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Factors Affecting Foreign Exchange Reserves

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is the opportunity cost. The results show that India's DTNH is very sensitive to vulnerability.

financial account and less sensitive to opportunity costs.


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Sehgal and Sharma (2008) studied the function of India's GDP with the dependent variable being GDP/GDP and the independent variables being the factors affecting GDP. These factors include the import/GDP ratio representing the payment of transactions with foreign countries. The two ratios of short-term foreign debt/GDP and portfolio investment/GDP represent the volatility of the financial account causing high liquidity risk, representing the role of the precautionary motive of GDP. The average export growth rate (calculated based on the previous 3 periods) reflects the possibility of encountering trade shocks, requiring intervention in the exchange rate and representing the role of the trade motive of GDP. In addition, the variables of economic scale (represented by GDP) and the opportunity cost of holding foreign exchange are also included in the model. The authors conducted regression models using cointegration and VECM methods with quarterly data of India from Q2/1992 to Q1/2006 and found that from the obtained demand function for foreign exchange, there is evidence that foreign exchange holdings in India are for both trade and hedge motives.

Nainwal et al. (2013) argue that factors affecting the current account balance include international trade (represented by current account surplus/deficit), international investment (including direct investment and indirect investment) reflected in large capital flows into the country as the basis for domestic currency appreciation and increased current account balance, price changes (represented by price index or inflation), economic strength (represented by fiscal balance, foreign debt, GDP size and growth, etc.) that help strengthen domestic currency and increase current account balance, government policies, and political factors. Therefore, the study has constructed a demand function for current account balance with explanatory variables being trade openness (including both exports and imports), foreign investment (including direct and indirect investment), wholesale price index, GDP, nominal exchange rate, and broad money supply. Using Indian data during the period 1991 – 2011 and OLS method for linear multiple regression model with log for all variables, the study found the demand function of Indian GDP with significant variables being wholesale price index, nominal exchange rate, broad money supply, foreign investment in which, wholesale price index variable plays the most important role.

Factors Affecting Foreign Exchange Reserves

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Afrin et al. (2014) continued to apply Edison's (2003) model to build a model of Bangladesh's foreign exchange demand. However, in this model, the authors only used four influencing factors, eliminating the economic scale factor due to data unavailability. The difference is that to measure the volatility of the exchange rate, the authors used the GARCH model instead of calculating the usual standard deviation. The variables of the model are foreign exchange, import/GDP ratio, broad money supply ratio M2/GDP, and exchange rate volatility, all in log form. The opportunity cost variable is calculated by the formula ln[(1+ Bangladesh's 91-day T-bill interest rate)/(1+ US T-bill interest rate)]. Using Johansen cointegration technique for quarterly data of Bangladesh for the period 1997 – 2012, the study has constructed the demand function of foreign exchange for Bangladesh and found that two variables of current account vulnerability and exchange rate flexibility play an important role in the demand function of foreign exchange for Bangladesh.

Chowdhury et al. (2014) argued that for Bangladesh, foreign aid, remittances, export revenues and foreign direct investment can strongly promote the increase in FDI. Therefore, the study has built a FDI demand model with explanatory variables such as remittances, exchange rate, inflation, export price index, broad money supply M2, foreign aid and GDP per capita. Using the ADF unit root test and Engle Granger cointegration method for annual data of Bangladesh from 1972 to 2011, the authors have built a FDI demand function with influencing variables such as exchange rate, remittances, broad money supply, export price index and GDP per capita.

In Vietnam, studies on factors affecting GDP are still quite scarce, especially the construction of GDP demand functions is even rarer. In 2010, a related study was a project submitted to the scientific research award "Young Economist - Year 2010" by a group of students from Ho Chi Minh City University of Economics, which was carried out quite carefully. This project studied the factors affecting GDP in Vietnam and built a GDP demand function for Vietnam. The research group relied on the GDP demand function of Edison (2003) to build a GDP demand function for Vietnam with indicators representing the same variables as Edison (2003) built, but eliminated the factor of economic scale because it was determined that Vietnam's economic scale is still small so it does not affect GDP. The research group

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The study used data from Vietnam for the period 1996 - 2009 by year and by quarter. Using the Johansen unit root and cointegration test method for yearly data, the authors constructed a long-term demand function for domestic currency in Vietnam. In this function, the variables affecting domestic currency include current account vulnerability expressed in the current account deficit/GDP ratio, financial account vulnerability is the broad money supply ratio M2/GDP, exchange rate flexibility is the standard deviation of the exchange rate in 12 months and opportunity cost is the difference between the VND refinancing rate and the US government's USD bond interest rate according to the formula (1 + VND refinancing rate)/ (1 + US USD bond interest rate). At the same time, the study used the VECM model with quarterly data to examine the short-term impact of these factors on Vietnam's domestic currency.

Phan Tien Nam (2017) believes that in Vietnam, exchange rate deviation has a certain impact on the domestic currency. Specifically, Vietnam is undervaluing the domestic currency to encourage exports, causing the exchange rate to be incorrect and the encouragement of exports to increase export revenue is the basis for the domestic currency to increase accordingly. At the same time, in periods when remittances and foreign investment flow strongly into Vietnam, the domestic currency will appreciate. In order to continue implementing the policy of undervaluing the domestic currency, the State Bank needs to supply domestic currency to the market to buy foreign currency, continuing to increase the domestic currency. However, this amount of domestic currency needs to be neutralized by the State Bank by issuing valuable papers with interest rates much higher than the interest rates earned from foreign currency assets, leading to large neutralization intervention costs.

2.4.2. Factors affecting foreign exchange reserves


Through the relevant empirical studies summarized above, the five factors affecting the GDP in Edison's (2003) study appear more or less in all subsequent studies. Moreover, many other studies acknowledge and apply the construction of the GDP function according to these five influencing factors. These five factors include the size of the economy, the vulnerability of the current account, the vulnerability of the financial account, the flexibility of the exchange rate and the opportunity cost of holding foreign exchange. Obviously, from the perspective of the theoretical basis of GDP presented in section 2.1, it is completely reasonable that the five factors mentioned above are considered to affect the GDP. The fluctuations of the current account and the financial account lead to the fluctuations of the GDP.

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The dynamics of the current account and the financial account are indisputable. Therefore, the vulnerability of the current account and the financial account, which show the sensitivity to fluctuations of these two accounts, will certainly affect the current account. Meanwhile, the size of the economy affects the size of these two accounts and, in turn, the size of the current account. In addition, the current account is a tool for regulating the exchange rate with the main component being foreign currency, so the current account is closely linked to the exchange rate and the flexibility of the exchange rate is natural. As for opportunity cost, this is a reason why countries have to try to find the level of the current account and high opportunity cost will affect the decisions and policies of the country when implementing the current account. Therefore, opportunity cost is certainly a factor affecting the national current account. In addition, Nainwal et al. (2013) and Chowdhury et al. (2014) also argued that some basic macroeconomic factors such as inflation, government economic management policies, political regime, etc. that demonstrate the stability and steadfastness of the country can affect the domestic currency position and thereby affect the DTNH.

In summary, through relevant empirical studies and theoretical basis of DTNH, the factors affecting DTNH can be listed as the size of the economy, vulnerability of the current account, vulnerability of the financial account, flexibility of exchange rate, opportunity cost, and stability of the country. These factors are analyzed specifically below.

2.4.2.1. Size of the economy


As the size of the economy increases, international transactions such as trade and capital transactions will also increase in size, meaning that the current account and financial account will expand in size. This implies that the DTNH will increase accordingly to ensure sufficient funding capacity if a shock occurs. According to Edison (2003) and Prabheesh et al. (2007), the size of the economy is measured by indicators such as population size and real GDP per capita. Meanwhile, according to Gosselin and Parent (2005), Sehgal and Sharma (2008), Nainwal et al. (2013) or Chowdhury et al. (2014), for simplicity, the size of the economy is measured by GDP or GDP per capita.

2.4.2.2. Current account vulnerability

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The surplus or deficit of the current account causes a corresponding increase or decrease in the current account. Therefore, the more vulnerable the current account is, the more likely it is to cause large fluctuations in this account and create many fluctuations in the current account. Thus, the vulnerability of the current account is reflected in the magnitude of the level of fluctuations in this account. Meanwhile, the fluctuations of the current account or current balance depend on the fluctuations of the items that make it up. The first important item with the highest proportion is the trade balance. In addition, for developing countries like Vietnam, the source of remittances entering the country in the one-way transfer item is also an important source of increasing the current account. In short, fluctuations in the trade balance and the source of remittances are two important factors causing fluctuations in the current account/current account and affecting the current account.

Fluctuation of trade balance : The level of fluctuation of trade balance is shown through the increase and decrease of export and import and is measured through the following two indexes.

(i) Trade openness : The more open a country's economy is to trade, the more vulnerable it is to external shocks, leading to greater fluctuations in the trade balance and the need for financing from the central bank. Therefore, the more open a country is to trade, the more foreign exchange reserves it has to ensure protection against external shocks. Trade openness can be measured by many different indicators. However, in empirical studies, Edison (2003), Prabheesh et al. (2007), Sehgal and Sharma (2008), Afrin et al. (2014) used the import/GDP ratio to represent trade openness.

(ii) Export fluctuations : If the level of export fluctuations is small, insignificant, and within the ability to finance imports, it will not greatly affect the trade balance deficit and therefore will not greatly affect the GDP. If the level of export fluctuations is large enough, it can affect the trade balance and GDP. At this time, if the level of export fluctuations is large enough but increasing, the foreign currency supply in the national foreign exchange market will be more abundant and the country will have conditions to easily accumulate more GDP, helping to increase GDP. However, if the level of export fluctuations is large enough but increasing

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If the export turnover declines due to the negative impact of a struggling national economy or external shocks, the foreign exchange reserve will decline as the supply of foreign currency in the market decreases and the country must use the foreign exchange reserve fund to support foreign currency demand, especially from the country's import demand. This shows that the level of export volatility is positively or negatively correlated with the foreign exchange reserve depending on the case. In the empirical study, Gosselin and Parent (2005) measure export volatility by the standard deviation of export revenue. Meanwhile, Sehgal and Sharma (2008) measure export volatility by the growth rate (change) of exports.

Remittance size : Khan and Ahmed (2005) stated that in Pakistan and other developing countries, remittances are an important source of increasing GDP. Chowdhury et al. (2014) also made similar comments, stating that remittances contribute significantly to Bangladesh's GDP. The more abundant the remittances, the more the GDP increases. Empirical studies by the above authors also show that the remittance variable is statistically significant in the GDP demand function. In empirical studies, the remittance variable was expressed in logarithmic form by Khan and Ahmed (2005) and expressed in percentage form by Chowdhury et al. (2014).

2.4.2.3. Vulnerability of financial accounts


The vulnerability of the financial account, in other words the degree of volatility of the financial account or financial balance, depends on the following factors.

Financial openness : According to Edison (2003), similar to the current account, the larger the financial openness, the more vulnerable the financial account is to external shocks, which means the volatility of the financial account is larger and the need for foreign exchange increases to be able to finance large fluctuations of this account. With Gosselin and Parent (2005), financial openness is measured by the ratio between capital inflows/outflows and GDP. Specifically, in the empirical study, the authors used the ratio of short-term foreign debt/GDP to represent financial openness. Subsequently, Sehgal and Sharma (2008) used both the ratio of short-term foreign debt/GDP and the ratio of portfolio investment/GDP to measure financial openness or volatility of the financial account.

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Broad money supply M2 : The larger the broad money supply M2, the more likely it is that domestic people own liquid domestic currency assets that can be easily converted into foreign currency assets, indicating a higher possibility of capital flight from domestic currency and therefore, can cause a large damage to the financial account and the greater the demand for domestic currency to ensure sufficient funding for this damage. In empirical studies, Edison (2003), Gosselin and Parent (2005), Prabheesh et al. (2007) and Afrin et al. (2014) all measure the broad money supply M2 variable by the broad money supply M2/GDP ratio.

2.4.2.4. Exchange rate flexibility


DTNH is a tool used by the Central Bank to intervene in the exchange rate, so DTNH is obviously closely linked to the level of exchange rate fluctuations in the national economic activities. If a country allows a higher exchange rate flexibility, the demand for DTNH will decrease because the Central Bank does not need much DTNH to intervene to help stabilize the exchange rate. Therefore, the flexibility of the exchange rate represents the exchange rate regime that the country pursues, which can be measured by the actual fluctuations of the exchange rate in the economy. If the exchange rate fluctuates freely (volatile strongly), it shows that it allows high exchange rate flexibility, the Central Bank does not need DTNH to intervene to fix the exchange rate. On the other hand, if the exchange rate fluctuates low under the fixed exchange rate regime, the demand for DTNH will increase to maintain the fixed exchange rate. Exchange rate flexibility therefore has an inverse relationship with DTNH in theory.

However, Edison (2003) argues that in reality, many countries that accept to allow high exchange rate flexibility (including managed floating exchange rate regime) are still afraid of strong exchange rate fluctuations causing many shocks to the economy, so they still prevent by increasing the demand for foreign exchange to intervene in the exchange rate when necessary. The stronger the exchange rate fluctuations allow for higher exchange rate flexibility, the more proactive these countries are in using foreign exchange. Therefore, exchange rate flexibility can also have a positive relationship with foreign exchange in some countries.

Since exchange rate flexibility is expressed through exchange rate volatility, in empirical studies, this variable is measured by the standard deviation of the exchange rate as applied by Gosselin and Parent (2005), Prabheesh et al. (2007) or Afrin et al. (2014).

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2.4.2.5. Opportunity cost


Foreign exchange assets must ensure the characteristics of safety and high liquidity, so the return from foreign exchange investment will be much less than that from investing in another common instrument with higher risk. Therefore, the opportunity cost of holding foreign exchange is the difference between the return from foreign exchange investment and the return from an alternative investment instrument or, to extend it in a simple way, we can take the rate of return of a representative alternative investment instrument as the opportunity cost of holding foreign exchange. Thus, the more foreign exchange a country holds, the higher the opportunity cost it has to bear. Therefore, Edison (2003) argues that with increasing opportunity costs, countries may be reluctant and unwilling to hold more foreign exchange and the reserve level will be lower. Opportunity costs are difficult to measure accurately and therefore, empirical studies use many different methods to measure opportunity costs. Edison (2003) or Gosselin and Parent (2005) use the difference between the high domestic interest rate and the low foreign interest rate as the opportunity cost. Khan and Ahmed, (2005) use only one interest rate in the money market as the opportunity cost. Studies by Prabheesh et al. (2007) or Afrin et al. (2014) calculate the opportunity cost = (1+ domestic short-term interest rate)/(1+ foreign short-term interest rate).

2.4.2.6. National stability


In each country, a large amount of foreign currency is still held by the people. Therefore, a stable country can help improve the position of the domestic currency, the demand for converting foreign currency assets of the people to domestic currency increases. Thus, the supply of foreign currency in the market increases and is a good opportunity for the country to accumulate more DTNH from the foreign currency held by the people. The stability of a country mainly includes economic stability and political stability.

Economic stability : To assess the stability of an economy, fundamental factors that demonstrate the strength of the economy will be considered such as inflation, GDP growth, budget status, government economic management methods, etc. In particular, the study by Nainwal et al. (2013) emphasized the inflation factor and the government's economic management policy.

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