Financial Stability, the Trilemma, and International Reserves

TLDR

International reserves have grown rapidly, especially in emerging markets, and this growth remains puzzling. The paper proposes a financial‑stability and openness model to explain modern reserve holdings. The model identifies domestic liabilities (M2), financial openness, debt‑market access, and exchange‑rate policy as key predictors of reserve stocks. The empirical model outperforms traditional and external‑debt explanations. JEL codes: E23, E43, E44, F31, F32, F34.

Abstract

The rapid growth of international reserves, a development concentrated in the emerging markets, remains a puzzle. In this paper, we suggest that a model based on financial stability and financial openness goes far toward explaining reserve holdings in the modern era of globalized capital markets. The size of domestic financial liabilities that could potentially be converted into foreign currency (M2), financial openness, the ability to access foreign currency through debt markets, and exchange rate policy are all significant predictors of reserve stocks. Our empirical financial-stability model seems to outperform both traditional models and recent explanations based on external short-term debt. (JEL E23, E43, E44, F31, F32, F34)