What drives some countries to hoard foreign reserves?

Managing capital flows and liquidity demand has been a central issue for emerging-market countries. In an era of global imbalances, rapid accumulation of foreign exchange reserves by surplus countries is also an issue for the international system. In a well-functioning international financial system there would be no advantage to holding large reserves so this raises the question of whether surplus countries have a deliberate strategy of building reserves and why they would do this. This paper examines the motives for foreign reserve accumulation and analyzes the effects of financial development and capital flows on reserve accumulation in East Asian economies. We present a model in which a state holds reserves to supply foreign exchange liquidity in underdeveloped financial markets. Using annual data for 12 Asian economies between 1980 and 2009, our empirical results confirm the precautionary motives and financial stability motives in the region. We also find that financial development attenuates central banks’ motivation to hoard reserves by reducing the impacts of capital flows on foreign reserve demand. The policy implications are that improving financial market development within developing countries will reduce the incentive to build surpluses and accumulate reserves, while improving the international financial system to reduce volatility would also help.