Macroeconomic Impacts of Foreign Exchange Reserve Accumulation: A Theory and Some International Evidence

Recently, a dramatic accumulation of foreign exchange reserves has been widely observed among developing countries. The purpose of this paper is to explore what macroeconomic impacts accumulated foreign reserves have in developing countries. In the first part, we analyze a simple open economy model where increased foreign reserves reduce costs of liquidity risk. Given the amount of foreign reserves, the utility-maximizing representative agents decide consumption and the amounts of liquid and illiquid foreign debts. The equilibrium values of these macro variables depend on the amount of foreign reserves. When the government increases its foreign reserves, not only liquid debt but also total debt increases, while the debt maturity becomes shorter. The increased foreign reserves also lead to permanent decline of consumption, depreciation of real exchange rate, and temporal improvement of current account. In the second part, we show several empirical supports to the theoretical implications. We provide several supportive evidences by using the panel data of the Penn World Table. We also explore how foreign debt maturity structures changed in East Asia. We find that many East Asian economies reduced short-term borrowings temporarily after the crisis but increased short-term borrowings in the early 2000s. Since short-term debt is liquid debt, the instantaneous change after the crisis is consistent with the case where only private agents responded to increased aversion to liquidity risk. However, accompanied by substantial rises in foreign exchange reserves, the change in the early 2000s is consistent with our model implications. JEL Classification Numbers: F21, F32, F34