Optimal Foreign Reserve Intervention and Financial Development

Abstract: We document evidence of a U-shaped relationship between financial development and the adjustments of foreign exchange (FX) reserve holdings in response to a U.S. interest rate increase. Countries with intermediate levels of financial development sell reserves aggressively, while those with low or high levels adjust little. A model with borrowing constraints and foreign-currency debt rationalizes these findings. Optimal FX reserve policy faces a tradeoff between the rate of return on capital outflows and a pecuniary externality linked to foreign currency debt in the borrowing constraints. This pecuniary externality is maximized at intermediate levels of financial development.

DOI: https://doi.org/10.24149/wp2538r1

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