt. Accordingly, we include three variables to capture precautionary demand against capital account shocks: a measure of the de jure openness of the capital account—the Chinn-Ito index, which is based on the IMF Annual Report on Exchange Arrangements and Restrictions, KA; short-term debt on a residual maturity basis, ShortDebt/GDP; and banking system liabilities/broad money, Money/GDP. Each is expected to be associated with higher precautionary demand for reserves.

B. Mercantilist Motives and Other Variables

Obtaining proxies that capture possible mercantilist motives for reserve accumulation (as a by-product of maintaining an undervalued real exchange rate) poses significant challenges. To get improved proxies, we rely on the three methodologies that underlie the IMF’s exchange rate assessments (see Lee et al., 2008). Under the macro balance approach, the exchange rate is undervalued if a real appreciation is required to close the gap between the actual current account and its “norm” (the value predicted from a cross-country regression of medium-run determinants of the current account). The equilibrium real exchange rate approach compares the real exchange rate to its equilibrium value implied by “fundamentals” (productivity differentials, terms of trade, government consumption, and the net foreign asset position). Under the external stability approach, the real exchange rate is compared to the level that would generate a current account balance that stabilizes the net foreign asset position at some benchmark value.

Once the implied misalignments under the three approaches are obtained, we average them and map the average into an indicator of more than 10 percent undervaluation (Undervaluation); see Appendix A. In our robustness tests, we use an alternative proxy of mercantilism, namely whether the country exports more than would be expected on the basis of a trade gravity model (Qureshi and Tsangarides, 2010): excess exports. While these proxies are an improvement over existing measures, they cannot distinguish between undervalued exchange rates resulting from crises and those that correspond to deliberate mercantilism. Another issue is that undervaluation of the exchange rate is associated with the accumulation of reserves, not with the holding of a stock per se (by contrast, precautionary motives give rise to the demand for a stock of reserves). Of course, if a country accumulates reserves as a by-product of deliberate mercantilism, then over time this will be reflected in a rising stock of reserves as well, which is what we capture in our baseline regression. As a robustness check, however, below we consider the effect of the accumulation of periods of undervalued exchange rate on the stock of reserves as well.

Regardless of the motive for holding reserves, the benefits need to be weighed against the costs. To this end, we add the interest rate differential between the Treasury bill rate in the country and the US short-term T-bill rate (the typical return on reserve assets). In addition, since the dependent variable is expressed in percent of GDP, we include per capita income and population to allow for non-homogenous scale effects in the demand for reserve holdings as income rises. In the baseline regression, we exclude time and country fixed effects as we are interested in whether we can explain the rise in average reserve holdings and the dispersion across countries with plausible economic determinants. In the robustness tests, however, we add both.

Our full model is therefore:

log(Res/GDP)it=β0+β1log(ypc)it+β2log(Pop)it+β3Pegit+β4σ(ΔNEERit)+β5ln(Imports/GDP)it+β6σ(Exports/GDP)it+β7σ(Δypartner)it(1)+β8KAit+β9(ShortDebt/GDP)it+β10log(Money/GDP)it+β11UnderValit+β12IntRateDifferit+εit

IV. Empirical Analysis

Our empirical analysis proceeds in four steps. We begin by estimating (1) using OLS over the full sample, 1980-2010. Then we consider various sub-samples: 1980-97 (pre-Asian crisis); 1998-2004 (post-Asian crisis); 2005-2010 (global imbalances). Next we turn to quantile regressions to allow the effect of regressors to vary according to the amount of reserves held. We conclude by reporting the results of various robustness tests.

A. Full Sample

We build up to our full model (1) in steps, starting with just the “scale variables” of per capita income and population to provide a benchmark (Table 1 [1]). Reserve holdings are not homogenous in (the US dollar value of) GDP, as the coefficient on per capita income is positive and statistically significant; the regression explains about 15 percent of the variation of the (logarithm) of the reserves-to-GDP ratio. Next, we add the exchange rate regime variables on grounds that countries that wish to limit exchange rate flexibility require more reserves to defend their de jure or de facto pegs. This turns out to be the case, with nominal exchange rate volatility being statistically significant, though the pegged exchange rate regime dummy is not (Table 1 [2]).9 Perhaps surprisingly, the interest rate differential against US assets, which is our proxy for the cost of holding reserves, is statistically insignificant. Adding these variables raises the regression R-squared only marginally to about 17 percent.

Table 1.

Current Account, Capital Account and Mercantilist Determinants of Reserve Demand

article image
Notes:1. Robust standard errors in parentheses

p<0.1,

p<0.05,

p<0.01.

What does make a material difference to the explanatory power of the regression is the addition of current account precautionary variables, which more than doubles with the R-squared to 47 percent (Table 1 [3]). Reserve holdings are strongly related to imports, with one percentage point of GDP higher imports eliciting an almost proportionate increase in the ratio of reserves to GDP. The volatility of trading partner growth is also statistically significant, though the volatility of the country’s own exports is not (controlling for other variables, its estimated coefficient becomes significant). A one-standard deviation increase in each of these current account variables would (individually) raise the implied level of reserves by about 2 percent of GDP (against a sample average of about 13 percent of GDP).

Turning to precautionary demand against capital account shocks, both de jure financial openness and banking system liabilities are positive and statistically significant determinants of reserve holdings (Table 1 [4]). The coefficient on short-term debt, albeit positive, is not statistically significant. This is surprising inasmuch as policy advice at least over the past decade has emphasized the need for EMEs to hold reserves equivalent to the country’s short-term debt exposure. This result is, however, consistent with that of other studies who generally find that short-term debt performs poorly as a determinant of reserve holdings (see Obstfeld et al., 2010; IMF, 2001). Overall, with the addition of the capital account precautionary variables, the regression’s explanatory power rises to about 55 percent, with one-standard deviation increases in the capital account variables individually raising the level of reserves by 1.5 percent of GDP.

As discussed above, mercantilism forms a quite distinct explanation for accumulating international reserves. Table 1 [5] adds our measure of currency undervaluation to the model with just the exchange rate regime variables (i.e., excluding the current and capital account precautionary variables). Our proxy for mercantilism is strongly related to reserve holdings; a country whose currency is undervalued by (at least) 10 percent would, other factors equal, hold some 3 percent of GDP more foreign exchange reserves than a country without an undervalued currency. Although the coefficient is highly significant, the contribution to the model’s explanatory power is modest (an incremental R-squared of about 2 percent), possibly because of the limited variation of the undervaluation dummy variable.

The full model, including exchange rate regime, current and capital account precautionary variables, and mercantilist motives is given in Table 1 [6]. The model explains about 56 percent of the variation in reserve holdings percent without the inclusion of annual or country fixed effects. Moreover, most coefficient estimates are of the expected sign and are statistically significant, with the notable exceptions of the exchange rate regime variables, short-term debt, and the implied carry cost of reserves, all of which are statistically insignificant.

B. Sub-periods: Pre- and Post-Asian Crisis

How have the motives for holding reserves evolved over time? In Table 1 [7]-[9], we re-estimate the full model over various sub-periods: the years preceding the East Asian crisis (1980-97), and the years following it, which we further subdivide into 1998-2004 and 2005-10—the latter period being when global imbalances came to the fore amidst charges that (some) EMEs were pursuing mercantilist policies. While the model’s explanatory power remains roughly the same over the three periods, a time pattern emerges on the importance of the various motives.

During the early period of the sample (1980-97; Table 1 [7]), there is a clear dominance of exchange rate regime and current account precautionary motives. The pegged exchange rate regime dummy is positive and significant (nominal exchange rate volatility is not significant, possibly because most EMEs during this period had de jure or de facto pegs). Imports are a highly significant determinant of reserve holdings during this period, with the coefficient appreciably larger (0.68) than in subsequent periods (0.47). Likewise, the other current account precautionary variables (volatility of exports and volatility of partner country growth) are statistically significant in this period but not in the subsequent periods (1998-04; 2005-10). Conversely, the capital account precautionary variables are either insignificant (short-term debt) or have smaller coefficients (broad money) than in subsequent periods. Lastly, the coefficient on undervaluation is both economically and statistically insignificant in the pre-Asian crisis period. To put this in perspective, a one-standard deviation increase in the current account variables in this period would (individually) raise reserve holdings by 1.2 percent of GDP; the corresponding effect of an increase in the capital account variables is 0.5 percent of GDP, while the estimated effect of an undervalued currency is similar, at around 0.5 percent of GDP.

The Asian crisis appears to have been a wake-up call in terms of the need for reserves as a buffer against capital account shocks (Table 1 [8]). During this period (1998-04), precautionary reserve holdings against current account shocks become less important (the coefficient on imports falls relative to the earlier period, while the volatility of exports, and of partner country growth turn insignificant). By contrast, the coefficients on capital account variables (financial openness, broad money, short-term debt) become statistically significant or larger in magnitude. Moreover, currency undervaluation now becomes positive and statistically significant.

These trends continue in the final sub period (2005-10; Table 1 [9]) where none of the exchange rate regime or current account precautionary variables (except imports, whose coefficient diminishes further) is statistically significant. On capital account variables, the coefficient on broad money increases while that on short-term debt is slightly smaller; both are statistically significant. Financial openness becomes insignificant, possibly because by this period most (though not all) emerging market countries have largely open capital accounts.10 The magnitude of the interest rate differential coefficient becomes larger in absolute value though it remains statistically insignificant. Finally, the coefficient on undervaluation is positive, larger than in the previous periods, and highly statistically significant. One-standard deviation increases in the current account variables would individually raise the implied level of reserves by 1.6 percent of GDP, while corresponding increases in the capital account variables would raise it by 2.0 percent of GDP; undervaluation of the currency would raise it by 7 percent of GDP. (These may be contrasted with the results given above for the 1980-97 period, where current account variables have a larger impact than either capital account variables or undervaluation.)

Confirming our hypothesis, regressions over the sub periods thus suggest shifting motives for holding reserves.11 In the 1980s and 1990s, EMEs held reserves to defend their exchange rate pegs or as a buffer against current account shocks. Following the Asian and other EME capital account crises, insurance against capital account shocks (including banking crises that could spill on to the balance of payments) gained importance. At the same time, mercantilism in the form of an undervalued real exchange rate appears to have contributed to higher reserve holdings. While this pattern accords well with intuition, it need not be limited to motives shifting over time: different levels of reserves across countries at a given point in time may likewise correspond to different reasons for holding them.

C. Quantile Regressions

Do countries that hold a lot of reserves (in relation to GDP) do so for different reasons than those that hold few reserves? To examine this possibility, we adopt quantile regression techniques developed by Koenker and Bassett (1978). Briefly, quantile regressions allow the coefficients on the regressors to vary according to the position of the dependent variable. The key advantage of quantile regressions is that they avoid the (potentially serious) sample selection bias that OLS on subsamples (stratified by the level of reserve holdings) would imply.12 Intuitively, if a variable helps determine whether a country holds high or low reserves but does not help determine reserve holdings within the group of high (or low) reserve holders, then OLS on subsamples would not identify it as such, but quantile regressions would. Both by allowing the marginal impact of explanatory variables to vary by the value of the dependent variable, and by identifying factors that might be missed in OLS, quantile regressions potentially offer a richer picture of what has been driving reserve accumulation across time and countries.13

Quantile regressions can be estimated at any percentile; here we report the results of estimating our full model for each quartile, so the regression becomes:14

log(Res/GDP)it=β0q+β1qlog(ypc)it+β2qlog(Pop)it+β3qPegit+β4qσ(ΔNEERit)+β5qln(Imports/GDP)it+β6qσ(exports/GDP)it+β7qσ(Δypartner)it(2)+β8qKAit+β9q(ShortDebt/GDP)it+β10qlog(Money/GDP)it+β11qUnderValit+β12qIntRateDifferit+εitq=25,50,75,95

Estimating (2) suggests some commonalities, but also important differences in the determinants of reserve holdings at various points in the distribution (Table 2; Figure 4). Figure 4 traces the change in the coefficient estimates as the quantiles increase, holding all other variables constant. The solid line in each figure plots the point estimate from quantile regressions ranging from 0.05 to 0.95 percentile of the distribution and the associated confidence interval. The straight dotted lines represent the estimates for the average reserve holder (i.e., the OLS results in Table 1 [6]) along with their confidence intervals. The majority of the graphs show little “overlap” between the quantiles line and average OLS estimates suggesting that there are indeed differences in both the magnitude and significance of the regressors at different points along the reserves distribution. Indeed, several variables (nominal exchange rate volatility, short-term debt, and the carry cost/interest rate differential) that were insignificant in the OLS regressions for the average reserve holder (reproduced in Table 2 [1]), turn out to be highly significant at various points on the reserve holding distribution.

Table 2.

Reserves Demand Across Quantiles

article image
Notes:1. Quantile regression estimates 1980-2010.2. Robust standard errors in parentheses

p<0.1,

p<0.05,

p<0.01.

Figure 4.
Figure 4.

Comparison of Quantile Regression and OLS Coefficient Estimates

Citation: IMF Working Papers 2012, 034; 10.5089/9781463933197.001.A001

Source: Authors’ calculations.

Comparing across quantiles, the exchange rate regime and precautionary demand against current account shocks is more important for low reserve holders than for high reserve holders. Thus the coefficient on imports declines from 0.85 for observations in the lowest quartile (Table 2 [2]) to 0.37 for observations above the 75th percentile (Table 2 [5]), with the differences in coefficients across the distribution statistically significant. Likewise, volatility of exports is a significant determinant for below-median reserve holders (Table 2 [2]-[3]) but not for above-median reserve holders (Table 2 [4]-[5]), while the coefficient on volatility of partner-country growth decreases with rising reserve holdings, albeit statistically insignificant throughout the distribution.

The picture is more mixed for capital account shocks. At the lower end of the distribution (Table 2 [2]-[3]), the coefficients on financial openness and short-term debt are large and statistically significant, whereas they are smaller and/or insignificant for above-median reserve holders (Table 2 [4]-[5]).15 The coefficient on broad money, by contrast, increases along the distribution: for high-reserve holders, banking system liabilities are a more important determinant of reserves accumulation than for low-reserve holders. This is intuitive in that, for high-reserve holders, banking system liabilities (which average 70 percent of GDP for this group) are a much larger source of potential capital account shocks than is short-term debt (17 percent of GDP).16

The cost of holding reserves (proxied by the interest rate differential), which was always insignificant in the OLS regressions, becomes negative and statistically significant for above-median reserve holders (Table 2 [4]-[5]). This makes sense since the absolute cost of holding reserves will be proportional to reserve holdings (in percent of GDP). Therefore, the carry cost will be largely irrelevant when reserves are low (and perhaps at the prudent minimum required for precautionary purposes), but will figure more prominently in the country’s cost-benefit analysis as reserve holdings (and therefore their absolute carry cost) increases.

More surprising, undervaluation of the exchange rate is important across the distribution, with the coefficient always positive and highly significant (Table 2 [1]-[4]).17 Although charges of mercantilism and currency manipulation tend to be leveled against countries with larger stocks of reserves, the analysis here suggests that currency undervaluation as a driver of reserves accumulation may be a more common phenomenon. What we suspect, however, is that the correlation between undervalued exchange rates and reserves for low-reserve holders largely reflects collapsed real exchange rates in the aftermath of the 1980s debt crisis (and other EME financial crises) rather than deliberate undervaluation through sterilized intervention. It is noteworthy in this regard that undervaluation for low-reserve holders is typically in the context of declining reserves (on average, reserves declined by about 2 percent for low-reserve holders with undervalued exchange rates) whereas undervaluation for high-reserve holders is associated with increasing reserves of about 15 percent.

D. Robustness

To test the sensitivity of our estimates to alternative specifications and proxies, we conduct several robustness tests on both the OLS and quantile regressions, reported in Tables 3-5. First, in the OLS regressions, we replace our exchange rate undervaluation variable with a PPP-based measure (Table 3 [2]) or “excess” exports (i.e., whether the country exports more than would be predicted by a gravity model of international trade; Table 3 [3]). Using either variable yields a positive and statistically significant coefficient, suggesting that our findings above on mercantilist motives are not driven by any idiosyncrasy of our proxy. Next, we consider whether changes in EME reserve accumulation behavior during the global financial crisis that started in 2008 might be driving our results. We alternatively stop the sample in 2007 or 2008 (Table 3 [4]-[5]) instead of 2010; this makes virtually no difference to the results.

Table 3.

Robustness of OLS Estimates

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Notes:1. Robust standard errors in parentheses

p<0.1,

p<0.05,

p<0.01.

Table 4.

Robustness of Quantile Regressions

article image
Notes:1. Robust standard errors in parentheses

p<0.1,

p<0.05,

p<0.01.

Table 5.

Robustness of Undervaluation Measure

article image
Notes:1. Robust standard errors in parentheses

p<0.1,

p<0.05,

p<0.01.