Foreign Reserve Accumulation in China：A DSGE Analysis of Main Motivations and Their Relative Contributions

Abstract

Over the past decade, the question of why China’s emerging market policymakers have accumulated such massive international reserves has been posed and debated by scholars. However, given the existence of several competing explanations, the excess amount and rapid growth of China’s foreign exchange reserves remains a puzzle.

In order to identify the primary motivations for the reserve accumulation, this thesis discusses the role of intergenerational transfers, exchange rate policy and the precautionary savings motive. We develop an estimated DSGE model for China, including these three motives, to evaluate various competing explanations for China’s foreign exchange reserves. Through analysis of impulse response function, risky steady state and shock decompositions of the model, we pursue the primary motivation for the reserve accumulation.

This thesis uses DSGE techniques to explore and compare the influence of the competing theories. The estimation results suggest that the total economic value of intergenerational transfers in China is bigger than the capital flow caused by the other two motivations. However, from an economic growth perspective, the influence of currency undervaluation plays a more important role.

The thesis findings indicate that the precautionary motivation is the most significant factor in China’s accumulation of international reserves. The impact of capital outflows causes more change and decline in China’s foreign exchange reserves than any other competing explanation. The precautionary motive is therefore the primary motivation for the current accumulation of foreign exchange reserves by China. The originality of this research, and its contribution to the foreign reserves literature, lies in the use of the DSGE method to analyse the motives for amassing foreign exchange reserves.