Foreign Reserves as Hedging Instruments in Emerging Countries

Emerging markets in the last decade increased the stock of foreign reserves and simultaneously managed to raise GDP growth while leaving short term foreign debt and investment in net fixed capital nearly unchanged. This work builds a model able to derive these facts as the result of greater openness to global goods and financial markets. Emerging countries generate the observed high ratios of reserves to short term foreign debt to hedge against volatility of foreign capital inflow with the purpose of stabilising not the short term but the long term finance available to domestic firms. Numerical simulations of the model derive the rising level of reserves to short term foreign debt ratio and about half of the observed rise in GDP growth as a result of a falling cost of long term finance and the increasing competitiveness of domestic industry.