Seminario CEDE - Humberto Martínez

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Why do emerging markets accumulate foreign reserves for precautionary purposes while advanced economies do not? In this paper, I argue that, in contrast to advanced economies, developing countries accumulate reserves because they lack the sufficient fiscal capacity - ability to extract resources from its citizens - to provide liquidity during crises successfully. By accumulating reserves, developing countries emulates the liquidity provision capabilities of advanced economies. To show this argument, I develop a three period model of small open economy whose funding costs are driven by a global financial cycle. Moreover, I present empirical evidence for a sample of 100 countries between 1990 and 2018 that countries with lower fiscal capacity tend to have larger stocks of foreign reserves. In terms of policy, it shows that overcoming currency mismatch, without improving fiscal capacity, might not be sufficient to eliminate the need for foreign reserves.