THE INTERNATIONAL RESERVES GLUT: IS IT FOR REAL?

Giulio Cifarelli* Giovanna Paladino**

October 2005

Abstract
Monthly data from January 1985 to December 2004 are used to investigate reserves management in
ten Asiatic and Latin American countries. Idiosyncratic explanatory variables enter cointegration
relationships based on a stochastic buffer stock model, where a reserve variability measure is obtained
via conditional variance approaches. International factors influence the cointegration residuals
(representing

the excess demands for reserves), which tend to co-move within and across

geographical areas. Principal components analysis is implemented then to associate their common
drivers with the US fed fund effective interest rate and real effective exchange rate. This two-step
approach sheds light on some controversial aspects of reserves and exchange rate management in
emerging markets such as fear of floating and mercantilist behavior. Our results suggest, contrary to
common belief, that the size of recent excess reserves holdings is probably overstated.

Keywords: emerging markets international reserves, cointegration analysis, principal components analysis.
* University of Florence, Economics Department, via delle Pandette 9, 50127 Florence, Italy.
giulio.cifarelli@unifi.it
** LUISS University and Sanpaolo IMI Economic Research Dept., viale dellArte 25, 00144 Rome, Italy.
giovanna.paladino@sanpaoloimi.com

The average reserve holdings of several emerging markets have risen in recent years,
irrespectively of their official exchange rate regime, both in absolute terms and as percentages
of GDP or of standard international trade and finance adequacy indicators, such as the level of
imports or the short term external debt. They have reached $1.8 trillion at the end of 2004, up
roughly $800 billion from 2002 and more than four times their level in 1994, exceeding the
potential requirements of any foreseeable shock. So what is the purpose of possessing
international reserves in excess of common measures of adequacy? This puzzle has attracted
considerable attention from both practitioners and academics. Precautionary behavior of
central banks, fear of the disruptive effects of an exchange rate depreciation (motivated by the
experience of the financial crises and sudden capital reversals of the 1990s), difficult access to
international capital markets and mercantilist export support are possible explanations set out
in a burgeoning literature.
In this paper monthly data from January 1985 to December 2004 are used to investigate the
national idiosyncratic and international determinants of reserve changes in five Asiatic and
five Latin American countries. Idiosyncratic explanatory variables are mostly associated with
the tenets of the benchmark buffer stock model of Frenkel and Jovanovic (1981) while
international explanatory factors reflect the pivotal role played by the U.S. monetary
authorities in emerging markets finance.
The use of a monthly frequency has a number of drawbacks due to the non stationary nature
of the time series and to the difficulty of estimating consistent cointegration relationships and
error correction structures. The twenty year data span, however, provides a large number of
observations and allows to estimate the relevant relationships for each country in isolation.
Most previous empirical studies (Flood and Marion, 2002, Aizenman and Marion, 2004,
among others) are performed with yearly data and rely on the panel data approach. The latter
posits that the specification of the relationship is the same over the cross section and that any
idiosyncratic effect is adequately captured by differences in the constant term. In the present
investigation, however, the specification of the demand for reserves, the sign and the
significance of the coefficients and the speed of convergence to equilibrium differ too much
across the countries of the sample to be properly assessed using a pooled data procedure. A
different estimation methodology is called for.

The rapid growth of short term capital flows provides a sensible explanation for the relevance
of the precautionary demand for reserves of the buffer stock model. Capital flows to and from
emerging markets, however, have specific characteristics that go beyond the standard
approach. According to the buffer stock model international reserves are explained by
domestic factors only, reserve volatility and a national bond yield which reflects the
opportunity cost of holding them. This parameterization misses some relevant determinants of
reserve behavior. International financial flows involving emerging markets are highly volatile
and are affected by US monetary policy. Over the last two decades convincing evidence
shows that financial turbulence (and the ensuing impact on reserve holdings) is not restricted
to the epicentre of a crisis but tends, usually, to spread from country to country within and
even across geographical areas. The two-step estimation procedure implemented in this paper
is meant to capture these aspects of emerging markets finance.
Cointegration reserve relationships are independently estimated, at first, for each country. The
corresponding residual time series are assumed to quantify the fraction of the long run reserve
holdings which cannot be explained by the buffer stock model explanatory variables.1 Their
correlation is carefully analyzed in a second step and the relevance of common drivers is
assessed using principal components analysis. Geographical area co-movements are
identified; the behavior of the first principal component - which explains almost 40 percent of
the variability of the residuals of the Asiatic reserve cointegration relationships - turns out to
be affected by the U.S. federal funds and real effective exchange rate.
The signs of the estimated coefficients suggest that reserve residual co-movements reflect
both the generalized impact of U.S. monetary policy due to a fear of floating reaction
(Calvo and Reinhart, 2002) and a common desire to prevent real exchange rate appreciation.
The latter may be related to an export support mercantilist exchange rate policy (Aizenman
and Lee, 2005 ).
The paper improves upon previous research in the following aspects:

The two-step approach fits well with the model of Frenkel and Jovanovic which posits that observed reserves
are proportional to optimal reserves determined according to the buffer stock paradigm up to an error term
that is uncorrelated with the determinants of the latter. Optimal reserve holdings are the fitted values of the
cointegration relationships.

the empirical section includes an accurate analysis of the time series; additive outliers that
may affect both the unit root tests and the cointegration results are disposed of using
approaches set forth by Perron and Rodrguez (2003) and Nielsen (2004).

Reserves volatility clustering is modelled using conditional volatility techniques; the

IGARCH parameterizations produced by the data suggest that the volatility estimates in
previous research, that relied on unconditional variance estimation, may well be biased.

The two-step estimation approach sheds light on some controversial aspects of exchange
rate management, such as fear of floating and mercantilist behavior. A distinction is
drawn between the national (idiosyncratic) and the international factors that affect reserve
holdings. The former enter the long run cointegration relationships while the latter
influence the disequilibrium residuals, which tend to co-move across countries. Principal
components analysis is then used to associate their common drivers to US monetary and
exchange rate policy.

Contrary to common belief and, indeed, to the implications of standard adequacy

measures, our analysis suggests that current excess reserve holdings are not consistently
larger than their 1995-2004 averages.

The paper is structured as follows. Section 1 summarizes the theoretical and empirical
discussion on reserve adequacy rules and on optimal reserve holdings; section 2 measures
reserve excess demand, using rules of thumb and cointegration analysis; section 3 investigates
excess reserve co-movements and assesses the relevance of fear of floating and of
mercantilist export support policies. Section 4 concludes the paper.

1 The demand for international reserves

In this section the literature on the demand for international reserves is briefly summarized.
The structure of the dynamic stochastic model set forth by Frenkel and Jovanovic (1981) is
then examined in more detail as it constitutes the theoretical framework of the applied
analysis of the subsequent sections.

1.1 From rules of thumb to optimal reserve management

An adequate stock of reserves is assumed to finance potential gaps between outlays and
receipts of foreign currency, smoothing out external payment imbalances and preventing in
that way an exchange rate crisis. It is typically determined by a ratio between the minimum
amount of reserves the authorities have to hold on average and a component of the balance of
payments. In the 1950s and 1960s the trade balance was the largest aggregate of the latter and,
according to standard Keynesian macroeconomics, reserves were geared to imports. Studies
by the IMF Staff (1958) and Triffin (1960) suggested that reserve adequacy required a
minimum average yearly reserve to import ratio of 30-35 percent.
The relative marginalization of trade aggregates in the overall balance of payments accounts
brought about by the liberalization of capital flows in the 1980s and 1990s called for the
introduction of a more effective rule of thumb. It was suggested that since recent currency
crises tended to be associated with capital outflows rather than with trade financing, the size
of the reserves of emerging market economies be somehow related to their short run external
debt outstanding. The Asian crisis had shown that the countries that held large reserves had
been able to weather the turbulence better than the others.2
Two proposals for a new minimum reserve stock benchmark were set out in 1999,
respectively, by Pablo Guidotti, Argentinas former Deputy Minister of Finance, and Alan
Greenspan, Chairman of the US Federal Reserve Board, both involving short term emerging
market debt.
Guidotti proposed, as an empirical rule of thumb for reserve stock adequacy, that a country be
able to satisfy its net external payments liabilities without additional foreign borrowing for up
to one year. The current account deficit is thus included in this reserve adequacy criterion
along with short term debt. In a similar way Greenspan suggested to calibrate reserve
adequacy on short term debt outstanding with maturity of less than one year. He introduced,
however, two additional conditions: (i) that the average maturity of a countrys external

A link has been identified in a recent IMF study (IMF, 2000) between short term debt over reserves and the
likelihood of a crisis in a sample of emerging market economies. In the same way Early Warning System studies
by Bussire and Mulder (1999), among others, have found that low reserve to short term external debt ratios
increased the probability of a crisis.

liabilities exceed a three year threshold and (ii) that the reserve authorities operate following a
liquidity at risk procedure.
A third reserve adequacy criterion is the reserve to broad money (M2) ratio. Kaminsky et al.
(1997), among others consider it an accurate predictor of crises. De Beaufort Wijnholds and
Kapteyn (2001) point to the usefulness of this ratio for assessing the relevance of internal
demand for foreign reserves due to possible capital exports by domestic residents.
In an authoritative study Heller (1966) went beyond reserve adequacy and analyzed
precautionary optimal reserve management by monetary authorities. International liquid
reserves allow to finance external imbalances and to avoid deflationary measures with a
relevant macroeconomic cost. Reserve holdings, however, have an opportunity cost given by
the difference between the social yield on capital invested and the (lower) yield of
international reserves. The optimal stock of reserves corresponds to the amount which
minimizes the sum of the cost of adjusting for and of financing the balance of payments
disequilibrium in such a way that the marginal cost of the former equals that of the latter. The
analysis of Heller is relevant also from a formal point of view.3 In spite of the shortcomings
pointed out by Hamada and Ueda (1977), it provides the basic original framework for most
subsequent theoretical and empirical research on optimal foreign reserve management.

1.2 The stochastic buffer stock model of the demand for reserves

Extending a previous model on transactions and precautionary demand for money, Frenkel
and Jovanovic (1981) set forth a stochastic reformulation of optimal reserve demand based on
the tenets of inventory management. Their model posits that changes in reserve holdings,
between restockings, be modelled by the following stochastic equation

dRt = dt + dWt

(1)

He assumes that the process of change in the stock of international reserves is a random walk and provides an
algebraic formulation which links the optimal amount of reserves a country should hold to the propensity to
import, the opportunity cost of holding reserves and to a proxy for the stability of its international accounts, as
reflected by the average yearly past imbalances.

where Wt is a Wiener process with mean zero and variance t. At any point in time the
distribution of the reserve holdings reads as
Rt = R 0 + Wt

(2)

where R0 is the optimal initial stock of reserves, is a drift parameter and is the standard
deviation of the Wiener reserve increment. Optimal reserve management involves the
selection of the cost minimizing stock of reserves once reserves have reached a lower bound,
set here to zero. Since reserve holdings follow a stochastic process, the authorities are
assumed to select the initial level of reserves R0 that minimizes total expected costs. Costs
here have two interrelated components : (i) the opportunity cost of reserve holdings and (ii)
the adjustment cost of reserve restocking whenever the latter have reached their lower bound.
The latter stems from the output (welfare) reduction brought about by the need to generate the
balance of payments surplus, which will generate the reserve build up.
Frenkel and Jovanovic assume that balances of payments tend on average to be in equilibrium
and that the reserve drift between restockings is zero. They obtain, after some algebraic
manipulation, the following second order Taylor series approximation of optimal initial
reserve holdings in logarithmic terms
log R0 = c + 0.5 log 0.25 log r

(3)

The crucial additional assumption is then made that observable reserves Rt are proportional
to optimal (initial) reserves up to an error term that is uncorrelated with and r. The
following testable relationship is then derived
log Rt = b0 + b1 log t + b2 log rt + ut

(4)

where it is assumed a priori that b1 > 0 and b2 < 0 .4

Flood and Marion (2002) argue that optimal and observed reserves are linked by the relationship Rt = BR0 e ut ,
where B is a country specific proportionality factor.
4

Reserve holdings at time t are reduced if the opportunity cost rt rises and increased whenever
their volatility t rises. A higher volatility implies that holdings are likely to hit their lower
bound more frequently and require costly restockings that the authorities want to avoid.
The resurgence of interest for reserve hoarding management in the aftermath of the financial
crises of the 1990s has prompted various attempts to adapt precautionary demand modelling
to the financial characteristics of emerging market countries. The latter have to face a limited
access to international borrowing in periods of stress, an inefficient tax collection system and
- at times a severe default risk. Reserves are assumed to have an insurance value. Aizenman
and Marion (2004), using a two period intertemporal consumer utility maximization model,
suggest that reserves reduce the cost of consumption smoothing between prosperous and bad
states of nature. In the latter the marginal cost of public funds would be much higher.
Subsequent studies focus on an output stabilization role of international reserves. Aizenman et
al. (2004) show that reserve holdings mitigate the probability of a banking crisis and thus
reduce the expected output costs of a sudden freeze of international capital inflows. Their
demand for reserves increases both with the expected output cost of a credit crisis and with
the effectiveness of reserves in reducing the probability of the crisis. As shown in Aizenman
and Lee (2005) a macro liquidity shock to an emerging market cannot be diversified away and
may force the liquidation of a first period investment if it exceeds the stock of reserves
outstanding, reducing second period output. Optimal reserve management diminishes
potential liquidation costs.
1.3 Empirical investigation on precautionary reserves management

A large body of empirical research relies on the buffer stock model paradigm, spanning more
than twenty years see Bahmani-Oskooee and Brown (2002) for a comprehensive survey.
Reserves are typically linked to four regressors in a panel data study: a variability measure,
the marginal (or average) propensity to import, the level of imports and an opportunity cost
proxy.
It is generally found that net external payments variability exerts a positive and significant
impact on reserve holdings; the demand for the latter increases with the fluctuations in the
balance of payments, quantified in various ways by a variability index.

The sign of the coefficient of the second regressor, the propensity to import, is more
controversial. On Keynesian grounds it should be negative; the larger the propensity to
import, the smaller the adjustment cost when expenditure reduction policies are called for and
the smaller the demand for reserves (Heller, 1966). If, however, the propensity to import is
assumed to quantify a countrys openness and vulnerability to external shocks, the sign of the
coefficient should be positive as more reserves are required whenever the propensity rises
(Aizenman and Lee, 2005).
The third regressor, the value of imports, is positively related to the demand for reserves. It is
believed to measure the effects of trade and is used as a scale variable.5 Indeed Heller (1968),
assumed that banks transactions demand for foreign exchange increased with the square root
of the level of transactions. De Beaufort Wijnholds and Kapteyn (2001) point out that the
presence of economies of scale (which justify the use of imports as scale variable) hinges on
the hypothesis that balance of payments disequilibria grow in proportion to international
transactions.
The opportunity cost of holding reserves has been measured in various ways. Frenkel and
Jovanovic (1981) used government bond yields and Edwards (1985), among many others,
spreads between domestic and corresponding US interest rates. The negative coefficient of the
opportunity cost regressor is seldom significantly different from zero, a finding that can be
attributed to the risk averse nature of central banks.
The choice of the variables entering the cointegration analysis performed in the paper - as the
first step of the estimation procedure - is broadly in line with the above mentioned research.
Long run reserve demand is assumed to be related to a variability index, the level of imports
and to a long term bond yield. The average propensity to import is dropped from the analysis.
The problems associated with openness and external vulnerability are dealt with in the second
step.
2 Assessment of the excess demand

One of the main lessons to be drawn from the Asian and Latin American crises is that fear of
insolvency may trigger sudden and dangerous capital reversals even in countries that do not

seem to have - prima facie serious debt sustainability problems. Reserve and debt
management are thus key factors in crisis prevention.6 Holding foreign assets is costly and
while the case for Central Bank reserve accumulation is evident, it is still not clear what is
their optimal level. Indeed, some countries seem to have an insatiable appetite for reserves as
if Mrs Machlups wardrobe theory were to hold.7
In this section measurements of excess reserve demand are set forth for ten countries located
in Asia and in Latin America using two alternative approaches.

2.1 Stylized evidence from the rules of thumb

In the absence of a widely accepted theoretical approach to optimal reserve size, popular rules
of thumb, summarized in section 1.1 above, have supplied guidance to central bankers.
[Insert Table I]

The computation of five different reserve adequacy benchmarks for Argentina, Brazil, Chile,
Mexico, Venezuela, Indonesia, Korea, Malaysia, the Philippines and Singapore is set forth in
table I. The description and the sources of the time series used in the empirical analysis can be
found in Appendix I.
The first benchmark is measured in terms of month worth of imports. It can be seen
according to a balance of trade and/or a consumption smoothing criterion as a way to ensure
a certain degree of autonomy from scarce international borrowing. International reserves are
thus required to cover 4 to 6 months of imports. This index has lost most of its relevance over
time as emerging economies increasingly rely on private capital flows to balance their
external accounts. The Guidotti rule discussed above is motivated by this development and by
evidence that vulnerability, during the Asian crisis, was mainly related to a countrys asset
and liquidity management. It provides a benchmark based on a ratio of reserves to short term
debt and is meant to gauge the capability of a country to live without foreign borrowing for up
to a year (in that case the reserve adequacy ratio would be 100 per cent). The third column
5

A positive coefficient, smaller than one in absolute value, would signal the presence of economies of scale.
Real GDP, real GDP per capita or population size are also used as scaling variables.
6
..We have also seen in the recent crises that countries that had big reserves by and large did better in
withstanding contagion than those with smaller reserves.. , (p.1-3). Fischer, S. (2001). Opening Remarks,
IMF/World Bank International Reserves: Policy Issues Forum (Washington, DC, April 28).

expands the Guidotti rule and incorporates an additional cushion of 3 percent over and above
short term external debt in order to buy time for the required policy change before the
reserves to short term debt threshold is reached (Bird and Rajan, 2002).
De Beaufort Wijnholds and Kapteyn (2001) argue that a reserve to short term debt ratio may
fail to capture the threat of an internal drain due to capital exports by residents. Capital
flights are accounted for with greater accuracy by the measure based on broad money supply
(M2) of column four. The ratio of reserves to M2 should be close to 30 percent as only a
fraction of M2 may realistically be expected to be mobilized on short notice.
The last index too takes into account both internal and external capital drains. It is based on
the Greenspan liquidity at risk refinement of the Guidotti rule.8 We implement here the
version set out by De Beaufort Wijnholds and Kapteyn (2001). The denominator of the
Guidotti rule is modified introducing a probability factor which depends on a country risk
index weighted according to the exchange rate regime. The ratio is fully explained in the
notes to table I.
This table sets forth adequacy measures computed for the years 1985, 1995 and 2004. They
are underlined if the estimates exceed the corresponding adequacy benchmarks. The reserve
to import ratios record a net improvement over time, with the exception of Mexico and the
Philippines, where the increase is less relevant. As for the remaining indexes, they suggest
that all the countries in the sample currently hold reserves that are significantly above the
adequacy thresholds set at 100 percent and 30 percent for, respectively, the Guidotti and
Guidotti-Greenspan rules and for the reserve to M2 ratio. Our findings so far, in line with the
common wisdom, support the hypothesis of a generalized increase in reserve holdings from
1985 to 2004.

2.2 Long-run demand and reserves misalignment

Conventional adequacy rules are simplistic by construction and may underestimate emerging
markets reserve requirements. This section describes the econometric strategy used to
7

Professor Machlup suggested that monetary authorities tended to maximize the stock of reserves as his wife
was maximizing the amount of clothes in the wardrobe.
8
A. Greenspan (1999). Currency Reserves and Debt, remarks at the World Bank Conference on Trends in
Reserve Management (Washington, DC, April 29).

10

determine the optimal long run demand for reserves. This measure of reserve adequacy
evolves over time and provides a dynamic benchmark that can be used to assess the relevance
of overstocking. The optimal buffer stock model demand for reserves, discussed in section
1.2, is estimated using Johansens (1988, 1991) cointegrating approach. The data set spans the
January 1985 - December 2004 time period and encompasses some important episodes of
distress both in Asia and Latin America.

2.2.1 Stationarity and volatility analysis

Recent econometric findings summarized in Vogelsang (1999) have shown that additive
outliers introduce in the residuals of standard unit root test estimates a moving average
component with a negative coefficient which, in turn, inflates the size of the test and causes
over-rejection of the null hypothesis. The Latin American and Asiatic crises have brought
about long lasting changes in Central Bank behavior and the corresponding outliers in the
time series may well be considered additive in the sense of Hendry and Doornik (1994). We
have implemented the test procedure of Perron and Rodrguez (2003) and have identified
several additive outliers. The value of the test statistics that are significant at the 5 percent
level and the corresponding dates are set out in Appendix II. The unit root tests of table II are
thus performed using the statistic by Ng and Perron (2001), which is robust to size distortions
due to negative serial correlation of the residuals. With one single exception, they fail
systematically to reject the null of non stationarity.
[Insert table II]

Additive outliers may also distort inference on cointegration rank in finite samples (Franses
and Haldrup, 1994). Following the interpolation strategy suggested by Nielsen (2004), the
outlying observations are eliminated and replaced by an average of the respective adjoining
data. The smoothed time series will then be used in the cointegration analysis below.
Reserve volatility plays a relevant role in models of optimal demand for foreign reserves and
has to be carefully estimated. Most previous empirical studies borrow a method originally
developed by Frenkel (1974) and estimate reserve volatility as a multiperiod rolling standard

11

deviation of (detrended) reserve changes.9 Our sample period includes periods of turbulence
and

reserve

changes

display

volatility

clustering

i.e.

autoregressive

conditional

heteroskedasticity. The presence of ARCH effects is corroborated by the serial correlation of

the squared reserve increments. Indeed, almost all Ljung Box Q-statistics in table A.II reject
the null of no ARCH at the standard levels of significance. Unbiased volatility estimates are
thus obtained using conditional measures, computed as the square root of the GARCH(1,1)
variance of monthly reserve changes. In the case of an asymmetric response to innovations,
the following Threshold GARCH(1,1) parameterization by Glosten et al. (1993) is used to
estimate the conditional variance

t2 = + ut21 + t21 + S t 1ut21

(5)

where ut is the reserve innovation, t2 is the corresponding conditional variance, is a

coefficient of asymmetry and St-1 is a dummy which takes value 1 if ut 1 < 0 , and 0 otherwise.
[Insert Table III]

Table III reports the conditional variance model estimates. Symmetric GARCH(1,1)
parameterizations have a reasonably good fit in most countries, the only exception being
Venezuela and Malaysia, where significant asymmetry is detected and a TGARCH(1,1) is
called for. The corresponding coefficients are negative; the volatility tends to be smaller
when, because of negative shift in reserves, the currency is under pressure to depreciate.
(Central Banks seem thus to lean with the wind when the currency depreciates and against the
wind when it appreciates.) Interestingly, conditional variances turn out to have an
IGARCH(1,1) parameterization. Standard Wald tests fail to reject the null hypotheses that
1--=0 and 1-(+0.5)-=0 in, respectively, the symmetric and asymmetric GARCH(1,1)

models. Conditional variances are thus non stationary in a weak sense.10 In this case the

This variability proxy is problematic. As pointed out by Flood and Marion (2002, appendix II), reserve
volatility and measurement errors in reserves may interact. Biased OLS estimates of the volatility coefficient will
follow because of the skewness of the latter. It can be shown that the use of conditional variances drastically
reduces the size of the bias.
10
In an IGARCH(1,1) the conditional variance is strictly stationary even if the model lacks unconditional
moments and is thus covariance non stationary (Nelson, 1990 ).

12

unconditional variance of reserve innovations is not defined and the conditional GARCH
approach provides the only meaningful measure of reserve volatility.

2.2.2 Cointegration estimates of long run reserves demand

The empirical investigation is performed using the multivariate cointegration analysis of

Johansen (1988, 1991). The selection of this approach is not arbitrary. It is motivated by its
resilience in terms of power and of size to the conditional heteroskedasticity of the VECM
residuals detected by Boswijk et al. (2000).11
[Insert table IV]

The trace test statistics set forth in table IV identify a single cointegration relationship in each
of the ten countries. The treatment of the deterministic component is not homogeneous and
reflects the differing properties of the time series.
Table V presents the cointegration equation estimates and the corresponding error correction
coefficients obtained with the FIML procedure of Johansen and Juselius (1990). The short
term components of the VECM are not set forth here for lack of space. The long run reserve
demand relationship is formulated as
log Rt 0 1t 1 log $ t 2 log M t 3 log rt = t

(6)

where $ t is the fitted value of a preliminary IGARCH conditional volatility estimate of the
reserve change, M t is the volume of imports, rt is the domestic (US dollar denominated)
government bond yield and t is a time trend.
[Insert table V]

11

They perform a Monte-Carlo comparison of the Johansen LR cointegration test and of alternative LM
approaches that try to exploit the non-normality of the residuals in the case of Gaussian and non-Gaussian
distributions of the VECM innovations. The Gaussian QLR test of Johansen loses power in the presence of
skewness and of flat tailedness. It turns out, however, to outperform the alternative cointegration tests when the
innovations exhibit, a major problem in our empirical analysis, GARCH(1,1) volatility clustering (see table 1,
pages 15-16). The sizes of the cointegration tests are not seriously affected by non-Gaussianity but for the rather
unrealistic case of an ARCH(1) parameterization of persistent conditional volatility.

13

The estimates are far from homogeneous across countries.12 The computed values of the
coefficients of reserve volatility and of the opportunity cost proxy corroborate the
specification of the buffer stock model only in the case of the Asiatic countries. A rise in
interest rates is associated with an increase in reserve holdings in three of the five Latin
American countries, possibly reflecting - as suggested by Aportela et al. (2005) - the effect of
foreign capital inflows sterilization policies by local monetary authorities. Reserve volatility
too does not fit well with the model in Latin America: with the exception of Venezuela it is
either irrelevant or has a negative impact on the demand for reserves. Only the coefficient of
the volume of imports is significant and has the appropriate sign in most countries of the
sample. With few exceptions, its size fails to support the hypothesis of economies of scale in
the use of reserves, a finding that may be due to the impact of the introduction of reserve
adequacy rules geared on imports.
The error correction terms, finally, are with two exceptions, Malaysia and the Philippines
significant and of the correct sign. Rather small in absolute value, they suggest that it might
take long time for the reserve equations to return to equilibrium after a shock.

3 Excess reserve co-movements and international capital markets integration

Standardized cointegration residuals in figures 1 and 2 show that the amount of recent excess
reserve holdings may well be overstated. Contrary to common belief - and, indeed, to the
implications of the adequacy thresholds of table I - emerging market countries Central Banks
do not seem to have modified their behavior in recent years since excess reserve holdings are
not consistently larger than their 1995-2004 averages.
[Insert Figure I]
[Insert Figure II]

Having singled out the idiosyncratic factors that determine, in each country, the precautionary
demand for reserves, we investigate the co-movements among the cointegration residuals in
order to assess the relevance of common international drivers on reserve overstocking.
Factors that influence international capital and trade flows are likely to affect
12

The differences involve the sign, absolute value and significance of the coefficients of most regressors and are
not restricted to the constant term. These findings suggest that a panel data procedure would be misleading if
applied to our data set.

14

contemporaneously the entire set of countries of the sample. The size of the cross country
correlation coefficients reported in table VI is indicative of a common element among the
estimates of excess reserve holdings.
[Insert Table VI]

3.1

Principal components analysis

Principal components analysis (PCA) allows to investigate the pattern of the co-movements in
reserve misalignments. Exploiting the potential information redundancy in multivariate data
sets, PCA reduces the dimensionality of the data with minimal loss of information. It
transforms a set of N correlated variables (the Johansen cointegration residuals) into a smaller
subset of M N uncorrelated variables (principal components) that are orthogonal linear
combinations of the original ones. The first component will have the maximum possible
variance, the second the maximum possible variance among the linear combinations
uncorrelated with the first principal component and so on.
Let y i ,

i = 1,..., N be a Tx1 vector of cointegration residuals and xi = ( y i y i ) i be the

corresponding standardized residual vector where y i and i are the unconditional sample
mean and standard deviation. xi is a column of the TxN matrix, X, of standardized excess
reserve time series. Principal components analysis is based on the eigenvalue eigenvector
decomposition of the (correlation) matrix = X ' X / T .
The principal components transformation of X reads as
Z = X

(7)

where Z is a TxN matrix of principal components, each column of which, z j (j=1,, N), is a
Tx1 principal component vector.
The jth principal component
z j = X j

(7)

15

has zero mean and variance j . With the latter appropriately normalized it is possible to
measure the fraction of the variance of the original data explained by the corresponding
principal component. Similarly, the sum of the first M normalized eigenvalues indicates how
much variation is explained by the first M principal components.
Consistent estimation of the correlation matrix and of the corresponding principal components
requires that the time series be stationary. This is the case here since cointegration residuals
are stationary by construction.
PCA, implemented on excess reserve holdings, shows that the first principal component may
explain up to 38 percent of the variability of the residuals of the reserve cointegration
relationships in the case of Asia. The first three principal components explain 60 to 85 percent
of the excess reserve variability in the single area and cross area estimates.
[Insert Table VII]

3.2 Fear of floating and mercantilist factors affecting reserve holdings

The remaining issue is whether there are international drivers able to explain the behavior of
the identified common patterns (principal components) among excess reserve holdings. This
section presents the economic rationale and the empirical evidence supporting the hypothesis
that the US policy rate and the US dollar real effective exchange rate are key international
factors driving Central Banks decisions to accumulate reserves beyond their optimal level.
Recent global economic integration has offered interesting financing opportunities but has
also increased the exposure of emerging countries to contagion and to inflation pass through.
Several studies suggest that capital flows are driven by common international factors. As
shown by Calvo et al. (1996) and Mody et al. (2001), among others, shifts in US monetary
policy influence emerging markets financial liquidity. A tight US monetary policy makes
investment in these countries less attractive, raising debt price. The corresponding increase in
the rate of interest differential results in cross border financial flows.13
The extent to which the local monetary authorities react to changes in the US interest rate
depends, in principle, on the nature of the exchange rate arrangements. Under a pegged

16

exchange rate regime the reaction would be strong, in order to avoid the insurgence of a risk
premium. Under floating regimes, changes in international interest rates could be
accommodated through exchange rate movements. Frankel (1999), however, found that also
in free floating countries (such as Brazil and Mexico) an increase in the fed fund rate brings
about a more than proportional increase in the domestic interest rate. The latter is due to the
large effect of interest rate differentials on capital outflows and to the required large premium
for devaluation and default risk.
This picture is not exhaustive since the monetary policy framework matters as well. Under an
inflation targeting regime, even in the case of free floating exchange rates, an increase in the
US interest rate may cause a depreciation of the national currency (because of lower capital
inflows or capital reversals towards higher US risk adjusted returns) and the authorities will
be willing to reduce liquidity, trading off economic growth with inflation. This fear of floating
can be faced, alternatively, increasing the foreign reserve holdings above precautionary levels.
In general, a large buffer for future exchange market intervention reduces the degree of
external vulnerability to contagion. International linkages among monetary policies may thus
influence the strategies of Central Banks directly through the interest rate and indirectly via
reserve holding decisions. If, according to the empirical evidence mentioned above, a US
monetary policy tightening has an adverse effect on emerging market financial stability, we
expect a positive relation between the US fed fund effective rate and reserve overstocking.
Purchases of foreign currency during a period of upward pressure on the domestic exchange
rate and rather limited intervention on the downside are consistent with an attempt to avoid a
deterioration of national competitiveness i.e. with a deep-rooted mercantilist desire to
maintain an undervalued exchange rate. This explanation agrees with the suggestion of
Dooley at al. (2003) that emerging countries build up reserves in order to support their
exports. A sensible development strategy might then require a distortion in the real exchange
rate in order to channel domestic investment towards export industries and a process of
reserve accumulation, which would appear sub-optimal, is in reality an element of an optimal
investment strategy.

13

See Arora and Cerisola (2001) and Uribe and Yue (2003). It is also believed that US monetary policy plays a
relevant role in triggering financial and banking crises since a rise in industrial country interest rates worsens the
conditions for the access of emerging markets to offshore funds.

17

The depreciation of the US real effective exchange rate is used here as a synthetic (global)
measure of domestic foreign exchange pressure due to trade. Thus a depreciation, i.e. a
negative shift, in the US real effective exchange rate has to be associated with an increase in
excess reserve holdings. Emerging market Central Banks buy foreign assets and sell domestic
ones in order to avoid a reduction of domestic competitiveness through an undesired
exchange rate appreciation.14
In this section empirical evidence on the impact of the selected international factors is
provided by regressing the first principal component of the interregional and of the two
regional sets of countries on the US fed fund effective rate and on the US dollar real effective
exchange rate. The following relationship is estimated
PC1t = + log it ,US + log REERt ,US + et

(8)

where PC1t is the first principal component, i t ,US is the detrended fed fund effective interest
rate and REERt,US, the real effective exchange rate, is obtained using CPI deflators. The time
series are stationary and the estimation is performed in levels.15
[Insert table VIII]

Table VIII contains GMM estimates of equation (8) with heteroskedasticity and serial
correlation consistent standard errors. We find evidence of a relevant impact of the above
mentioned factors on excess reserve accumulation decisions. The coefficients are significant
and have the expected sign. The adjusted R2 statistics are, moreover, relatively large and
explain up to 45 percent of the total variance of the first principal component of the excess
reserve co-movements of the interregional system.
14

Past negative experience may play a relevant role here. Most periods of turbulence over the last two decades
started with currency crises in emerging markets with pegged exchange rate regimes and were triggered by a US
dollar appreciation (Whitt, 1999).
15

The ADF tests of the i t ,US and REERt,US time series can be summarized as follows

i t ,US
REERt,US
ADF(c, t, lag)
-3.07**(0,0,10)
-3,68* (c,t,2)
c: constant; t: determinitic trend; *: 5 percent
significance level;**: 1 percent significance level
The three principal components are stationary by construction, being linear combinations of stationary variables.
This property of the time series is corroborated by ADF test statistics, not reported here for lack of space.

18

4 Conclusion

Large-scale accumulation of foreign reserves by emerging market economies has recently

attracted considerable attention. Most rules of thumb point out that reserve demand is
excessive with respect to common adequacy levels. These rules, however, are simplistic by
construction and tend to underestimate actual reserve requirements. This paper proposes an
alternative assessment of reserve adequacy based on long run estimates of the buffer stock
model for ten emerging countries, located in Asia and Latin America, over the 1985-2004
time period. Optimal reserves are the fitted values of cointegration relationships obtained with
the Johansen procedure and the corresponding cointegration residuals quantify excess reserve
holdings. Our results suggest that the current size of excess reserves is probably overstated in
the literature.
Over-accumulation may be attributed to Governments fear of floating and/or to a
mercantilist rationale. In the first case foreign reserves are stocked to reduce vulnerability to
external shocks in countries with uncertain and pro-cyclical access to global financial
markets. Capacity to draw on reserves smoothes consumption in the presence of external
shocks and reduces vulnerability to creditor runs arising from currency and maturity
mismatches. Mercantilist reserve accumulation is driven by a desire to maintain competitive
exchange rates and, hence, economic growth. (The thesis by Dooley et al. 2003 assumes that a
strategy of deliberately under-valuing the exchange rate to promote exports can deliver long
run benefits.) The relevance of these interpretations is corroborated by our empirical findings.
Cointegration residual co-movements - filtered using principal components analysis - are
investigated to detect the impact of common international factors such as the US fed fund rate
and the US dollar real effective exchange rate. The former represents the US monetary policy
and is an identified driver of international capital flows, while the latter quantifies adverse
external shocks on emerging markets competitiveness.
The US interest rate exerts a significant positive effect on excess reserve demand as central
bankers try to reduce their exposure to sudden capital reversals. In the same way, a
depreciation of the US dollar real effective exchange rate brings about an increase in excess

19

demand as central bankers react to the negative impact on competitiveness of an appreciation

of the domestic currency.
Central bankers' behavior is far from irrational and is explained by idiosyncratic and common
economic factors. Reserves are accumulated above buffer stock precautionary levels in order
to weather financial crises and to foster export led economic growth.

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22

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APPENDIX I
Data description
Time series are monthly and cover the period between January 1985 and December 2004.

Reserves excluding gold are series l1da quoted in US dollars from the IMF International Financial
Statistics Data Base. International reserves do not include gold because of valuation problems and of
the modest amount of the precious metal in the EME reserve stocks.

Interest rates are the money market rates in series 60b for Argentina, Brazil, Indonesia, Korea,
Malaysia, Mexico, and Singapore. Treasury bill rate in series 60c was used for the Philippines. The
deposit rate in series 60l was used for Chile and Venezuela. They are all from the IMF International
Financial Statistics Data Base.

Imports are series 71da (cif quoted in US dollars) from the IMF International Financial Statistics Data
Base.

M2 is the sum of M1 series 35a and Quasi money 34a. The M2 series are quoted in national currency
and were converted into US dollars using the end of period exchange rate. They are all obtained from
the IMF International Financial Statistics Data Base.

Real effective exchange rate for the US is USI..RECE - CPI BASED SADJ from the IMF
International Financial Statistics Data Base.

US short interest rate, federal fund effective interest rate is from the Federal Reserve database.

Short term external debt series are taken from the IIF data base but for the Singaporean one which is
computed adding item G-H-I taken from the BIS/IMF/World Bank /OECD data base.

APPENDIX II
Perron and Rodrguez outlier detection test
Perron and Rodrguez (2003) propose the following test for multiple outlier detection based on first differences
of the data. Estimate the following regression by OLS

y t = D( Tao )t D( Tao )t 1 + t

(II.1)

where y t is the time series under examination, Tao is the date at which a single outlier occurs with magnitude ,
D( Tao )t = 1 if t = Tao (0, otherwise) and D( Tao )t 1 = 1 , if t = Tao + 1 (0, otherwise). If the data in levels are
trending a constant should be added as a regressor. Compute the t-statistic t d ( Tao ) for testing = 0 in (II.1). If

d =

SUP
Tao

| t ( Tao )| , the absolute value of the largest of the t-statistics, is greater than the Perron Rodrguez
threshold values reported in table IV, page 203, the corresponding observation is an outlier and is dropped from
the time series. The procedure is then repeated and continues until the test statistic becomes insignificant.

23

Table A.1 - OUTLIER DETECTION TESTS

Abolute value tstatistics++

Corresponding
period

Absolute value tCorresponding

statistics++
period
Domestic Short Term Interest Rate
Argentina
4.19
1989m05
C
3.92
1989m12
5.04
1990m01
4.01
1990m02
7.75
1990m03
7.57
1990m04
Brazil
C
Chile
5.56
1992m03
C
3.76
1993m12
3.91
2001m03
Mexico
4.00
1995m03
C

Reserves
Argentina
C

5.78

1989m06

Brazil

4.49

1990m03

Chile

4.50
8.50
4.11
5.70
4.38
6.77
6.60

1985m11
1985m12
1988m01
1990m02
1990m03
1995m01
1995m02

5.00
4.35

Venezuela
1987m07 Indonesia
1990m05

4.31
5.29
5.88
3.71
5.75

1986m01 Korea
1987m11 C
1987m12
1997m12
1994m01 Malaysia

Philippines

6.15
3.96

1989m12 Philippines
1991m01 C

Singapore

4.25

1998m01 Singapore
C
Value of Imports

4.13
5.55
5.70
3.74
3.96
3.84
4.66
4.24
3.75
3.77
4.02
4.38
4.47
4.05
4.09
5.35
5.34

1995 m07
1998 m08
1998m10
2002m06
1985m12
1999m07
2002m04
2002m05
1987m05
1993m11
1994m05
1990m12
1991m01
1991m12
1992m01
1997m08
1997m09

Mexico
C

Venezuela
Indonesia
C

Korea
C

Malaysia
C

Reserve Volatility
Argentina
Brazil

Chile

Mexico

Venezuela

3.75
4.65
6.17
4.29
4.16
5.12
3.87

2002m03
1997m07
1997m08
2002m02
2004m09
2004m10
1994m08

4.10
6.51
5.87
3.86
5.22
4.76
4.20
4.84
7.05
4.63

1986m10
1986m11
1987m03
1997m06
1997m07
1986m02
1987m02
2000m11
1995m05
1999m04

Argentina
Brazil

4.48
4.36
6.05

1990m02
1996m12
1997m01

Chile

3.92
3.75

1985m09
2002m01

Mexico
C

3.74

1995m05

Venezuela

4.18

1994m02

24

Indonesia

4.38

Korea
C

4.77
3.88
3.99
3.94
3.81
4.23
5.31
4.93
4.74
3.76
4.20
3.95
4.97

Malaysia

Philippines

Singapore
C

2000m08 Indonesia
C
1997m11 Korea
1997m12 C
2003m05
2003m06
1990m10 Malaysia
1990m11
1992m08
1992m09
1997m07 Philippines
1997m08
2000m03
2000m04
1995m03 Singapore
C

3.86
4.53
4.00
5.19
4.46

1986m12
1990m04
1985m12
1986m12
1987m01

3.79

1997m02

3.97

1998m05

4.26
4.99
4.06

1997m02
1998m04
1998m05

Notes. ++ : Perron and Rodrguez (2003) critical values with constant: 4.20(1%), 3.75 (5%), 3.56 (10%); with
constant and trend: 4.19(1%), 3.74 (5%), 3.55 (10%); C: constant term in equation (II.1).

APPENDIX III
Analysis of the conditional heteroskedasticity of the international reserves first difference time series

Table A.II - CONDITIONAL HETEROSKEDASTICITY TESTS

LB Q(j)
3

Argentina
63.91**

Brazil
0.34

Chile
5.61*

Mexico
20.63**

Venezuela
6.39*

Indonesia
33.11**

Korea
27.95**

Malaysia
36.07**

Philippines
5.11*

Singapore
52.08**

71.50**

6.41

8.68*

33.23**

8.12*

39.30**

35.00**

36.73**

18.05**

91.76**

83.22**

22.53**

11.19*

40.54**

39.76**

43.91**

37.86**

19.51**

135.56**

8.97

Notes. LB Q(j): Ljung Box Q-statistic for the null of no autocorrelation up to order j; *: rejected at the 5% level;
**: rejected at the 1% level. The reserve first differences have been filtered, if necessary, in order to eliminate
serial correlation. The number of degrees of freedom of the 2 distribution has been correspondingly adjusted.

25

Table I - RESERVE ADEQUACY MEASURES - RULES OF THUMB

Reserves/ Imports
(months)

Argentina
Brazil
Chile
Mexico
Venezuela
Indonesia
Korea
Malaysia
Philippines
Singapore

Guidotti Rule
Reserves /STDEB
(percentage)

Guidotti Rule Augmented

Reserves/(STDEB*(1+3%))
(percentage)

Capital Flow approach

Reserves/M2
(percentage)

1985

1995

2004

1985

1995

2004

1985

1995

2004

1985

1995

2004

10
9
10
3
15
6
1
5
1
6

9
11
11
3
6
4
3
4
3
7

10
10
8
4
13
8
11
8
4
8

42
83
55
48
89
91
16
NA
7
NA

74
91
265
38
110
43
60
309
104
38

105
232
244
186
331
205
332
386
144
156

41
81
53
46
86
88
15
NA
7
NA

72
88
258
37
107
42
58
300
101
37

102
225
237
181
321
199
322
375
140
151

NA
NA
41
14
42
24
9
24
7
96

27
25
55
23
53
14
16
32
17
95

41
30
43
33
79
31
37
53
27
89

Guidotti-Greenspan Rule
Reserves/ (STDEB+M2 )
(percentage)

low

1995
high

242
37
99
37
55
228
90
38

222
35
90
33
51
181
80
37

2004
low
high
88
75
194
167
230
218
167
151
258
212
147
114
301
276
319
272
127
113
152
147

Notes. is the percentage of broad money (M2) assumed by De Beaufort Wijnholds and Kapteyn (2001) to represent the amount of capital outflows stemming
from residents. It ranges from 5 to 10 percent in the case of countries with independently floating regimes and from 10 to 20 percent in the case of countries with
managed floating or fixed exchange rate regimes. is the country risk score index of the Economist Intelligence Unit. STDEB indicates the short term external
debt in millions of US dollars.

Table II UNIT ROOT TESTS

NP*
Reserves
-1.35

Argentina
C, t, lag 0
Brazil
-0.22
C, lag 1
Chile
1.00
C, lag 1
Mexico
-2.69
C, t, lag 0
Venezuela
-1.61
C, t, lag 1
Indonesia
-1.65
C, t, lag 2
Korea
-1.81
C, t, lag 2
Malaysia
-1.73
C, t, lag 2
Philippines
0.86
C, lag 14
Singapore
0.79
C, lag 12
Reserve Volatility
Argentina
C, lag 1
Brazil
C, lag 1
Chile
C, lag 1
Mexico
C, lag 1
Venezuela
C, lag 5
Indonesia
C, lag 0
Korea
C, lag 1
Malaysia
C, lag 2
Philippines
C, lag 1
Singapore
C, t, lag 0

I(1)
I(1)
I(1)
I(1)
I(1)
I(1)
I(1)
I(1)
I(1)
I(1)

-1.19

I(1)

-0.23

I(1)

-0.30

I(1)

-1.13

I(1)

-0.03

I(1)

0.52

I(1)

0.07

I(1)

-0.24

I(1)

-0.40

I(1)

-2.07

I(1)

NP
Domestic Short Term Interest Rate
Argentina
-1.81
I(1)
C, t, lag 9
Brazil
-1.15
I(1)
C, lag 9
Chile
-1.40
I(1)
C, t, lag 11
Mexico
-2.72
I(1)
C, t, lag 13
Venezuela
-0.56
I(1)
C, lag 0
Indonesia
-1.77
I(1)
C, lag 1
Korea
-0.96
I(1)
C, lag 1
Malaysia
-1.53
I(1)
C, lag 7
Philippines
-2.60
I(1)
C, t, lag 3
Singapore
-2.64
I(1)
C, t, lag 2
Value of Imports
Argentina
C, lag 12
Brazil
C, lag 13
Chile
C, lag 14
Mexico
C, t, lag 12
Venezuela
C, lag 1
Indonesia
C, lag 2
Korea
C, t, lag 12
Malaysia
C, lag 13
Philippines
C, t, lag 13
Singapore
C, t, lag 14

-0.82

I(1)

0.77

I(1)

0.47

I(1)

-2.34

I(1)

-3.58

I(0)

0.42

I(1)

-2.49

I(1)

0.28

I(1)

-1.47

I(1)

-1.97

I(1)

Notes. *: Ng Perron (2001) unit root test. The GLS-detrended autoregressive spectral density
estimator of the frequency zero spectrum uses the modified AIC to select the number of lags.
Critical values with constant, C, and trend, t: -3.42(1%),-2.91(5%); with constant without trend:
-2.58(1%),-1.98(5%).

27

Table III - VOLATILITY OF RESERVES

CONDITIONAL VARIANCE PARAMETERIZATION

t2 = + ut21 + t21 + St 1ut21

Argentina
Brazil
Chile
Mexico*
Venezuela

Indonesia
Korea
Malaysia
Philippines+
Singapore

(5)

15858.5
(10651.8)
22515.9
(29745.5)
1609.8
(1579.0)
135721.8
(116109.3)
3267.4
(2152.0)

0.19
(0.06)
0.15
(0.08)
0.05
(0.04)
0.10
(0.07)
0.12
(0.05)

0.81
(0.04)
0.88
(0.04)
0.94
(0.05)
0.87
(0.07)
0.93
(0.02)

5058.6
(3448.3)
10640.3
(7788.8)
6747.6
(4755.4)
1270.9
(1242.2)
572.4
(2046.6)

0.07
(0.04)
0.14
(0.04)
0.20
(0.08)
0.06
(0.03)
0.18
(0.07)

0.93
(0.04)
0.88
(0.03)
0.92
(0.02)
0.94
(0.03)
0.86
(0.05)

LLF
-1947.14
-2131.25
-1700.80
-2046.56

-0.11
(0.06)

-0.21
(0.08)

-1833.59

Standardized Residuals
Sk.
Kurt.
JB
0.166
4.101
13.22
[0.001]
-0.471
7.759
234.38
[0.000]
0.428
5.532
71.18
[0.000]
0.184
5.605
69.20
[0.000]
0.164
3.971
10.42
[0.005]

-1836.16

0.327

4.994

-1992.78

-0.303

4.983

-1907.20

-0.475

9.149

-1718.19

0.185

4.545

-1923.75

0.209

3.794

43.87
[0.000]
42.65
[0.000]
385.59
[0.000]
25.04
[0.000]
7.99
[0.018]

W
0.007
[0.932]
0.407
[0.523]
0.307
[0.579]
0.265
[0.606]
0.008
[0.930]
0.067
[0.796]
0.991
[0.319]
0.560
[0.454]
0.071
[0.790]
2.561
[0.109]

Notes. Sk.: Skewness; Kurt.: Kurtosis; JB: Jarque-Bera test statistic; W: Wald 2 test of the null hypothesis that
1--=0 in the GARCH(1,1) estimates and of the null hypothesis 1-(+0.5)-=0 in the TGARCH(1,1) ones; *:
the conditional distribution of the residuals is modeled as a t-distribution with degree of freedom 2.91 (standard
error 0.7674); : the conditional distribution of the residuals is modeled as a GED with tail parameter 0.8641
(standard error 0.1141); + : the conditional distribution of the residuals is modeled as a GED with tail parameter
1.1471 (standard error 0.1591). In the remaining estimates the standard errors of the coefficients are robust to
heteroskedasticity.

28

Table IV - JOHANSEN COINTEGRATION TESTS

TRACE TEST STATISTICS

List of variables in the VAR: Log (Reserves) = log Rt ; Log (Volatility of Reserves)= log t ; Log (Imports) =log M t ;
Log (Domestic Interest Rate)= log rt

Argentina

Brazil

Chile

Mexico

Venezuela

Indonesia

Korea

Malaysia

Philippines

Singapore

Hypothesized No. of
Cointegration
Relationships
None
at most 1
at most 2
at most 3
None
at most 1
at most 2
at most 3
None
at most 1
at most 2
at most 3
None
at most 1
at most 2
at most 3
None
at most 1
at most 2
None
at most 1
at most 2
at most 3
None
at most 1
at most 2
at most 3
None
at most 1
at most 2
at most 3
None
at most 1
at most 2
at most 3
None
at most 1
at most 2
at most 3

Trace Statitics

0.05 percent
Critical Value

67.29*
30.57
15.35
3.05
57.34*
27.52
11.62
2.48
57.91*
28.65
8.75
2.79
53.41*
26.27
12.64
3.25
34.95*
17.79
8.09

62.99
42.44
25.32
12.25
53.12
34.91
19.96
9.24
53.12
34.91
19.96
9.24
47.21
29.68
15.41
3.76
34.91
19.96
9.24

56.32*
33.20
18.79
6.89
55.62*
26.41
12.03
2.64
58.81*
25.81
11.53
3.19
50.43*
26.46
11.18
1.96
63.34*
31.44
13.31
3.58

53.12
34.91
19.96
9.24
53.12
34.91
19.96
9.24
53.12
34.91
19.96
9.24
47.21
29.68
15.41
3.76
62.99
42.44
25.32
12.25

Deterministic Trend
Assumption

No. of Lags in
VAR

Restricted linear
deterministic trend

Restricted constant

Restricted constant

Linear deterministic
Trend

15

Restricted constant

Restricted constant

Restricted constant

Restricted constant

Linear deterministic
trend

Restricted linear
deterministic trend

Notes. *: denotes rejection of the null hypothesis at the 5 percent level .

29

Table V - JOHANSEN COINTEGRATION EQUATION ESTIMATES

log Rt 0 t t 1 log $ t 2 log M t 3 log rt = t

(6)

2
-6.73
(1.38)

-2.56
(0.44)

-0.007
(0.002)

E.C.

Argentina

58.82

-0.023
(0.01)

--

Brazil

7.92
(1.94)

--

--

-2.11
(0.21)

-0.21
(0.05)

-0.03
(0.01)

Chile

-7.85
(3.25)

--

2.02
(0.77)

-1.79
(0.37)

-0.37
(0.20)

-0.02
(0.004)

-14.9

--

1.25
(0.27)

-0.63
(0.16)

0.45
(0.17)

-0.06
(0.02)

0.24
(0.11)

-0.027
(0.018)

Mexico

Venezuela

Indonesia

-4.09
(0.99)

-0.80
(0.19)

--

3.09
(1.24)

-0.29
(0.13)

-1.16
(0.19)

--

-0.04
(0.009)

1.23
(0.29)

-0.02
(0.005)

--

Korea

-3.59
(2.74)

--

--

-1.09
(0.26)

Malaysia

-2.68
(0.05)

--

-0.69
(0.11)

-0.41
(0.10)

0.55
(0.09)

0.02
(0.014)

Philippines

0.56

--

-2.30
(0.32)

--

1.83
(0.27)

0.02
(0.018)

Singapore

-0.56

0.005
(0.001)

-0.23
(0.07)

-1.18
(0.10)

0.40
(0.07)

-0.02
(0.009)

LR Test*

H 0 : 1 = 0
0.0086
[0.92]

H 0 : 1 = 0
0.0058
[0.80]

H0 : 3 = 0
0.044
[0.833]

H 0 : 1 = 0
1.21
[0.270]

Tests on cointegration residuals

Normality
Joint VAR
Cond. Het.
Test
Serial Corr.
Q-stat.
1 eq.**
LM Test
4.9 (lag 1) 25.9 (lag 1)
4.76
[0.03]
[0.05]
[0.09]
14.1 (lag 3) 31.3 (lag 3)
[0.00]
[0.01]
0.3 (lag 1) 12.1 (lag 1)
32.09
[0.60]
[0.73]
[0.00]
1.1 (lag 3) 16.8 (lag 3)
[0.78]
[0.39]
2.1 (lag 1) 20.2 (lag 1)
2.32
[0.14]
[0.21]
[0.31]
11.1 (lag 3) 24.7 (lag 3)
[0.03]
[0.07]
6.2 (lag 1)
5.7 (lag 1)
2.27
[0.01]
[0.46]
[0.32]
6.3 (lag 3) 18.3 (lag 3)
[0.09]
[0.30]

0.42
[0.80]

6.8 (lag 1)
[0.01]
14.5 (lag 3)
[0.00]

6.7 (lag 1)
[0.67]
7.1 (lag 3)
[0.62]

24.66
[0.00]

0.8 (lag 1)
[0.37]
16.9 (lag 3)
[0.00]

18.6 (lag 1)
[0.28]
23.6 (lag 3)
[0.10]

0.1 (lag 1)
[0.70]
0.2 (lag 3)
[0.96]
0.9 (lag 1)
[0.34]
2.2 (lag 3)
[0.52]
6.6 (lag 1)
[0.01]
19.4 (lag 3)
[0.00]
4.4 (lag 1)
[0.04]
5.3 (lag 3)
[0.14]

18.3 (lag 1)
[0.30]
17.2 (lag 3)
[0.37]
11.4 (lag 1)
[0.78]
21.7 (lag 3)
[0.15]
12.6 (lag 1)
[0.70]
27.1 (lag 3)
[0.04]
25.8 (lag 1)
[0.06]
12.2 (lag 3)
[0.73]

99.15
[0.00]

11.49
[0.00]

H0 : 2 = 0
0.07
[0.78]

24.67
[0.00]

1.83
[0.40]

Notes. E.C.: error correction coefficient; *: Likelihood Ratio test of the cointegration vector restrictions; **:
Jarque-Bera normality test; : Johansen (1995) VECM residuals autocorrelation LM test; standard errors are in
parentheses and probability values in square brackets.

30

Table VI - CORRELATION MATRICES OF THE JOHANSEN COINT. RESIDUALS

ASIA

Indonesia
Korea
Philippines
Malaysia
Singapore

Indonesia

Korea

Philippines

Malaysia

Singapore

1.00
-0.61
-0.27
0.03
-0.04

-0.62
1.00
0.08
0.22
0.32

-0.27
0.09
1.00
0.11
-0.10

0.03
0.22
0.11
1.00
0.49

-0.04
0.32
-0.10
0.49
1.00

Argentina

Brazil

Chile

Mexico

Venezuela

1.00
0.35
0.12
0.12
0.18

0.35
1.00
0.21
0.01
0.27

0.12
0.21
1.00
0.03
0.37

0.12
0.01
0.03
1.00
-0.01

0.18
0.27
0.37
-0.01
1.00

Chile

Mexico

Venezuela

0.23
0.09
0.18
-0.35
0.34

-0.12
-0.19
-0.35
0.01
-0.17

0.20
-0.09
0.39
0.22
0.31

LATIN AMERICA

Argentina
Brazil
Chile
Mexico
Venezuela
CROSS AREA

Indonesia
Korea
Philippines
Malaysia
Singapore

ASIA-LATIN AMERICA
Argentina
Brazil
0.23
-0.21
0.12
0.14
-0.12

0.56
-0.37
0.27
-0.05
0.07

Table VII - PRINCIPAL COMPONENTS ANALYSIS

ASIA AND LATIN AMERICA
Comp 1
Eigenvalue
Cumulative prop. of
variance explained
LATIN AMERICA

Eigenvalue
Cumulative prop.of
variance explained
ASIA

Eigenvalue
Cumulative prop. of
variance explained

Comp 2

Comp 3

2.51

2.15

1.44

0.25

0.47

0.61

Comp 1

Comp 2

Comp 3

1.76

1.06

0.94

0.35

0.56

0.75

Comp 1

Comp 2

Comp 3

1.89

1.39

0.97

0.38

0.66

0.85

31

Table VIII - DETERMINANTS OF THE EXCESS DEMAND OF RESERVES

PC1t = + log i t ,US + log REERt ,US + e t

Dependent Variable

(8)

R2

PC1 Interregional system

42.83
(5.78)

0.98
(0.27)

-9.49
(0.28)

0.45

PC1 Latin America

20.76
(5.33)

0.69
(0.27)

-4.60
(1.17)

0.17

PC1 Asia

14.86
(5.88)

1.30
(0.36)

-3.29
(1.31)

0.21

Notes. Autocorrelation and heteroskedasticity consistent standard errors in parentheses.

32

Figure I. Reserve overstocking - Latin America

Normalized four quarter moving averages of the cointegration residuals (y axis in standard deviations)

EXCESS_AR

2.0

1.5

EXCESS_BR

EXCESS_ID

EXCESS_KO

31

1.0
2

0.5 1

0.0

-0.5

-1
0

-1.0
-1
-1.5

-2
-1

-2.0-2

-2-3

95
95 96
96 9797 9898 99
99 0000 0101 0202 0303 0404

9 595 9696 9797 9898 9999 0000 0101 0202 0303 0404

EXCESS_MY
3

EXCESS_PH

EXCESS_CL

-1

-1

-2

-1

-1

-2

-3

-2 95 96 97 98 99 00 01 02 03 04
95 96 97 98 99 00 01 02 03 04

-2 9 5 96 97 98 99 00 01 02 03 04
95 96 97 98 99 00 01 02 03 04

EXCESS_SP
3

EXCESS_VE
2

11

EXCESS_MX

-1

-1
-2
-2
-3
95

96

97

98

99

00

01

02

03

04

-3
95

96

97

98

99

00

01

02

03

04

33

Figure II. Reserve overstocking - Asia

Normalized four quarter moving averages of the cointegration residuals (y axis in standard deviations)

EXCESS_ID

EXCESS_KO

2.0

1.5

1.0
2

0.5

0.0

-0.5

-1.0
-1

-1.5

-2.0

-2

95

96

97

98

99

00

01

02

03

04

95

96

97

EXCESS_MY

98

99

00

01

02

03

04

02

03

04

EXCESS_PH

-1

-1

-2

-2

-3

95

96

97

98

99

00

01

02

03

04

02

03

04

95

EXCESS_SP
3

-1

-2

-3
95

96

97

98

99

00

01

34

96

97

98

99

00

01