The Impact of Foreign Exchange Reserve Accumulation on External Debt

Abstract

This paper analyzes the impact of foreign exchange reserves on external debt using panel analysis for 73 non-reserve currency countries during 1998-2015. The empirical results show that the increase of foreign exchange reserves has positive and significant impact on external debt. Also, the sectoral analysis classifying holders of external debt into the private and the public sector confirms that external debt of the private sector responds significantly to changes in foreign exchange reserves, while that of the public sector shows insignificant response. As previous literature supposes, the findings of this study imply that the increase of foreign exchange reserves as the precautionary demand ironically provides incentives for the private sector to increase external debt. This paper suggests two interpretations for the empirical results: (1) if the central bank absorbs foreign currency into reserves, it can cause the lack of foreign currency liquidity in the domestic FX market and lead to the increase of international borrowing by the private sector

and (2) increased foreign exchange reserves lower the credit risk of the country and facilitate international borrowing of the private sector, leading to the increase of external debt.