Does financial development reduce the motivation to hoard foreign reserves?

Managing capital flows and liquidity demand have been central issues for emerging market countries. This paper analyzes the effects of financial development and capital flows on foreign reserve accumulation in East Asian economies. Using annual data from 12 Asian economies between 1980 and 2009, the empirical results suggest that financial development can reduce a central bank’s motivation to hoard foreign reserves by reducing the impact of capital flows on foreign reserve demand. Based on the empirical observations, this study then constructed a simple model of foreign reserve accumulation in which the optimal level of foreign reserves depends on the level of financial development. With an asymmetric preference in exchange rate, the actual level of foreign reserves held by a central bank is usually higher than the optimal level of foreign reserves needed for liquidity supply.