Journal of International Money and Finance
Volume 68, November 2016, Pages 230–257
 

Kuk Mo Jung (a), , , Ju Hyun Pyun (b),
a School of Economics, Henan University, Kaifeng, China
b Korea University Business School, Seoul, South Korea
http://dx.doi.org/10.1016/j.jimonfin.2016.06.020

Abstract
The massive stocks of foreign exchange reserves, mostly held in the form of U.S. T-bonds by emerging economies, are still an important puzzle. Why do emerging economies continue to willingly loan to the United States despite the low rates of return? We suggest that a dynamic general equilibrium model incorporating international capital markets, characterized by decentralized trade and U.S. T-bonds as facilitators of trade, can provide one possible resolution to this question. Declining financial frictions in these over-the-counter (OTC) markets would generate rising liquidity premium on U.S. T-bonds, thereby causing low U.S. real interest rates. Meanwhile, the superior liquidity properties of the U.S. T-bonds would induce recipients of foreign investments, namely emerging economies, to hold more liquidity, that is U.S. T-bonds, in equilibrium. The prediction of our model is confirmed by an empirical simultaneous equations approach considering an endogenous relationship between OTC capital inflows and reserve holdings.

Keywords International reserves; Over-the-counter markets; Liquidity; Simultaneous equations