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Mr. Valerio Crispolti, Ms. Era Dabla-Norris, Mr. Jun I Kim, Ms. Kazuko Shirono, and Mr. George C. Tsibouris

Abstract

Low-income countries (LICs) are routinely faced with a wide range of exogenous disturbances—sharp swings in the terms of trade and export demand, natural disasters, and volatile financial flows—and the resulting high macroeconomic volatility imposes large welfare costs.1 The amplitude, frequency, and economic costs of external shocks tend to be higher than in advanced and emerging market economies. The presence of such risks underlies the importance of a protective infrastructure to soften the blow from adverse external shocks. Although sound macroeconomic policy frameworks are probably the most important measures for limiting country vulnerability, international reserves constitute the main form of self-insurance against such shocks. But assessing reserve adequacy in LICs has been bedeviled by lack of an agreed methodological framework, with policymakers relying on rules of thumb, such as maintaining reserves equivalent to three months of imports, to evaluate a country’s need. Although such metrics are intuitive and simple, they lack fully developed theoretical and empirical foundations.

Mr. Valerio Crispolti, Ms. Era Dabla-Norris, Mr. Jun I Kim, Ms. Kazuko Shirono, and Mr. George C. Tsibouris

Abstract

Low-income countries (LICs) are routinely faced with a wide range of exogenous disturbances—sharp swings in the terms of trade and export demand, natural disasters, and volatile financial flows—and the resulting high macroeconomic volatility imposes large welfare costs.1 The amplitude, frequency, and economic costs of external shocks tend to be higher than in advanced and emerging market economies. The presence of such risks underlies the importance of a protective infrastructure to soften the blow from adverse external shocks. Although sound macroeconomic policy frameworks are probably the most important measures for limiting country vulnerability, international reserves constitute the main form of self-insurance against such shocks. But assessing reserve adequacy in LICs has been bedeviled by lack of an agreed methodological framework, with policymakers relying on rules of thumb, such as maintaining reserves equivalent to three months of imports, to evaluate a country’s need. Although such metrics are intuitive and simple, they lack fully developed theoretical and empirical foundations.