Determinants of international reserves in Malaysia.

• Author: Puah, Chin-Hong
• Position: Report

1. INTRODUCTION

   Bank runs and capital flights are two of the processes explaining why financial crisis often precedes by currency crisis. In facing this scenario, the central bank needs to decide whether to maintain exchange rate by selling reserves, allow depreciation, or tightening the money (Hanson, 2005). The central bank usually opts for the latter two when international reserve is getting exhausted. In relation to this and in light of the past experiences, many countries especially across Asia began to expand their foreign reserves holding. According to Rodrik (2006), international reserves begin to trend sharply since 1990. Matthew and Thomas (2004), Rodrik (2006), Joshua and Jaewoo (2007), Cheung and Qian (2009), among others, view this trend as a precautionary for self-insurance against possible crisis in future.

   International reserve is a crucial asset for a country. The global reserves had increased dramatically over the past decade. Global reserves had almost doubling in nominal terms from US$1,254 billion at the end of 1994 to US$2,223 billion at the end of May 2002 (Aizenman and Marion, 2003). There are some Asian countries including Malaysia which have been accumulating reserves to keep their currencies undervalued in an effort to maintain external competitiveness, attract FDI and thus boost up export as well as stimulate growth. For Malaysia, the total international reserves had increased steadily in recent years. In 2001, the total reserves was RM113,585.4 million. This amount had then increased to RM128,109.8 million in 2002, RM167,812.3 million in 2003 and RM251,595.8 million in 2004. In 2005, the total reserves was RM265,147.8 million and the total reserves had next increased to RM290,399 million in 2006, with an increment of around 9.5 percent from the previous year.

   Researchers argued that there are many factors affecting the accumulation of international reserves. In the case of emerging Asia, Gosselin and Parent (2005) found that there was a relatively stable long-run reserves demand function that depended on five explanatory variables, which consist of economic size, current account vulnerability, capital account vulnerability, exchange rate flexibility and the opportunity cost. In East Asia, reserves to import ratio, short-term indebtedness and trade openness were identified as the major determinants of reserves accumulation. In addition, Choi and Baek (2004) showed that country size, exchange rate regime, real openness and financial openness were the important determinants of international reserves. Additionally, Flood and Marion (2002) had also reported that both real and financial openness were positively correlated with international reserves holding. However, the demand for international reserves varies across the countries. Empirical literatures on the demand for reserves do not provide clear evidence about the determinants and reasons for recent large reserves holding in Malaysia. Thus, it motivates us to conduct a study to deal with this issue by examining the determinants of international reserves in Malaysia as well as to fill up the gap in the literature.

2. FACTORS AFFECTING INTERNATIONAL RESERVES

   Recent studies had used a number of factors to explain international reserves holding. In this study, five explanatory variables are used to investigate their impacts on the international reserves holding in Malaysia. These variables include economic size, exchange rate, openness, balance of payments and the opportunity cost of reserves holding. The choice of these five explanatory variables is mostly motivated by their relevance for the Malaysian economy.

   The size of economy for a particular country has an effect, normally a strong positive effect on international reserves holding. Economic size can be represented by GDP, GDP per capita or population size. In this study, GDP has been used as the proxy of the economic...