Surplus liquidity,central bank losses and the use of reserve requirements in emerging markets

Since the turn of the millennium, stocks of foreign reserves held by central banks in many emerging markets and developing countries have exceeded currency in circulation. To steer money market rates, these central banks have been absorbing liquidity from, rather than providing it to, the banking sector in their regular monetary policy operations. When interest rates in countries with major reserve currencies are low, the yield on foreign reserves is low. A higher interest rate on liquidity‐absorbing operations may expose central banks to losses. Although a central bank is not a profit‐maximizing institution, central bank losses can undermine the independence of the central bank. Using data for a large panel of central banks, this paper provides some evidence that central banks tend to apply low‐remunerated reserve requirements when profitability is at stake.