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International Reserves and the Composition of Foreign Equity Investment


  • The authors wish to thank Joshua Aizenman, Menzie Chinn, Frank Westermann and two anonymous referees for helpful comments and advice. They also thank participants of seminars at the University of Osnabrueck, the Graduate School of Economics and Business, University of Groningen, the 7th Annual APEA Conference in Busan, the 4th Annual Conference “Emerging Economies in Globalized Financial Markets” in Halle, the EEA–ESEM meeting in Malaga, the Annual Conference of the German Research Committee on Development Economics, and HKIMR for their valuable comments and suggestions. We are very grateful to Philip Lane and Christian Lundblad forsharing data.


This paper studies the effect of central banks' international reserve hoardings on the composition of foreign equity investment. Specifically, it examines whether reserves affect the share of foreign portfolio equity investment (PEI) in total foreign equity investment, which includes both PEI and foreign direct investment (FDI). Foreign investors' decisions regarding the location and the type of equity capital investment might be influenced by a country's level of international reserves. In a simple theoretical model, it is shown that higher reserves, thanks to their ability to lower exchange rate risk, reduce the risk premium of PEI. Hence, higher reserves are expected to increase the inflow of PEI relative to FDI. This hypothesis is tested for a sample of 76 developing countries during the period 1980–2010 using different estimation methods, model specifications and data samples. The results suggest that higher levels of reserves are associated with a larger share of PEI relative to FDI. This result points to a collateral benefit of reserves that has been neglected so far. Reserves may contribute to develop domestic financial markets and facilitate domestic firms' access to foreign portfolio equity financing. In addition, this paper finds a strong negative effect of the global financial crisis beginning in 2008 on the share of PEI, which confirms the hypothesis that PEI is more crisis-dependent than FDI.

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