Determinants of Foreign Currency Reserve Accumulation: Importance of Financial Sector Stability and Expansion

Rayhan Momin, Finance PhD student

Emerging Market (EM) central banks have continued to accumulate foreign currency (FC) reserves despite achieving sufficient coverage of short-term external liabilities, permitting greater foreign exchange regime flexibility, and loosening capital controls. In this context, the prominent explanations for why EM central banks accumulate reserves – the precautionary savings motive to protect against external liquidity shortfalls and the mercantilist motive to manipulate exchange rates – appears insufficient. Observing that FC reserve accumulation has coincided with expansion of EM central bank balance sheets and the expansion of domestic credit and the monetary base, we argue that financial sector stability and expansion concerns have played an important role in driving FC reserve accumulation. We present preliminary empirical work supporting this argument and would like to deepen this analysis by using Haver Analytics Emerging Markets exhaustive database. To complement our empirical work, we also propose to build a structural model replicating key moments in the data.