Managing Capital Flows and Exchange Rates
Edited by Dongsoo Kang and Andrew Mason
Chapter 6: Optimal international reserves with sudden stop risks
Emerging market economies have accumulated large stocks of international reserves over the past decade. Although the accumulation has attracted much attention from academic and policy circles, the reasons and appropriate need for the large holdings of international reserves have not been fully understood. This chapter investigates the optimal level of international reserves when agents face the risk of a sudden stop. When private capital flows out rapidly and output drops due to financial turmoil in the occurrence of sudden stops, available resources for consumption and investment in an economy decrease sharply. At the same time, the economy has only limited access to international financial markets. If the economy has accumulated enough international reserves, their decumulation can mitigate suffering from an abrupt adjustment process. There is a cost, however, to holding international reserves. For international reserves to play a role in the face of sudden stops, they must be invested in highly liquid and safe assets such as US Treasury bills. These kinds of assets, however, yield lower returns than alternative riskier investment. Thus, to find the appropriate level of international reserves, the benefits of insurance against sudden stop risks and the costs of lower-return investment need to be investigated.
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