An Empirical Analysis of Foreign Exchange Reserves in Emerging Asia,” Bank of Canada, Working Paper

ver the last few years, the U.S. ability to finance its current account deficit has been facilitated by massive pur-chases of U.S. Treasury Bonds and agency securities by Asian central banks. As a re-sult, Asian central banks have accumulated large stockpiles of U.S.-dollar foreign exchange reserves. In theory, a country holds reserves as a buffer stock to smooth unexpected and temporary im-balances in international payments. In deter-mining the optimal level of reserves, the monetary authority will seek to balance the costs of macroeconomic adjustment incurred if reserves are exhausted with the cost of holding reserves. Reserve hoarding entails sterilization costs stemming from the negative spread be-tween the interest earned on reserves and the in-terest paid on the country’s public debt. Moreover, if capital flows are not sterilized, sus-tained accumulation of reserves will, at some point, generate inflationary pressures that could threaten domestic financial stability. If Asian central banks decide to stop accumulating U.S.-dollar reserves, they could trigger an abrupt de-preciation of the U.S. dollar. Given the potential impact on global interest rates, economic growth, and financial stability, the issue of Asian reserve accumulation is of considerable importance. Our objective is to assess the degree to which the current level of foreign exchange reserves held by Asian central banks diverges from that predicted by the standard macroeconomic de-terminants.1 To do so, we estimate a long-run demand function for reserves in a panel of eigh