## _wp07151

## Source details

**Canonical URL:** [_wp07151](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07151.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07151.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07151.pdf.json)

---

### Introduction and research question
- Sample and scope:
  - Panel data from 36 emerging markets and 24 advanced economies for the 1980–2005 period.
- Central question:
  - How do (net) capital flows and financial integration affect the accumulation of international reserves, given financial frictions and information problems?
- Framing:
  - Sovereign liquidity management is analogous to corporate liquidity management: reserves provide insurance against uncertain income streams and volatile capital flows.
  - Financial frictions and information problems increase the option value of holding reserves; greater access to international capital markets (lower risk premia) reduces desired reserve stocks.

### Context and key statistics
- End-2005 cross-country highlights:
  - Average reserves-to-GDP ratio: 19 percent in emerging markets, 10 percent in advanced countries.
  - Emerging market reserves averaged 5.8 months of imports.
  - Korea and China held more than 8 months and 14 months of imports, respectively.
  - Ratio of reserves to short-term debt in 2005: greater than 3.0 for Korea and 6.5 for China.
- Period and averages:
  - Reserves relative to GDP over entire period: emerging markets 12.5 percent; advanced countries 9.6 percent.
  - Emerging markets have had higher net capital flows than advanced countries by about 2.5 percent of GDP.
  - Fiscal balance (average): deficit for emerging markets by 2.6 percent of GDP; deficit for advanced countries by 4.1 percent of GDP.
  - Credit ratings (S&P scale reported): average 22 for advanced countries and 14 for emerging markets; emerging range 2 to 23; advanced range 14 to 23.
  - GDP per capita: on average, advanced countries more than five times that of emerging markets.
  - Reserves-to-GDP after early 1990s: advanced countries ~10–11 percent; emerging markets rose to 20 percent by 2003 and slowed to 19% by 2005.

### Theoretical determinants and mechanisms
- Precautionary/buffer-stock motives:
  - Trade-off between opportunity cost of holding reserves and macroeconomic adjustment costs when reserves are lacking.
  - Volatility of international transactions and higher loss aversion raise precautionary reserves.
  - Lack of contingent instruments and limited access to external finance increase reserves’ option value.
- Opportunity cost and measurement:
  - Standard empirical measure: domestic interest rate minus comparable US treasuries; many studies find no significant negative effect, possibly due to measurement problems (reserve composition, non-market domestic rates).
  - Cost of acquiring international currencies depends on country-risk premium and access to international capital markets.
- Scaling and exposure:
  - Reserves should increase with size of international transactions; common scaling variables: GDP, GDP per capita, population (log of population may attenuate overstatement for China/India).
- Other considerations:
  - Exchange rate flexibility: conventional view—greater flexibility reduces reserve demand; countervailing motives exist (dampening appreciation, managing volatile flows).
  - Import share in output: ambiguous sign; interpreted as proxy for openness (positive) or for marginal propensity to import (negative).
  - Sovereign ratings: lower-rated countries may hold more reserves due to limited market access and higher premia.
  - Fiscal conditions: ambiguous effect—political-economy considerations can reduce reserve demand, fiscal fragility can increase precautionary reserves.

### Data and descriptive patterns
- Data sources:
  - International Financial Statistics, World Economic Outlook, CEIC (China Economic Information Company), Standard and Poor’s ratings, Reinhart and Rogoff (2004a) exchange rate regime classifications.
- Definitions:
  - International reserves defined as gross reserves net of gold.
  - Net capital flows measured by the capital and financial account of the balance of payments.
- Descriptive correlations and heterogeneity:
  - Reserves-to-GDP correlation with sovereign ratings: emerging markets 0.42; advanced countries –0.25.
  - Correlation between openness and net capital flows/GDP: emerging markets 0.34; advanced countries –0.36.
  - Pooled baseline fixed-effects regressions adjusted R-squares ~0.88; excluding fixed effects explained variation drops to 0.57. Group-specific adjusted R-squares: emerging markets 0.78, advanced countries 0.93; excluding fixed effects: emerging markets 0.39, advanced countries 0.72.

### Empirical strategy
- Baseline regressors:
  - SIZE = ln(population)
  - σ = exchange rate variability (std dev of nominal exchange rate growth)
  - IM/GDP = import-GDP ratio
  - SR = S&P sovereign rating
  - CF/GDP = net capital flows/GDP
- Models estimated:
  - OLS, IV, time-subsample regressions (Models 1 and 2), interactions with financial globalization (Model 3), and dynamic Arellano-Bond GMM panels.

### Main empirical findings
- Net capital flows (CF/GDP):
  - Emerging markets:
    - OLS CF/GDP coefficient positive (0.171**); IV 0.182 (IV not significant in some specs). Interpretation: in many specifications net inflows associated with reserve accumulation (stockpile motive), particularly after 1998 and strongly in 2001–05.
    - Time-varying: 1980s CF associated with lower reserves; 1991–97 little effect or small increases; 1998–05 substantial positive association.
  - Advanced countries:
    - OLS CF/GDP coefficient negative (–0.236***); IV (–0.489***). Interpretation: capital flows often finance current account deficits rather than build reserves.
    - Time-varying: generally negative effect, strongest in 1998–2005 and 2001–05.
  - Pooled regressions: CF/GDP coefficient often statistically insignificant (opposite group effects offset).
- Financial integration interactions (Model 3):
  - Two globalization measures: (A) total foreign assets and liabilities to GDP; (B) portfolio equity+FDI assets/liabilities to GDP.
  - Key patterns:
    - β_CF (CF/GDP alone): negative for emerging markets and positive for advanced countries in some panel specifications (sign differences across panels).
    - β_GL (interaction GLOB*(CF/GDP)): significantly positive for emerging markets and significantly negative for advanced countries.
  - Example (IV estimator, panel A, period-average total effect for 2001–05):
    - Emerging markets total effect = 0.135 (= −1.605 + 0.367 × 4.74).
    - Advanced countries total effect = −0.427 (= 3.468 − 0.658 × 5.92).
  - Interpretation: effect of net capital flows on reserves increases with financial integration for emerging markets (more stockpiling as integration rises); for advanced countries the effect becomes more negative with integration.
- World interest rates (WIR proxied by LIBOR):
  - Emerging markets: WIR coefficient significantly negative (–0.007*** OLS; –0.008*** IV in a specification), implying lower world rates reinforced reserve accumulation.
  - Advanced countries: WIR coefficient positive and significant in some specifications (0.002** OLS; 0.003** IV).
- Exchange rate regime and conditional factors:
  - Group means: emerging markets show lower reserves under more flexible regimes; advanced countries lowest under floating and highest under intermediate regimes.
  - Regression findings: emerging markets reserve holdings lower under floating regime; pooled and advanced samples show higher reserves under intermediate regime than fixed.
  - Interaction examples:
    - I(appreciation)*I(surplus) coefficient: emerging markets 0.014** (reserve accumulation with appreciation when running current account surpluses); advanced countries –0.013**.
- Dynamic panel (Arellano-Bond GMM):
  - Persistence: coefficient on Δ(IR/GDP)–1 ≈ 0.7–0.8 and highly significant.
  - ΔSR negative and significant (reserve increases associated with lower sovereign ratings).
  - Δ(CF/GDP) positive and significant for pooled and advanced samples (0.339** pooled; 0.739*** advanced in one spec); emerging markets Δ(CF/GDP) often insignificant or negative depending on specification.
  - Δ[GLOB*(CF/GDP)]: positive and significant for emerging markets (0.101***); negative and significant for advanced countries (–0.149***).
  - Δ(M2/GDP): positive and significant for emerging markets (0.128***); not significant for advanced countries.
  - Δ(F/GDP) (fiscal balance): statistically insignificant when groups estimated separately; positive and significant in pooled regression.
  - Diagnostics: Wald tests show joint significance of regressors; Arellano-Bond tests show expected first-order residual autocorrelation and no second-order autocorrelation.

### Interpretation and synthesis
- Changing role of capital flows:
  - Emerging markets shifted from using capital flows to finance deficits in the 1980s to using inflows to build reserves after 1998 and particularly in 2001–05.
  - Advanced countries generally show capital inflows associated with lower reserves, reflecting financing of current account deficits.
- Role of financial integration:
  - For emerging markets, greater financial integration amplified the stockpiling response to capital inflows.
  - For advanced countries, greater integration made the CF→reserves relationship more negative.
- Other reinforcing factors:
  - Lower world interest rates supported reserve accumulation in emerging markets.
  - Exchange rate regime and conditional exchange-rate factors matter: appreciation with current account surpluses spurred reserves in emerging markets but reduced them in advanced countries.

### Policy-relevant implications and recommendations
- Precautionary logic:
  - Reserve accumulation in emerging markets is consistent with insurance against costly capital flow reversals and liquidity shortages.
  - Financial integration increases the importance of sovereign liquidity management for macroeconomic stability.
- Institutional and policy responses:
  - Develop domestic financial markets to reduce reliance on large reserve holdings for self-insurance.
  - Promote regional arrangements for pooling reserves to improve sovereign liquidity management against volatile capital flows.
  - Maintain and improve access to international financial markets; better access should reduce the need for very large reserve stocks over time as crisis memories fade.
- Trade-offs:
  - Large reserves are costly but may be small relative to economic and social costs of crises (substantial output losses, adverse balance sheet effects).
  - Optimal reserve policy depends on country-specific access to markets, sovereign ratings, fiscal conditions, and exchange-rate regime choices.

*Source: _wp07151 - References.*

### References..............................................................................................................

### _wp07151 - References..............................................................................................................

### Introduction and research question
- Global holdings of international reserves have increased rapidly in recent years, with the increase being especially dramatic in emerging markets in both absolute terms and relative to reserves held by advanced countries.
- The paper uses panel data from 36 emerging markets and 24 advanced economies for the 1980–2005 period to examine the interaction between capital flows, financial integration, and reserve holdings.
- Central question: How do (net) capital flows and financial integration affect the accumulation of international reserves, given financial frictions and information problems?

### Motivation and motivations for reserve accumulation
- Drivers of reserve accumulation highlighted:
  - Cushioning against currency and financial crises and reversals in capital flows.
  - Insurance value: reserves allow countries to smooth consumption and avoid forced adjustment if access to external financing is lost.
  - Backing pegs or managed exchange rate systems; pervasive “fear of floating” even among countries classified as free or managed floats.
  - Protecting external competitiveness in export-dependent countries.
  - Risk diversification: holding foreign currency assets may be negatively correlated with domestic investments.
- Cost–benefit consideration: holding large reserves is costly, but costs may be small relative to the economic and social costs of crises (substantial output losses, balance sheet channels).

### Theoretical framing and analogies
- Sovereign liquidity management framed analogously to corporate liquidity management: liquid assets provide valuable insurance against uncertain income streams and volatile capital flows.
- Financial frictions and information problems increase the option value of holding reserves, particularly for countries with limited access to international capital markets or high external finance premia.
- Countries able to borrow at reasonable risk premia require smaller reserve stocks; reserve differentials across countries should depend on degree of access to international markets.

### Empirical approach (high level)
- Estimation: panel data models that account for economy size, import share, exchange rate variability, exchange rate regimes, world interest rates, and fiscal conditions.
- Data sample: 36 emerging markets and 24 advanced economies over 1980–2005.

### Key empirical findings (as reported in the Introduction)
- Sensitivity of reserves to capital flows has changed over time for emerging markets; reserve-holding patterns differ between emerging markets and advanced countries.
- 1980s:
  - For emerging markets, reserve holdings were negatively associated with capital flows (interpreted as capital flows financing current account deficits).
  - For advanced countries, the negative link was less pronounced.
- Recent years (toward end of sample):
  - For emerging markets, capital flows have a strong positive effect on reserves (suggesting inflows used to build reserve buffers).
  - For advanced countries, capital flows have a negative effect on reserves.
- Interpretation: With increasing financial integration and experience of capital account crises, emerging markets have used capital inflows to accumulate reserves as protection against “sudden stops” and loss of access to international capital markets.

### Contextual and numeric highlights preserved from the source
- Sample period: 1980–2005.
- Cross-section: 36 emerging markets and 24 advanced economies.
- At the end of 2005:
  - Average reserves-to-GDP ratio: 19 percent in emerging markets, 10 percent in advanced countries.
  - Emerging market reserves averaged 5.8 months of imports.
  - Korea and China held more than 8 months and 14 months of imports, respectively.
  - Ratio of reserves to short-term debt in 2005: greater than 3.0 for Korea and 6.5 for China.
- Prior to the 1990s, emerging market reserves fluctuated between three and four months of imports (traditional rule-of-thumb).

### Policy-relevant implications (from the paper’s framing)
- Reserve accumulation in emerging markets can be rationalized as insurance against costly capital flow reversals and liquidity shortages.
- Financial integration increases the importance of sovereign liquidity management for macroeconomic stability.
- The degree of access to international capital markets (and the cost of such access) is a key determinant of desired reserve holdings.

*Source: _wp07151 - References.*

### Section V concludes the paper. The appendix contains a description of the data.

### II. DETERMINANTS OF INTERNATIONAL RESERVES

### A. Buffer Stocks and the Precautionary Motive
- Buffer stock model: central banks choose reserve levels by balancing the opportunity cost of holding reserves with macroeconomic adjustment costs when reserves are lacking (Frenkel and Jovanovic, 1981; Bahmani-Oskooee, 1985).
- Empirical observations:
  - Global reserve holdings were about 17 weeks of imports at the end of 1999, which is almost double what they were at the end of 1960, and 20 percent higher than they were at the start of the 1990s (Flood and Marion, 2002).
  - IMF (2003), using a standard buffer stock model based on Aizenman and Marion (2004), suggests reserve accumulation in emerging markets between 1997 and 2001 was broadly in line with fundamentals, while the surge in reserves in 2002 and 2003 was above model predictions.
- Precautionary/stockpiling motive:
  - Sovereign liquidity analogous to corporate liquidity; liquid assets reduce dependence on costly external funding.
  - Firms draw on lines of credit to increase liquid assets when external finance becomes costly (Choi and Kim, 2001).
  - Financially constrained firms use cash flows to build liquid assets; unconstrained firms do not systematically do so (Almeida and others, 2004).
  - Large reserve holdings in emerging markets may reflect precautionary demand amid shocks and limited access to international capital markets.
  - Lack of terms-of-trade contingent instruments and differences in risk aversion give reserves option value (Van Wijnbergen, 1990).
  - An increase in loss aversion or volatility of shocks boosts precautionary reserves (Aizenman and Marion, 2003).
  - Precautionary reserves can provide self-insurance against sudden stops and capital flight (Aizenman and Lee, 2005).
  - Jeanne (2007) derives reserve determination by trading off reserve cost and risk of capital account crisis.
  - Reserves discussed as macroeconomic stabilizers (Ben-Bassat and Gottlieb, 1992; Caballero and Panageas, 2004).

- Scaling factors:
  - Scaling variable measures size of international transactions: GDP, GDP per capita, or population size.
  - Reserves should increase with size of international transactions; positively correlated with population or standard of living (Aizenman and Marion, 2004).
  - For large-population emerging markets (China, India), population may overestimate transaction size; logarithm of population can attenuate this problem.

- Opportunity cost of holding reserves:
  - Standard empirical measure: differential between the country’s own-interest rate and interest rate on comparable US treasuries.
  - Most empirical studies do not find a significant negative effect for the opportunity cost (Flood and Marion, 2002; IMF, 2003; Aizenman and Marion, 2004).
  - Measurement problems: reserve composition not adequately reflected; until early 1990s many emerging markets lacked market-determined domestic interest rates.
  - Standard measure omits cost of acquiring international currencies, which depends on country-risk premium and access to international capital markets.

- Volatility of international transactions:
  - Buffer stock approach predicts reserves increase with volatility of international transactions (Frenkel and Jovanovic, 1981; Flood and Marion, 2002; Aizenman and Marion, 2004).
  - Volatility usually measured by standard deviation of trend-adjusted changes in reserves over some period.
  - Alternative measure: volatility of export receipts (Edwards, 1985; Aizenman and Marion, 2004).
  - Footnote: reserve volatility measure can be contaminated because it combines jumps in reserves owing to reserve restocking and sudden declines due to speculative attacks (Flood and Marion, 2002).

### B. Other Considerations
- Exchange rate flexibility:
  - Conventional view: greater exchange rate flexibility should reduce demand for reserves since large stockpiles are less needed to maintain or enhance peg credibility (Disyatat, 2001; Flood and Marion, 2002; Aizenman and Marion, 2004).
  - Flexible regimes can better accommodate shocks and thus may need smaller liquidity buffers (Heller and Mohsin, 1978).
  - Countervailing effects:
    - Need for reserves may increase with exchange rate flexibility to temper exchange rate movements if capital flows are volatile.
    - Central banks may accumulate reserves to dampen currency appreciation (Frankel and Dornbusch, 1995; Dooley and others, 2004).
  - Footnote: analyzing exchange rate regimes assumes correct classification; Reinhart and Rogoff (2004a) propose reclassifying regimes based on de facto practices.

- Import share in output:
  - Ambiguous relationship with reserves (Heller and Khan, 1978).
  - If import share proxies marginal propensity to import, relationship negative: countries use reserves to reduce output adjustment costs.
  - If import share represents openness/vulnerability to external shocks, relationship positive: more open countries need greater reserves (Edwards, 1984; Aizenman and Marion, 2004).
  - Reserve-to-imports ratio implies positive relationship.
  - Many empirical studies use import share in GDP to represent openness and required reserves.

- Sovereign ratings:
  - Low-rated countries have limited access to international capital markets and may hold more reserves to withstand external shocks.
  - Ratings summarize macroeconomic indicators, default history, social and political factors (Cantor and Packer, 1996).
  - Political and credit risk influence capital flows from rich to poor countries (Reinhart and Rogoff, 2004b).
  - Governments seek ratings to ease access and broaden investor base; many investors prefer rated securities (Kaminsky and Schmukler, 2002).
  - Sovereign ratings affect country risk premia and stock returns for emerging markets.

- Fiscal conditions:
  - Net effect of fiscal stance on reserves depends on political-economy factors and crisis risk.
  - Political-economy: greater chance of opportunistic future policymakers reduces demand for international reserves and may increase external borrowing to raise current consumption of interest groups (Aizenman and Marion, 2004).
  - Political corruption may reduce optimal reserve holdings (Aizenman and Marion, 2003).
  - These considerations suggest a positive link between reserves and fiscal surpluses.
  - Conversely, fiscal problems raise risk of currency or banking crises; weaker fiscal stance increases sovereign default risk and external finance premium, possibly leading fiscally fragile countries to hold larger reserve cushions—implying a negative link between reserves and fiscal surpluses (Reinhart and Rogoff, 2004b).

### C. Capital Flows and Financial Integration
- Scope of reserve management expanded with financial integration: now includes moderating exchange rate volatility, facilitating trade, and managing cross-border asset transactions.
- Sovereign liquidity management increasingly important to reduce vulnerability to international financial shocks.
- Traditional buffer stock model assumes fixed brokerage/liquidation costs for restocking reserves; in reality restocking costs depend on access to international capital markets and are state-dependent.
  - In good times: low country-risk premia, easy capital raising.
  - In bad times: restricted access, expensive borrowing for low-creditworthiness countries.
- Precautionary view: countries stockpile reserves when liquidity is available at low financing costs; reserve holdings respond to capital flows depending on financial environment (Choi and Kim, 2001; Almeida and others, 2004).
- International markets remain incomplete and subject to frictions and information problems; recent experience raises concern about sudden reversals in capital flows and financial crises (Calvo, 1998, 2002; Aizenman and Marion, 2003; Caballero and Panageas, 2004; Edwards, 2004).
- Financial integration plus credit market imperfections can generate endogenous sudden stops via collateral constraints on dollarized external debt, explaining large reserve buildups (Durdu and others, 2007).
- Measuring financial openness:
  - De jure measures: policies promoting capital account liberalization.
  - De facto measures: actual capital flows (Prasad and others, 2003; Lane and Milesi-Ferretti, 2006).

### III. DATA AND DESCRIPTIVE STATISTICS
- Sample and period:
  - Annual data for 36 emerging markets and 24 advanced countries for the 1980–2005 period (see Appendix A for country list).
- Data sources:
  - International Financial Statistics, World Economic Outlook, CEIC (China Economic Information Company).
  - Sovereign ratings: Standard and Poor’s.
  - Exchange rate regime classifications: Reinhart and Rogoff (2004a).
- Definitions and summary statistics:
  - International reserves defined as gross reserves net of gold (as in Aizenman and Marion, 2004; IMF, 2003).
  - Reserves relative to GDP over the entire period:
    - Emerging markets: 12.5 percent.
    - Advanced countries: 9.6 percent.
  - On average, GDP per capita in advanced countries is more than five times that of emerging markets.
  - Population size on average greater in emerging markets, driven in large part by China and India.
  - Exchange rate variability is far higher in emerging markets.
  - Import-GDP ratio is higher for advanced countries than for emerging markets.
  - Net capital flows measured by the capital and financial account of the balance of payments.
  - Emerging markets have had higher net capital flows than advanced countries by about

*Source: _wp07151 - Section V concludes the paper. The appendix contains a description of the data.*

### 2.5 percent of GDP. The current account balance is on average close to zero for advanced

### _wp07151 - 2.5 percent of GDP. The current account balance is on average close to zero for advanced

### Key cross-country patterns and descriptive findings
- The (overall) fiscal balance is on average in deficit for emerging markets (by 2.6 percent of GDP) and advanced countries (by 4.1 percent).  
- The credit ratings are higher on average for advanced countries (22 compared to 14 for emerging markets).  
- The range for sovereign ratings: emerging markets from 2 to 23; advanced countries from 14 to 23 (all advanced countries are above investment grade).  
- The reserves-to-GDP ratio: advanced countries fluctuated around 10-11 percent after early 1990s; emerging markets rose to 20 percent by 2003 and slowed to 19% by 2005.  
- Average net capital flows and current account patterns:
  - Emerging markets: net capital flows rose in 1991–96, fell in 1997–98 (Asian crisis), then recovered; current accounts showed a downward swing in 1991–96 and a rising trend in recent years.
  - Advanced countries: net capital flows showed a downward trend since 1991, a sharp increase after the Asian crisis, and an upsurge since 2000 (reflecting funding of large U.S. current account deficits); current account on average negative since 1998 (U.S. driven), but positive excluding the U.S.
- Monetary aggregates: The M2-to-GDP ratio is on average higher for advanced countries than for emerging markets, indicating higher monetization in advanced economies.

### Simple correlations and heterogeneity
- Reserves-to-GDP correlation with sovereign ratings: emerging markets 0.42; advanced countries –0.25.  
- Correlation between openness and net capital flows/GDP: emerging markets 0.34; advanced countries –0.36.  
- Large role of country-specific heterogeneity: pooled baseline fixed-effects regressions show adjusted R-squares ~0.88; excluding fixed effects the explained variation drops to 0.57. Group-specific adjusted R-squares: emerging markets 0.78, advanced countries 0.93; excluding fixed effects: emerging markets 0.39, advanced countries 0.72.

### Baseline regression results (IR/GDP determinants)
- Basic regressors: SIZE = ln(population), σ = exchange rate variability (std dev of nominal exchange rate growth), IM/GDP, SR = S&P sovereign rating, CF/GDP = net capital flows/GDP.  
- Robust findings across OLS and IV:
  - SIZE coefficient positive (larger for emerging markets than advanced countries).
  - σ coefficient negative and significant for both groups (exchange rate variability reduces reserves held relative to GDP); σ coefficient much smaller for emerging markets in level due to higher average exchange rate variability.
  - IM/GDP coefficient positive for all groups and more significant for emerging markets.
  - SR coefficient negative overall (higher creditworthiness reduces reserve needs); in baseline regressions SR not significant for emerging markets but negative and significant for advanced countries.
- Net capital flows (CF/GDP):
  - Emerging markets: CF/GDP coefficient positive in OLS (0.171**) and IV (0.182, IV not significant), suggesting a stockpile motive dominating financing motive in some specifications.
  - Advanced countries: CF/GDP coefficient negative and significant in OLS (–0.236***) and IV (–0.489***), suggesting capital flows finance current account deficits rather than build reserves.
  - Pooled regressions: CF/GDP coefficient statistically insignificant (opposite effects across groups may offset).

### Time-varying effects of capital flows (Models 1 and 2)
- Model 1 (three subperiods D(80-90), D(91-97), D(98-05)) and Model 2 (four subperiods D(80-90), D(91-97), D(98-00), D(01-05)) show:
  - Emerging markets:
    - 1980s: net capital flows associated with lower reserves (used to finance current account deficits).
    - 1991–97: little effect or small increases in reserves despite large inflows (flows used for domestic expenditures).
    - 1998–05 (particularly 2001–05): net capital flows associated with substantial reserve accumulation.
  - Advanced countries:
    - Net capital flows generally associated with lower reserves, especially strongly negative in 1998–2005 and 2001–05 periods.

### Financial integration (Model 3) and interaction effects
- Two globalization measures used: (A) ratio of total foreign assets and liabilities to GDP; (B) ratio of stock of portfolio equity assets/liabilities plus FDI assets/liabilities to GDP.  
- Key coefficients:
  - β_CF (effect of CF/GDP alone): significantly negative for emerging markets and significantly positive for advanced countries in some specifications (panel A and B show sign differences).
  - β_GL (interaction GLOB*(CF/GDP)): significantly positive for emerging markets and significantly negative for advanced countries.
- Interpretation:
  - For emerging markets, the effect of net capital flows on reserve accumulation increases with financial integration (drifts up over time from negative to positive).
  - For advanced countries, the effect decreases with financial integration (becomes more negative).
- Example of period-average total effect (IV estimator, panel A): for 2001–05 total effect = 0.135 (= −1.605 + 0.367 × 4.74) for emerging markets and −0.427 (= 3.468 − 0.658 × 5.92) for advanced countries.

### World interest rates and exchange rate regimes
- Inclusion of world interest rate (WIR proxied by LIBOR):
  - Emerging markets: WIR coefficient significantly negative (–0.007*** OLS; –0.008*** IV in one specification), suggesting lower world rates reinforced reserve accumulation.
  - Advanced countries: WIR coefficient positive and significant in some specifications (0.002** OLS; 0.003** IV), possibly reflecting advanced countries contributing to global liquidity rather than stockpiling reserves.
- Exchange rate regime (Reinhart and Rogoff classification: fixed = 1, intermediate = 2, floating = 3):
  - Group means: emerging markets show lower reserves under more flexible regimes (floating associated with lower reserves); advanced countries show lowest reserves under floating but highest under intermediate regime (managed float requires more reserves).
  - Regression with regime dummies: for emerging markets, reserve holdings lower under floating regime; for advanced countries and pooled sample, reserves-to-GDP ratio significantly higher under the intermediate regime than under the fixed regime.
- Conditional exchange-rate factors (additional regressions):
  - Exchange rate variability interacted with conditional volatility of capital flows: for advanced countries the negative effect of exchange rate variability on reserves declines with higher conditional volatility of capital flows.
  - Exchange rate appreciation interacted with current account surplus: emerging markets accumulate reserves in the face of appreciation when running current account surpluses; advanced countries reduce reserves in the same circumstance (I(appreciation)*I(surplus) coefficient positive for emerging markets: 0.014**; negative for advanced countries: –0.013**).

### Dynamic panel (Arellano-Bond GMM) results and robustness checks
- Dynamic specification includes two lags of Δ(IR/GDP) and first-differenced time-varying covariates; sovereign ratings, net capital flows, fiscal balance, and M2 treated as endogenous.
- Main dynamic results:
  - Persistence: coefficient on Δ(IR/GDP)–1 ≈ 0.7–0.8 and highly significant for pooled, emerging, and advanced samples.
  - ΔSR negative and significant (reserve increases associated with lower sovereign ratings; higher ratings lead to smaller reserve changes).
  - Δ(CF/GDP) positive and significant for pooled and advanced samples (0.339** pooled; 0.739*** advanced in one specification); for emerging markets Δ(CF/GDP) often insignificant or negative depending on specification.
  - Δ[GLOB*(CF/GDP)]: positive and significant for emerging markets (0.101***), negative and significant for advanced countries (–0.149***).
- Inclusion of fiscal balance (Δ(F/GDP)) and M2-to-GDP (Δ(M2/GDP)) in dynamic panels:
  - Fiscal balance: statistically insignificant for both emerging markets and advanced countries when groups estimated separately; positive and significant in pooled regression (political-economy factors may dominate precautionary motive across groups).
  - M2/GDP: positive and significant for emerging markets (0.128***), not significant for advanced countries.
- Diagnostic tests:
  - Wald tests: joint significance of regressors (highly significant across specifications).
  - Arellano-Bond autocorrelation tests: first-order residual autocorrelation strongly rejected (as expected by first-differencing), second-order not rejected (consistent with correct specification).

### Synthesis and policy implications (concluding remarks)
- Despite increasing financial integration and more flexible exchange rates, emerging markets have used capital inflows to build substantial reserve stocks, particularly after 1998 and strongly in 2001–05.  
- Advanced economies show reserve accumulation negatively correlated with net capital flows (flows often finance current account deficits rather than build reserves).  
- Explanations for emerging market reserve accumulation include precautionary motives following capital account crises and the lower cost of acquiring capital in international markets in recent years.  
- Policy and institutional implications emphasized:
  - Development of domestic financial markets and regional arrangements for pooling reserves to improve sovereign liquidity management against volatile capital flows.
  - Better and continued access to international financial markets should, over time, reduce the need for very large reserve stocks as crisis memories fade.

*Italic: Summary derived from the IMF working paper content provided in the source PDF.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07151.pdf_