Essays on Foreign Exchange Reserve Accumulation
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I study the effect of foreign exchange reserve accumulation on domestic financial markets. Central banks sterilize reserve purchases through sales and issuance of domestic debts. Therefore, reserves are funded by central banks' domestic borrowing. Public borrowing affects credit allocation in domestic financial markets. First, it reduces total credit to private sector. Second, as creditors adjust their portfolio after taking over public debts, different debtors are differently affected according to their risk-return characteristics. The first chapter studies how sterilized accumulation of reserves affects bank lending. I develop a model of imperfect capital mobility where reserve is accumulated by the central bank's borrowing. The model analytically shows that reserve accumulation crowds out bank loans. I examine monthly balance sheets of all Korean banks from September 2003 to August 2008 and find that bank lending declined after reserve accumulation. The crowding-out coefficient, defined as the ratio of reduced lending to accumulated reserves, is estimated to be 0.5. I further investigate whether reserve accumulation leads banks to cut lending by examining bank characteristics that can make some banks more responsive to reserve accumulation than others. I find that strong banks(highly capitalized, large size banks with abundant core deposits), which can expand lending easily, cut loans more. Also, foreign bank branches, which specialize more in security trading than loan provision, cut loans more aggressively compared to domestic banks. The second chapter continues by examining the effect of reserve accumulation on firms' financial constraints. I build a model of reserve accumulation with heterogeneous firms and show differential crowding out effects of reserve accumulation on different-sized firms. The negative effect from reserve accumulation is larger on large firms that issue debt securities more substitutable with risk-free, low-return central bank papers. Using firm level data from Korea during 1999 to 2007, I measure firm financial constraints using investment-cash sensitivity regressions. I find that large firms become more financially constrained after reserve accumulation, whereas small firms are not affected. The large firms' investment loss in the sample amounts to 0.5% of GDP per every 1% of GDP reserve accumulation.