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Domestic financial instability and foreign reserves accumulation in China

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  • Lirong Wang
  • Chiayang James Hueng

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.

Suggested Citation

  • Lirong Wang & Chiayang James Hueng, 2019. "Domestic financial instability and foreign reserves accumulation in China," International Finance, Wiley Blackwell, vol. 22(2), pages 124-137, August.
    • Handle: RePEc:bla:intfin:v:22:y:2019:i:2:p:124-137
    DOI: 10.1111/infi.12338
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    Cited by:

    1. Wang, Lirong & Zhou, Jinnan & Hueng, C. James, 2022. "Dynamics of gross capital flows and financial stress in China," Finance Research Letters, Elsevier, vol. 44(C).
    2. Shang, Binbin & Shang, Pengjian, 2022. "Effective instability quantification for multivariate complex time series using reverse Shannon-Fisher index," Chaos, Solitons & Fractals, Elsevier, vol. 160(C).
    3. Xuan Lv & Menggang Li & Yingjie Zhang, 2022. "Financial Stability and Economic Activity in China: Based on Mixed-Frequency Spillover Method," Sustainability, MDPI, vol. 14(19), pages 1-22, October.

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