By Jamel Saadaoui, BETA, CNRS, University of Strasbourg

In an era of strong financial integration, we study the relationship between the real exchange rate and international reserves using non-linear and threshold regressions on 110 countries from 2001 to 2020. Our study shows that the level of development of financial institutions plays a key role in explaining the mitigating effect of international reserves. Countries with underdeveloped financial institutions can use their international reserves as a shield to cope with the negative consequences of terms-of-trade shocks on the real exchange rate. We also find that the mitigating effect is greater in countries with intermediate levels of financial openness.

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