By any metric of risk, levels of reserve holdings in emerging markets far exceed prudential levels. Yet, emerging markets across the world cite prudential concerns as the primary reason for reserve accumulation over the past decade. Moreover, the ?prudential? justification for reserves implies greater exchange rate flexibility than has been seen over the past decade. Also, the interest rate spread between borrowing domestically and investing in US treasuries abroad is almost always negative, which implies that there is a huge cost attached to accumulating reserves. This makes high levels of reserve accumulation paradoxical from a prudential perspective.

Some of these paradoxes are being resolved in this time of crisis. As exports are slumping, and financial flows being deleveraged, many emerging markets (including India and China) are dipping into their reserve holdings to defend against capital outflow and exchange rate depreciation. Econometric studies find that capital flight and depreciation is higher in non-reserve accumulating economies than in those with excessive levels of reserve holdings. Does this short period give us better insight into what drives excessive reserve holdings? Maurice Obstfeld, Alan Taylor and Jay Shambaugh explore this question in their NBER working paper ?Financial instability, reserves, and central bank swap lines in the panic of 2008?.

They have one, central, controversial finding. Prudential levels of reserve accumulation are proportional to the size of the banking system of the country in question. This finding helps resolve the main paradox of reserve accumulation in large emerging markets such as India, China and Russia. The intuition behind this finding is that countries use reserves to hedge not just against capital outflow, but also against a run on the domestic banking system.

Examining data on 29 emerging markets and 10 developed countries, they find that variations in reserve holdings can be viewed as a function of three factors – a measure of financial openness, the exchange rate regime and the ratio of money supply to GDP.

While the first two are measures of external vulnerability, the third is purely a domestic variable which captures the depth of the domestic banking system.

This insight helps them estimate the ?predicted? level of reserve holdings by countries and compare it to actual holdings. Doing so allows a better understanding of whether countries were ?over-insured? or ?under-insured? for the crisis. They find that currencies of countries that hold more reserves relative to money supply have appreciated slightly in this crisis, while currencies of countries that hold less reserves relative to money supply have depreciated. They also examine swap lines extended by various developed country central banks to their emerging market counterparts?and find that for most emerging markets, these have been largely symbolic rather than actually useful in defending the economy against unexpected capital outflows.

Therefore, not only do high reserves help in actually fighting capital outflows and depreciation, they also help prevent it in the first place. Does this imply that accumulation is desirable under all circumstances? Certainly not. There are severe limiting factors to the accumulation of reserves?most notably, fiscal space.

This is a concern for countries such as India, which are already struggling under large fiscal deficits. Accumulating reserves also has important signalling effects?it encourages moral hazard by signalling to private domestic financial institutions that they can expect to be bailed out in foreign currency, it furthers expectations of depreciation, and could lead to a loss of credibility in the long run.

The author is consultant, National Institute of Public Finance & Policy. These are her personal views