Beyond traditional defenses: Unraveling the dynamics of reserves and exchange rate volatility in the face of economic sanctions

Abstract

This study investigates the impact of economic sanctions on exchange rate volatility, with a specific focus on the role of foreign reserves in mitigating these effects across 21 countries from 2002 to 2022. Employing advanced econometric models, including Panel-Corrected Standard Errors (PCSE) and Feasible Generalized Least Squares (FGLS), our analysis identifies a positive correlation between economic sanctions and increased exchange rate volatility. A significant finding is that high reserves-to-GDP ratios do not fully stabilize exchange rate volatility in the presence of economic sanctions, challenging the traditional view of reserves as reliable stabilizers. It also demonstrates an inverse relationship between heightened reserves-to-GDP ratios and economic growth during periods of sanctions, indicating that larger reserves may reflect economic difficulties rather than strength. These findings implicitly call for a reevaluation of economic policies in favor of adopting strategies that mitigate global economic uncertainties. Supported by previous literature, the importance of international cooperation and governance that foster economic and trade diversification is highlighted. This approach can provide alternative sources of foreign exchange and reduce economic vulnerability to sanctions, enhancing overall economic resilience and stability.