| Abstract | Official flows in the form of foreign exchange (forex) reserves has changed the landscape of global financial markets. With the opening of capital accounts, the build-up and drawdown of forex reserves become an important policy tool to counter against fickle cross-border flows. The received wisdom is that the build-up of forex reserves will automatically play a stabilizing role. There is much empirical research on this yielding mixed results. For example, Aizenman et al.(2015) found that forex intervention could reduce depreciation pressure while Miyajima and Montoro (2013) showed that forex intervention actually worsened expectation and hence exacerbated exchange rate volatility. In addition, few theoretical research investigated formally the relationship between forex intervention and exchange rate determination.
We build on Gabaix and Maggiori (2015) by incorporating explicitly forex reserves and global liquidity cycle into a dynamic general equilibrium model of exchange rate determination. In our model, official flows and private flows are determined differently. While private flows are driven by expected returns from carry trade and global risk appetite, official flows are driven by both "adequacy" and "the willingness to use reserves."
We first show theoretically that during episodes of global liquidity squeeze, exchange rate stability depends not only on the adequacy of reserves, but more on the willingness to use it. When forex reserve policy is sufficiently counter-cyclical, it can reduce the negative impact of global liquidity squeeze. However, when there is reluctance or constraint to use reserves, reserve build-up actually amplifies the shock from global liquidity squeeze. This is a feature not properly investigated or highlighted by previous research. We explain it by highlighting the built-in positive feedback loop during the process of reserve build-up: by holding down the exchange rate and domestic assets prices, reserves attract more carry trade flows on the margin. This positive feedback loop requires that reserves accumulated through the capital account channel being actively drawn down when carry trade flows unwind. If not, the exchange rate has to overshoot to accommodate outflows. The more the reserves accumulated through the capital account, the higher the depreciation pressure when global liquidity cycle turns.
We then show empirically that the effectiveness of emerging markets forex intervention conforms to the pattern the theoretical model predicts. During and before the global financial crisis of 2008, most EMs actively deployed forex reserves as a tool against capital flow reversal; A country's forex reserve adequacy was positively associated with its exchange rate stability. Since 2010, however, when EMs shunned away from using reserves, the positive relationship turned upside down: the more reserves a country has, the more volatile its exchange rate becomes during outflows.
The contribution of this paper consists of three parts. Firstly, we are among the first to build a dynamic general equilibrium model that explicitly incorporates forex reserves and global liquidity cycle in studying the determination of exchange rates, providing a foundation for further research in forex intervention and its effectiveness. Secondly, we provide a theoretically consistent framework to explain why some forex interventions work and others don't. It is less about reserve adequacy but more about the willingness to use it counter-cyclically. Specifically, if a country only builds up forex reserves, the more it accumulates, the more the pressure when the global liquidity cycle turns. Thirdly, our analysis bears direct policy implications for emerging markets. The countercyclical intervention of forex reserves in essence is a trade-off between the overshooting of reserves quantity and the overshooting of exchange rate price. Whether price or quantity overshooting is more desirable depends critically on the degree of capital account openness. With an increasingly open capital account, the overshooting of reserves carries more risks and exchange rate flexibility becomes more vital. With a flexible exchange rate ex ante, the trade-off would no longer be relevant ex post because there would be no overshooting of reserves to begin with.
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