International reserve accumulation: balancing private inflows with public outflows

Abstract

We explore international reserve accumulation in Emerging Market Economies (EMEs), rationalizing policymakers’ belief that it counteracts the negative effects of capital inflows. Empirical evidence reveals that EMEs accumulate reserves in response to capital inflows driven by global push factors, especially when there are limitations on residents’ investments abroad. We elucidate these findings with a three-period model of a small open economy. In the first period, a large direct investment inflow occurs, prompting an EME to save abroad for consumption smoothing. If frictions hinder private overseas investments, the government can accumulate reserves to supplement insufficient private outflows. The theory highlights the role of reserves in managing capital inflows, as substantiated by our empirical findings.