International reserves for emerging economies: A liquidity approach |
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Institution: | 1. School of Economics, Henan University, Kaifeng, China;2. Korea University Business School, Seoul, South Korea;1. School of Economics, Henan University, Kaifeng, Henan 475004, China;2. Department of Economics, Lehigh University, Bethlehem, PA 18015, USA;1. School of Economics and Business Administration, Chongqing University, Chongqing, 400030, PR China;2. School of Economics, Henan University, Henan, 475000, PR China;3. College of Business Administration, Trident University International, Cypress, CA 90630, USA |
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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. |
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