Domestic financial instability and foreign reserves accumulation in China

• Author: Chiayang James Hueng,Lirong Wang
• Date: 01 August 2019
• DOI: http://doi.org/10.1111/infi.12338
• Published date: 01 August 2019

DOI: 10.1111/infi.12338

ORIGINAL ARTICLE

Domestic financial instability and foreign reserves

accumulation in China

Lirong Wang

1,2

|

Chiayang James Hueng

3,4

1

School of Economics, Northeast Normal

University, Changchun, Jilin, China

2

Key Laboratory of Applied Statistics of

Ministry of Education, School of

Mathematics & Statistics, Northeast

Normal University, Changchun, Jilin,

China

3

Department of Economics, Western

Michigan University, Kalamazoo,

Michigan, USA

4

School of Economics, Zhongnan

University of Economics and Law,

Wuhan, Hubei, China

Correspondence

Lirong Wang, Northeast Normal

University, No.2555 Jingyue Street,

Changchun 130017, China.

Email: wanglr793@nenu.edu.cn

Funding information

China Social Science Foundation,

Grant number: 15CGJ020

Abstract

Using a time series analysis, this paper argues that domestic

financial instability, which increases the potential for

resident-based capital flight from the domestic currency,

provides an incentive for China to hold more foreign

reserves in the short run. To measure its domestic financial

conditions, we construct a monthly Chinese financial stress

index, which is used as a proxy for the possibility of capital

flight. The empirical results show that this index is a

significant determinant of the movements of China's foreign

reserves around its trend and that using M2 as a proxy for

domestic financial instability as suggested by previous

studies is not a valid strategy for China. It is suggested that

greater attention should be given to the role of domestic

financial conditions in explaining China's short-run demand

for foreign reserves.

1

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INTRODUCTION

This paper contributes to the explanations of China's foreign reserves using a time series analysis. We

argue that domestic financial instability, which increases the potential for resident-based capital flight

from the domestic currency, provides an incentive for China to hold more foreign reserves in the short

run. To measure the financial conditions in China, this paper uses a principal component model to

construct a monthly Chinese financial stress index (CFSI). The variables used to construct the index are

carefully selected, including several Chinese market interest rates and their spreads and, more

importantly, the actual or expected behaviors of financial asset prices that we estimate. The empirical

results show that this index is a significant determinant of the movements of China's foreign reserves

International Finance. 2018;1–14. wileyonlinelibrary.com/journal/infi © 2018 John Wiley & Sons Ltd

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© 2018 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/infi International Finance. 2019;22:124–137.

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