Real exchange rate and international reserves in the era of financial integration

The great financial crisis has brought increased attention to the consequences of international reserves holdings. In an era of high financial integration, we investigate the relationship between the real exchange rate and international reserves using nonlinear regressions and panel threshold regressions over 110 countries from 2001 to 2020. We capture the buffer effect of international reserves, which is more pronounced in Europe and Central Asia, above a threshold of 17%. Unlike previous literature, our study shows how financial institution development plays an essential role in explaining the buffer effect of international reserves. Countries with low-developed financial institutions may use the international reserves as a shield to deal with the negative consequences of terms-of-trade shocks on the real exchange rate. We also found that the buffer effect is stronger in countries with intermediate levels of financial openness.