Reserve Adequacies and the Determinants of Foreign Exchange Reserves – Empirical Analysis through the Vector Error Correction Model: The Case of Lebanon

Investigating the causes and motives for reserves’ accumulation in a highly dollarized small open economy such as that of Lebanon is of extreme importance, especially since fluctuations in foreign reserves have been demonstrated to be a leading cause of economic and financial instability. For an emerging economy such as that of Lebanon, which is subject to internal and external shocks, the accumulation and holding of reserves signal, among other things, credibility and financial strength. Therefore, identifying the factors that determine the level of reserves in the long and short term is crucial for the stability of the entire economy. For an in-depth understanding of those factors, this study employs the vector error correction model (VECM), which helps distinguish between short- and long-term effects. The results indicate that currency substitution has the most significant impact on reserves in the short and long terms, while the trade balance and the real effective exchange rate have substantial effects but only in the long terms. The study also reveals that the reserves held by the central bank fulfil all the reserves’ adequacy criteria and are in alignment with the reserves’ adequacy ratios.