International reserves for emerging economies: A liquidity approach

Abstract

The massive stocks of foreign exchange reserves, mostly held in the form of U.S. T-bonds by emerging economies, are still an important puzzle. Why do emerging economies continue to willingly loan to the United States despite the low rates of return? We suggest that a dynamic general equilibrium model incorporating international capital markets, characterized by decentralized trade and U.S. T-bonds as facilitators of trade, can provide one possible resolution to this question. Declining financial frictions in these over-the-counter (OTC) markets would generate rising liquidity premium on U.S. T-bonds, thereby causing low U.S. real interest rates. Meanwhile, the superior liquidity properties of the U.S. T-bonds would induce recipients of foreign investments, namely emerging economies, to hold more liquidity, that is U.S. T-bonds, in equilibrium. The prediction of our model is confirmed by an empirical simultaneous equations approach considering an endogenous relationship between OTC capital inflows and reserve holdings. (C) 2016 Elsevier Ltd. All rights reserved.