Are Emerging Asia’s Reserves Really Too High?

IMF Working Papers, August 1, 2008

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Empirical analysis does not suggest that reserves are "too high" in the majority of Asian countries, though China may be a special case.
Much of the reserve increase in Asia can be explained by an optimal insurance model under which reserves provide a steady source of liquidity to cushion the impact of a sudden stop in capital inflows on output and consumption.
The benefits of reserves in terms of reduced spreads on privately held external debt further explains the observed growth in reserves since 1997-98.
Using threshold estimation techniques, the paper shows that most of Asia can still benefit from higher reserves in terms of reduced borrowing costs.

Optimal insurance model: Reserves serve as a steady liquidity source to cushion sudden stops in capital inflows and their impact on output and consumption.
Spread reduction channel: Reserves reduce spreads on privately held external debt, contributing to reserve accumulation dynamics since 1997-98.
Threshold estimation techniques: Used to identify reserve levels at which additional reserves begin to yield diminishing returns in borrowing-cost reductions.

For most Asian countries, current reserve levels are consistent with precautionary needs implied by optimal insurance considerations.
China may require separate consideration given its potentially distinct reserve dynamics.
Additional reserves can still be beneficial for most Asian economies by lowering borrowing costs through reduced spreads on external private debt.

Box 1: Why Scale Reserves by Gross External Liabilities?
- Box 1: Why Scale Reserves by Gross External Liabilities? (Markdown version)
- Box 1: Why Scale Reserves by Gross External Liabilities? (PDF)