We Are Not in a Gaussian World Anymore: Implications for the Composition of Official Foreign Assets

In the aftermath of the 1997-98 Asian crises, many emerging markets self-insured by accumulating international reserves (i.e., non-contingent assets) in excess of what many models predicted, while relying relatively little on state-contingent assets. This apparent over-reliance on self-insurance has been viewed as a puzzle in search of an explanation. A related, and still outstanding, puzzle is why the benefits of financial liberalization appear to be quite small and, yet, financial globalization has been unprecedented in recent decades. We show that these two puzzles can be solved by incorporating rare macroeconomic disasters in income risk. To this effect, we first fit a fat-tailed distribution to long output time series for 156 countries. We then develop a theoretical framework to quantify (i) the increase in welfare gains of financial integration and (ii) how the composition of official reserves (non-contingent and contingent) responds to bigger shocks. Our results show that fat tails lead to a sharp increase in both the gains of financial integration and self-insurance for standard values of the coefficient of risk aversion.