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Exchange Rate Regime and Demand for Reserves: Evidence from Kenya, Mexico and Philippines

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Abstract

This paper empirically investigates the demand for international reserves (and foreign exchange reserves) during fixed and floating exchange rates periods in three developing countries: Kenya, Mexico and Philippines. Based on theoretical models, three factors are identified as important for the demand of international reserves and foreign reserves: average propensity to import, volume of imports and variability of reserves. The paper employs the cointegration methodology and error correction method to investigate the relationships. Cointegration tests results indicate a reliable long-run stationary relationship between the international reserves (and foreign exchange reserves) and the stated explanatory variables across countries and sub-periods of fixed and clean float. The error correction results indicate causality from the explanatory variables to the reserves during both the short and long run. This is true during both the fixed and the floating periods.

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Notes

  1. For example, Heller and Khan (1978) noted for developing countries a stable or a rising reserve-to-import ratio following the move to managed float in 1972. Frankel (1983) contended that the fundamental pattern of countries’ reserves holding behaviour did not change much, notwithstanding the move to greater exchange rate flexibility. Flood and Marion (2002) noted that international reserves stood at 6% of global GDP in 1999, which were 50% higher than in 1990, and 3.5 times what they were at the end of 1960.

  2. The empirical tests are then extended to demand for foreign reserves. These further tests involving foreign exchange reserves are conducted to investigate the demand for such reserves, and to check whether the non-foreign exchange reserves components of the international reserves play an important role in this demand. A summary of the foreign reserves results are provided in footnotes later.

  3. Elbadawi (1990), Ford and Huang (1994), and Moosa (1992) also examined the issue using co-integration methodology.

  4. The IMF Annual Report of 1974 initially pointed out those issues.

  5. To rationalize the observed stability in reserve demand function and invariant economic behaviour of monetary authorities across regimes, Frankel (1983) attributed to the fact that the ‘fixed’ exchange period was largely characterized by ‘adjustable peg’ regime, while ‘floating’ exchange rate has in fact been ‘managed rates.’

  6. Therefore, foreign reserve assets are a sub-set of international reserve assets.

  7. Similar model is applied by Bahmani Oskooee (1988) in the study of speed of adjustment of reserves during fixed and floating regime.

  8. Bahmani Oskooee and Brown (2002) provide a comprehensive list of references.

  9. The GARCH(1,1) model provides similar results for the foreign exchange reserves. These results are available on request.

  10. Compared to other procedures the Johansen procedure provides more robust results when there are more than two variables (Gonzalo, 1994). The Johansen procedure reveals overall the least size distortion (Haug 1996) and is still more robust than the other methods, even when the errors are non-normal (Gonzalo, 1994).

  11. More detailed analysis of the Johansen procedure is provided in Dickey and Rossana (1994) and Harris (1995).

  12. According to Cheung and Lai (1993), the trace test shows more robustness to both skewness and excess kurtosis in the residuals than the maximum eigenvalue test. Further, according to Kasa (1992), the trace test tends to be more powerful than the maximum eigenvalue test when the eigenvalues are evenly distributed.

  13. Starting with a maximum length of eight lags, lags were eliminated if they were insignificant (as a group of 2) at the 10% level. According to Gonzalo (1994, p. 220), the cost of over-parameterizing by including more lags is small in terms of efficiency but this is not true if it is under-parametrized.

  14. We checked to determine the components, and results indicated the presence of a deterministic trend. These results are available on request.

  15. Similar results are found using the foreign exchange reserves. For all three countries during both periods, the trace statistics indicate one significant vector. Thus, in all cases, one significant long-run relationship is found between the variables.

  16. See Engle and Granger (1987) for a detailed discussion of the error correction modelling strategy based upon the information provided by cointegrated variables.

  17. With the cointegrating vector normalized on reserves, in which (international or foreign) reserves is the dependent variable, the associated element of θ 1 represents the speed of adjustment directly. In the remaining equations, the corresponding elements of θ 1 represent the ratio of speed of adjustment of the relevant variables to the value of their associated coefficient in the cointegration relationship.

  18. For example, the reserves volatility will be exogenous if only the lagged changes in the volatility are significant in the volatility regression.

  19. In both tests there is ample evidence of significant short-run causality from the variables to (including the variability) to the international reserves. The diagnostic statistics of the regression are quite satisfactory.

  20. In these tests also there is ample evidence of lagged independent variables exerting significant short-run causal effects on the movements of international reserves. The diagnostic statistics are again quite satisfactory.

  21. The short-run causality results and the diagnostic statistics in the Philippines tests are similar to the other two countries results. In the floating period, reserve variability fails to cause international reserves during both the short and the long-run period.

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Acknowledgment

The authors thank an anonymous referee and the editor of the journal for several useful comments and suggestions. Any remaining errors or omissions are the authors’ responsibility.

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Authors and Affiliations

  1. School of Management, University of Southampton, Highfield, Southampton, SO17 1, BJ, UK

    Taufiq Choudhry

  2. Faculty of Organisation and Management, Sheffield Hallam University, City Campus, Pond Street, Sheffield, S1 1, WB, UK

    Mohammad Hasan

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  1. Taufiq Choudhry
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  2. Mohammad Hasan
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Correspondence to Taufiq Choudhry or Mohammad Hasan.

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Choudhry, T., Hasan, M. Exchange Rate Regime and Demand for Reserves: Evidence from Kenya, Mexico and Philippines. Open Econ Rev 19, 167–181 (2008). https://doi.org/10.1007/s11079-007-9023-y

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