Foreign Reserve Management Strategy for Central Banks in Emerging Economies

This study presents a continuous-time optimal management strategy for foreign reserve holdings specifically designed for central banks in emerging economies. It intricately connects the dynamics of foreign reserves, international portfolio investments and domestic bond markets, providing a comprehensive framework for effective asset management. We model foreign reserve process as a Geometric Brownian motion with jumps, enabling us to capture essential economic dynamics without direct control. To illustrate the impact of accumulating excess foreign reserves on mitigating economic and financial instability, we examine the associated funding liquidity premium and related costs. The optimal solution path is determined through a stochastic impulse control paradigm in conjunction with pasting theory, while minimizing the total costs of foreign reserve holdings. Our analysis demonstrates how central banks can optimize foreign reserve management to enhance operational functions, ensure market liquidity and support monetary policy objectives, potentially increasing consumer consumption and overall utility. Additionally, we present a verification theorem that offers a solution to the quasi-variational inequality (QVI) related to the central bank’s optimal foreign reserve management problem.