Based on a dynamic open-economy macroeconomic model, this paper aims at understanding the contribution of domestic financial underdevelopment to foreign reserve accumulation in some emerging market economies, especially in China. It is argued that foreign reserve accumulation is part and parcel of a growth strategy based on strong capital investment in a financially constrained economy. It is further proved using a Ramsey problem that purchasing international reserves is a welfare-improving policy in terms of production efficiency gains if it is jointly used with capital controls. In fact, when domestic firms are occasionally credit-constrained and they do not have a direct access to international financial market, they need domestic saving instruments to increase their retained earnings so that they can sufficiently invest in capital. The central bank plays the role of financial intermediary and provides domestic firms with liquid public bonds, thus relaxing domestic financial constraints. The proceeds of domestic public bonds are invested abroad due to the limited scope of domestic financial market and a depressed domestic interest rate, leading to foreign reserve stockpiling. The speed of foreign reserve accumulation would slow down once the economic growth rate decelerates and the domestic financial market develops.
Classification JEL : E22, F31, F41, F43
Keywords : Foreign reserves, capital controls, credit constraints, domestic savings, capital investment, economic growth, Chinese economy.
Updated on: 06/12/2018 11:10