Economy & Business, Volume 12, 2018

Abstract: A puzzle in international economics is the high level of foreign exchange reserves accumulated by countries around the world. Such high levels of reserves represent a conundrum since they exceed all standard benchmarks of reserve adequacy, most notably in the case of leading emerging market economies (EMEs), such as Brazil, China, India, Russia, and South Korea. Unlike past studies that examined this phenomenon from a largely economic perspective, this study adopts a comprehensive political economy approach by focusing on both economic and political factors. The paper draws on an ‘audience cost’ argument to identify and examine various political economy factors in explaining why EMEs accumulate currency reserves, often beyond pure economic needs. The research focuses on a large-sample of over 100 developing and transition countries for the period 1980-2015. Fixed effects model estimates demonstrate support for the political economy thesis, particularly for strategic factors such as domestic political competition, mercantilism, and global political ambitions. Support is also found for institutional characteristics, namely, political system, central bank independence, and exchange rate system. The findings of the study advance our understanding of the motivations associated with international currency reserves and the drivers of policy choices in this domain.