Assessing Reserve Adequacy in Low-Income Countries (Occasional Papers)

Reserves grew more than gross domestic product GDP and imports in many countries. The only ratio that is relatively stable is foreign reserves over M2. Ratios relating reserves to other external sector variables are popular among credit risk agencies and international organizations to assess the external vulnerability of a country.

For example, Article IV of [7] uses total external debt to gross international reserves, gross international reserves in months of prospective goods and nonfactor services imports to broad money , broad money to short-term external debt, and short-term external debt to short-term external debt on residual maturity basis plus current account deficit.

Therefore, countries with similar characteristics accumulate reserves to avoid negative assessment by the financial market, especially when compared to members of a peer group. Reserves are used as savings for potential times of crises, especially balance of payments crises. Original fears were related to the current account, but this gradually changed to also include financial account needs.

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If a specific country is suffering from a balance of payments crisis, it would be able to borrow from the IMF. However, the process of obtaining resources from the Fund is not automatic, which can cause problematic delays especially when markets are stressed. Therefore, the fund only serves as a provider of resources for longer term adjustments.

Also, when the crisis is generalized, the resources of the IMF could prove insufficient. After the crisis, the members of the Fund had to approve a capital increase, since its resources were strained. Most countries engage in international trade , so to ensure no interruption, reserves are important.

A rule usually followed by central banks is to hold the equivalency of at least three months of imports in foreign currency. Also, an increase in reserves occurred when commercial openness increased part of the process known as globalization. Reserve accumulation was faster than that which would be explained by trade, since the ratio has increased to several months of imports.

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Furthermore, the external trade factor explains why the ratio of reserves in months of imports is closely watched by credit risk agencies. The opening of a financial account of the balance of payments has been important during the last decade. Hence, financial flows such as direct investment and portfolio investment became more important.

Usually financial flows are more volatile that enforce the necessity of higher reserves. Moreover, holding reserves, as a consequence of the increasing of financial flows, is known as Guidotti—Greenspan rule that states a country should hold liquid reserves equal to their foreign liabilities coming due within a year. Reserve accumulation can be an instrument to interfere with the exchange rate. Hence, commercial distortions such as subsidies and taxes are strongly discouraged.

However, there is no global framework to regulate financial flows. As an example of regional framework, members of the European Union are prohibited from introducing capital controls , except in an extraordinary situation. Some economists are trying to explain this behavior. Usually, the explanation is based on a sophisticated variation of mercantilism , such as to protect the take-off in the tradable sector of an economy, by avoiding the real exchange rate appreciation that would naturally arise from this process.

One attempt [12] uses a standard model of open economy intertemporal consumption to show that it is possible to replicate a tariff on imports or a subsidy on exports by closing the current account and accumulating reserves. Another [13] is more related to the economic growth literature. The argument is that the tradable sector of an economy is more capital intense than the non-tradable sector.

Assessing Reserve Adequacy In Low-Income Countries: IMF Occasional Paper -

The private sector invests too little in capital, since it fails to understand the social gains of a higher capital ratio given by externalities like improvements in human capital, higher competition, technological spillovers and increasing returns to scale. The government could improve the equilibrium by imposing subsidies and tariffs , but the hypothesis is that the government is unable to distinguish between good investment opportunities and rent seeking schemes.

Thus, reserves accumulation would correspond to a loan to foreigners to purchase a quantity of tradable goods from the economy. In this case, the real exchange rate would depreciate and the growth rate would increase. In some cases, this could improve welfare, since the higher growth rate would compensate the loss of the tradable goods that could be consumed or invested.

In this context, foreigners have the role to choose only the useful tradable goods sectors. Reserve accumulation can be seen as a way of "forced savings".

Assessing Reserve Adequacy: The Colombian Case

The government, by closing the financial account, would force the private sector to buy domestic debt in the lack of better alternatives. With these resources, the government buys foreign assets. Thus, the government coordinates the savings accumulation in the form of reserves. Sovereign wealth funds are examples of governments that try to save the windfall of booming exports as long-term assets to be used when the source of the windfall is extinguished. There are costs in maintaining large currency reserves. Price fluctuations in exchange markets result in gains and losses in the purchasing power of reserves.

In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates.

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Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets. Several calculations have been attempted to measure the cost of reserves. The traditional one is the spread between government debt and the yield on reserves.

The caveat is that higher reserves can decrease the perception of risk and thus the government bond interest rate, so this measures can overstate the cost. Alternatively, another measure compares the yield in reserves with the alternative scenario of the resources being invested in capital stock to the economy, which is hard to measure. One interesting [6] measure tries to compare the spread between short term foreign borrowing of the private sector and yields on reserves, recognizing that reserves can correspond to a transfer between the private and the public sectors.

In the context of theoretical economic models it is possible to simulate economies with different policies accumulate reserves or not and directly compare the welfare in terms of consumption. Results are mixed, since they depend on specific features of the models. A case to point out is that of the Swiss National Bank , the central bank of Switzerland. There's a problem loading this menu at the moment. Learn more about Amazon Prime. Get to Know Us. Delivery and Returns see our delivery rates and policies thinking of returning an item?

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Assessing Reserve Adequacy In Low-Income Countries

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