Essays on central bank foreign exchange reserve adequacy in emerging market economies

A simple analysis of IMF's ARA metric implied excess reserves-to-GDP ratio suggests that despite some of the EM countries holding reserves close to ARA metric implied levels, some countries' holdings diverge to a great extent. The first essay of this thesis shows that GDP, broad money, and trade balance augmented with 3-month of imports reflect the reserve holding decisions of central banks to a great extent. This metric mitigates the inherent problem of the IMF's ARA metric to overestimate the adequate level of reserves for some EM countries while underestimating for others, at least from the central banks' perspective. Although studies that attempt to explain the observed hoarding behavior of EMEs are abundant, research on whether the levels of foreign exchange reserves are excess or not is scarce. The second essay of this thesis attempts to identify the level of international reserves deemed adequate by the market using several reserve adequacy measures and the EM external debt market. The results suggest that the market assesses the IMF's ARA metric to overestimate the level of adequate reserves to a great extent. More importantly, hoarding reserves beyond adequate levels is not optimal since it is not rewarded by the market. For EMEs, holding relatively high or excess foreign exchange reserves is a way of limiting the adverse impact of external shocks. However, hoarding of international reserves may be distortionary to global financial stability and may be costly given the conservative approach of reserve authorities to reserve portfolio management. In the third essay of this thesis, we develop a simple framework that may help EMEs minimize the costs associated with holding excess reserves. CDS contracts are incorporated into the decision rule as contingent claims linked to sudden stops. The suggested framework provides the much-needed external liquidity in bad states and can be extended to include contingent claims linked to global factors for hedging the systematic risk component while a portfolio of CDS contracts on the external debt of comparable countries can be used for hedging the idiosyncratic risk component.