Financial strongStabilitystrong, the Trilemma, and International Reserves.pdf

By MAURICE OBSTFELD , JAY C. SHAMBAUGH , AND ALAN M. TAYLOR The rapid growth of international reserves—a development concentrated in the emerging markets—remains a puzzle. In this paper we suggest that a model based on financial stability and financial openness goes far toward explain- ing reserve holdings in the modern era of globalized capital markets. The size of domestic financial liabilities that could potentially be converted into for- eign currency (M2), financial openness, the ability to access foreign currency through debt markets, and exchange rate policy are all significant predictors of reserve stocks. Our empirical financial-stability model seems to outperform both traditional models and recent explanations based on external short-term debt. (JEL : E44, E58, F21, F31, F36, F41, N10, O24.) Over the past decade, the international reserves held by monetary authorities have risen to very high levels relative to national outputs. More rapid reserve accumulation, primarily attributable to relatively poor countries, is thought to have affected the global patterns of exchange rates, of capital flows, and of real interest rates. Foreign official purchases of dollars have also financed an unprecedented level of external borrowing by the world’s biggest economy, that of the United States. The upsurge in global reserve growth confronts economists with an important puzzle. What has driven it, and is it likely to endure? The facts to be explained can be summarized as follows. Starting from the end of the Bretton Woods era, global international reserve holdings as a fraction of world GDP grew dramatically— up by a factor of 3.5 from less than 2 percent in 1960 to 6 percent in 1999—despite the global shift toward more flex