Abstract
Measuring reserves and assessing international reserves adequacy in fully dollarized economies can be challenging. The role of international reserves may be different for these countries compared to countries with their own currencies. In addition, quantifying external risks and the opportunity costs that they face may be complex. This paper complements existing research by: first, exploring the challenges and judgements needed in measuring international reserves in dollarized economies according to country circumstances; and second, deriving a “synthetic” measure of international reserves for Panama and assessing its adequacy. As Panama does not have official international reserves, this paper proposes to use the statutory liquid assets in its banking system as its closest approximation. The paper is arranged in six parts: Section A provides an introduction. Section B summarizes the experiences of a sample of dollarized countries. Section C illustrates a stylized balance sheet of a central bank, depicting how international reserves are shown in a country with a central bank. Section Sections E discusses the liquidity buffers in Panama’s banking sector, while Section F synthesizes the illustrative measures of Panama’s international reserves to gauge reserves adequacy using the IMF metric. Section G discusses an indicator for government liquidity. Finally, section H concludes with a discussion of the policy implications.
Measuring Reserves and Assessing Reserves Adequacy1
Measuring reserves and assessing international reserves adequacy in fully dollarized economies can be challenging. The role of international reserves may be different for these countries compared to countries with their own currencies. In addition, quantifying external risks and the opportunity costs that they face may be complex. This paper complements existing research by: first, exploring the challenges and judgements needed in measuring international reserves in dollarized economies according to country circumstances; and second, deriving a “synthetic” measure of international reserves for Panama and assessing its adequacy. As Panama does not have official international reserves, this paper proposes to use the statutory liquid assets in its banking system as its closest approximation. The paper is arranged in six parts: Section A provides an introduction. Section B summarizes the experiences of a sample of dollarized countries. Section C illustrates a stylized balance sheet of a central bank, depicting how international reserves are shown in a country with a central bank. Section Sections E discusses the liquidity buffers in Panama’s banking sector, while Section F synthesizes the illustrative measures of Panama’s international reserves to gauge reserves adequacy using the IMF metric. Section G discusses an indicator for government liquidity. Finally, section H concludes with a discussion of the policy implications.
A. Introduction
This Paper Tries to Answer Two Questions
1. What are international reserves of a country that does not have its own central bank? In the absence of central bank, the IMF, for statistical purposes, has defined Panama’s international reserves as the net foreign assets of BNP (a large government-owned commercial bank in Panama), after adjusting for IMF transactions. Since BNP is a commercial bank, its net foreign assets correspond to the bank’s policy of diversification of assets and may not represent the international reserves of the country.
Liquidity Buffers: Central Government and Banking System
Liquidity Buffers: Central Government and Banking System
| Liquidity | Details |
|---|---|
| Central government | Excess cash placed as deposits in Banco Nacional de Panama (BNP) |
| Banking system | Short-term assets with maturities up to 186 days, comprising |
|
Liquidity Buffers: Central Government and Banking System
| Liquidity | Details |
|---|---|
| Central government | Excess cash placed as deposits in Banco Nacional de Panama (BNP) |
| Banking system | Short-term assets with maturities up to 186 days, comprising |
|
2. What is the appropriate reserve coverage for fully dollarized economies? Dollarized economies do not need reserves to stabilize the exchange rate and does not face the risk of currency mismatches. Existing literature suggests that in fully dollarized economies, “liquidity buffers” in the adopted foreign currency are needed to support domestic financial institutions, including cross border deposit withdrawals, and government financing needs. Moreover, Panama’s need to hold a foreign exchange liquidity buffer differs from non-dollarized countries as it does not face the risk of exchange rate fluctuations and currency mismatches.
Challenges in Measuring Reserves
3. Defining reserves in a fully dollarized economy without a central bank is challenging.2 As a very open economy with a large financial system, Panama receives the U.S. dollar supply through the balance of payments by cross-border financial transactions, international trade, public borrowing, and investment. In principle, any dollar in the economy could be used for international trade or for cross-border financial transactions. Moreover, without a central bank, Panama cannot accumulate reserves by issuing base money in exchange for FX assets (IMF (2013; 2015)). Instead, the country may accumulate reserves through deposits from the central government or a buildup of deposits in the banking system. Panama—being fully dollarized—does not need international reserves in order to smooth exchange rate fluctuations or prevent currency mismatches in the balance sheets. As such, reserves act more as a buffer in the financial system and the public finances.
4. In the absence of central bank, the IMF, for statistical purposes, has defined international reserves as the net foreign assets of BNP. As BNP is a commercial bank, its net foreign assets will depend on the bank’s internal operations decisions and may not represent the international reserves of the country. Notwithstanding, Panama’s need to hold a foreign exchange liquidity buffer differs from non-dollarized countries as it does not face the risk of exchange rate fluctuations and currency mismatches.
Challenges in Assessing Reserve Adequacy
5. How much reserves a country needs is a challenging question. In conjunction with sound policies and fundamentals, reserves are a critical external buffer for most economies as they can help reduce the likelihood of BOP crises and help preserve economic and financial stability. As a central part of countries’ external resilience, examining reserve adequacy is vital to any external sector assessment and represents an important part of the debate on economic and financial developments, policies, and risks in a country. But, doing so may be challenging—not just because of the multiple roles played by reserves, but also due to the complexity of quantifying external risks and vulnerabilities, and the opportunity cost each country faces. Therefore, the assessment should be based on—and tailored to—the specific country characteristics, vulnerabilities, and circumstances.
6. The IMF has developed its own reserve adequacy metric, but the use of other relevant statistics is encouraged. The IMF’s reserve adequacy (ARA) metric for EMs was proposed as a tool to help inform a comparable assessment across its membership, while balancing simplicity and completeness (Box 1).3 A key motivating factor was the experience of past BOP crises, characterized by multiple channels of market pressure, which suggests the need to hold reserves as a buffer against multiple vulnerabilities and a broad set of risks.
Answers to These Challenges
7. To measure reserves, this paper proposed a synthetic international reserve indicator. It also argues that cash buffers of the central government is another important liquidity indicator. These cash buffers are held as deposits at BNP.4 Section C provides further details.
8. Adequacy of reserves. The answer to this question is indeed a difficult one as it calls for judgment. The existing ARA metric was developed for two exchange rate regimes (fixed and floating) whereas Panama is a fully dollarized economy. One workaround method would be to compare Panama with the ARA metrics of countries with fixed exchange rate regime, with a caveat that Panama’s exchange rate is assumed to be in the category of “fixed” regime. Additionally, Panama’s ratio of “synthetic international reserve” to GDP could be compared with other emerging economies to gauge where the country stands.
How Does the ARA EM Metric Work?
The ARA EM metric was developed by the IMF as an additional metric to gauge the adequacy of international reserves.1 It comprises four components reflecting potential drains on the balance of payments:
Export income to take into account the potential loss from a drop in external demand or a terms of trade shock
Broad money to capture the risks of residents’ capital flight through the liquidation of their highly liquid domestic assets
Short-term debt to reflect debt rollover risks
Other liabilities to reflect other portfolio outflows.
The relative risk weights for each component are derived based on the 10th percentile of observed outflows from EMs during exchange market pressure episodes, according to two exchange rate regimes—fixed and floating (Table 1).
In general, reserves in the range of 100-150 percent of the composite metric are considered broadly adequate for precautionary purposes. Box Figure 1 shows the reserves of selected Emerging Economies, as measured in percent of the ARA Metric in 2021.
Reserves of Selected Emerging Economies
(In percent of ARA Metric, 2021)
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
Source: IMF staff calculations.Reserve Adequacy Metric and Exchange Rate Regimes
Reserve Adequacy Metric and Exchange Rate Regimes
| (In Percent) | Exchange Rate Regime | Short-term Debt | Other Liabilities | Broad Money | Export | |
|---|---|---|---|---|---|---|
| Without CFM | With CFM | |||||
| Weights | Fixed | 30 | 20 | 10 | 5 | 10 |
| Floating | 30 | 15 | 5 | 2.5 | 5 | |
Reserve Adequacy Metric and Exchange Rate Regimes
| (In Percent) | Exchange Rate Regime | Short-term Debt | Other Liabilities | Broad Money | Export | |
|---|---|---|---|---|---|---|
| Without CFM | With CFM | |||||
| Weights | Fixed | 30 | 20 | 10 | 5 | 10 |
| Floating | 30 | 15 | 5 | 2.5 | 5 | |
B. Experiences from Other Countries
Background
9. Twelve countries do not have their own legal tender, but use the currency of another country. Among them, seven economies have adopted the U.S. dollar, namely three in the Western Hemisphere (Ecuador, El Salvador, and Panama) and four in the Asian Pacific (Republic of Marshall Islands, Federates States of Micronesia, Palau, and Timor-Leste). Three other (non-eurozone) economies adopted the euro (Kosovo, Montenegro, San Marino), while the remaining two opted for the Australian dollar (Kiribati, Tuvalu). These countries are diverse in their size, location, level of development, market access, and institutions (Annex I). Six countries officially have a central bank, although with functions limited to: (i) promoting financial stability and financial supervision; (ii) providing financial services to the state and the public administration; and (iii) facilitating payment systems. In other countries, the national or development banks usually perform the last two functions. One country (Republic of Marshall Islands) has neither monetary authority nor a public bank. Also, one half of the sampled countries still use an official legal tender (but only as coins), motivated by the high costs of importing coins from abroad.
10. The adoption of the foreign legal tender involves important trade-offs. In addition to anchoring inflation and safeguarding financial stability, the adoption of a foreign currency as legal tender is also motivated by close trade and financial links with the country-issuer of the pegged currency, labor mobility, limited administrative capacity, and consideration of a stable monetary anchor. However, these advantages come at a cost of being unable to: (i) use monetary policy as a macroeconomic stabilization tool; (ii) earn seignorage (as no monetary base can be issued); (iii) manage external competitiveness in a flexible manner; (iv) act as a lender of last resort; and (v) accumulate foreign reserves through FX intervention. Notably, only five of these economies (three in Central America and two in Europe) have access to international capital markets, and therefore, are able to raise adequate external financing.
Reserves Adequacy Considerations
11. When assessing the reserve adequacy of economies with foreign legal tender (in Article IV reports), IMF staff has supplemented or modified the definition of the international reserves. For example:
Micronesia, Palau, and Republic of Marshall Islands: IMF staff measured reserves by U.S. dollar deposits by the government in local banks (IMF (2016b; 2018a; 2018c; 2019c)).
Timor-Leste: Instead of standard international reserves, IMF staff reported “public foreign assets”, which include the Petroleum Fund balance and the central bank’s official reserves (the former being significantly greater than the latter).
Tuvalu: IMF staff added foreign assets of the National Bank of Tuvalu (a public bank), Consolidated Investment Fund, and SDR holdings.
San Marino: IMF staff estimated the aggregate liquidity buffers, which include international reserves and decentralized liquidity buffer held by commercial banks outside of the Central Bank of the Republic of San Marino (CBSM).5
12. In other cases, IMF staff had modified the metrics for gauging reserves adequacy.6 This is supported by the rationale that fully dollarized/ euroized economies’ primarily need foreign reserves to provide liquidity to domestic financial institutions, finance government, and repay short-term external debt. For example:
IMF staff substituted traditional foreign reserves with the central government deposits and compared them against imports (Micronesia, Palau, Republic of Marshall Islands) and government spending (Micronesia, Palau), using the minimum of one and three months, respectively, as benchmarks.
San Marino: IMF staff developed an alternative adequacy metric, which includes: (i) 100 percent of demand deposits of banks, reserve requirements at the CBSM, and contingent liabilities to banks; (ii) two standard deviations of the historical series of CBSM financing provided to the government (about two months of government spending); (iii) any committed credit line the CBSM has given to the government; and (iv) 100 percent of demand deposits from other public institutions. In addition, they evaluated the sufficiency of the government deposits in terms of the number of months of the government spending.7
Montenegro: IMF staff modified the IMF adequacy metric for countries with fixed exchange rate regime by replacing the concept of broad money with deposits, while raising the weight of its component from 10 percent to 15 percent and eliminating a component of the other liabilities.8
El Salvador: IMF staff computed reserves adequacy as a sum of 30 percent of the short-term public debt at remaining maturity, 30 percent of deposits, and 1 month of the Central Government budget, minus the Central Bank’s funds.
Ecuador: IMF staff supplemented standard reserve adequacy metrics by an absolute reserve floor that comprised the minimum liquidity buffers needed to confront potential reserve drains from the banking and fiscal sectors. Under this criterion, reserves should be sufficient at least to cover: (i) all deposits of the banking system at the central bank; (ii) money issuance (e.g., coins) and securities issued by the central bank (Títulos del Banco Central del Ecuador); (iii) electronic money; (iv) a measure of volatility of public credit; and (v) contingent liabilities.
C. A Stylized Central Bank Balance Sheet
13. In a country with a central bank, the central bank’s balance sheet typically comprises domestic currency liabilities, and a varying mix of domestic and foreign currency assets. (Table 1).
On the liability side, the main liabilities comprise currency in circulation (coins and notes) and reserves of commercial banks (required reserves plus excess reserves). In addition, the government places its excess cash with the central bank as deposits. Non-monetary liabilities consist of securities issued by the central bank as instruments for monetary policy. A number of central banks also use their own securities for repo operations and collateralized lending.
The equity capital of a central bank may be low, but substantial reserves are usually built from retained earnings.9 Their equity is generally not traded and are implicitly backed by the government’s ability to raise taxes. They are not concerned with profit maximization; some central banks have arrangements governing the extent to which profits are used to increase their capital or paid to the government.
On the asset side, the central bank generally has a mixture of foreign currency assets (“international reserves”) and domestic currency assets (mostly government bonds and some deposits with banks). Sources of international reserves include surpluses in trade and international investment. In a floating exchange rate regime, swapping between foreign currency assets and domestic currency assets can be an important means of influencing the exchange rate. Domestic monetary policy is often implemented by sales and purchases of the domestic currency assets.
Panama: A Central Bank’s Balance Sheet
Panama: A Central Bank’s Balance Sheet
| ASSETS | LIABILITIES AND CAPITAL |
|---|---|
| Net foreign assets Net domestic assets |
Reserve money Currency in circulation Reserves of commercial banks Deposits liabilities Government Commercial banks Non-monetary liabilities Central bank securities Equity capital |
Panama: A Central Bank’s Balance Sheet
| ASSETS | LIABILITIES AND CAPITAL |
|---|---|
| Net foreign assets Net domestic assets |
Reserve money Currency in circulation Reserves of commercial banks Deposits liabilities Government Commercial banks Non-monetary liabilities Central bank securities Equity capital |
14. For Panama, which does not have a central bank, we will look at the balance sheet of the banking system, which has a few important differences from the balance sheet of a central bank.
The “asset” side comprises predominantly liquidity in the banking system, while the “liabilities” side is constituted by deposits from the public and private sector (Table 2). Commercial banks (including BNP) deposit the bulk of their liquid assets abroad (close to 90 percent) in the form of deposits in overseas banks, investment in liquid global bonds and other liquid foreign assets.10 This is akin to net foreign assets (which is defined as “international reserves”) in a traditional central bank’s balance sheet.
The “liabilities” side comprises mainly deposits from the government and private sector (households and corporations). The deposits from the public sector are mainly central government’s excess cash deposited at BNP.
Panama: Banking Sector’s Balance Sheet
Comprises 84 percent of total liquid assets with maturity of 186 days and below.
Comprises 16 percent of total liquid assets with maturity of 186 days and below.
Panama: Banking Sector’s Balance Sheet
| ASSETS | LIABILITIES |
|---|---|
| Foreign assets | Deposits liabilities |
| Liquid assets 1/ Other assets |
Government Private sector |
| Domestic assets | |
| Liquid assets 2/ Other assets |
Comprises 84 percent of total liquid assets with maturity of 186 days and below.
Comprises 16 percent of total liquid assets with maturity of 186 days and below.
Panama: Banking Sector’s Balance Sheet
| ASSETS | LIABILITIES |
|---|---|
| Foreign assets | Deposits liabilities |
| Liquid assets 1/ Other assets |
Government Private sector |
| Domestic assets | |
| Liquid assets 2/ Other assets |
Comprises 84 percent of total liquid assets with maturity of 186 days and below.
Comprises 16 percent of total liquid assets with maturity of 186 days and below.
15. Given that liquidity in the banking system mimics “international reserves” in a typical central bank, this indicator can be used as a synthetic measure for Panama’s “international reserves”. On the asset side of Panama’s banking system balance sheet, close to 90 percent of the statutory liquid assets (maturities of up to 186 days11) are kept as foreign assets, akin to international reserves (net foreign assets) in a typical central bank’s balance sheet. Findings from the IMF Guidance Note on the Assessment of Reserve Adequacy and Related Considerations (2016) support this measure. It argues that fully dollarized economies may need “liquidity buffers” in the adopted foreign currency to support domestic financial institutions and government financing needs.12 Moreover, as the existing IMF definition of international reserves only accounts for net foreign assets of BNP (which is a subset of the banking system), establishing a synthetic international reserve indicator by using liquid assets in the banking system would be a more appropriate approach.
16. As changes in government deposits at BNP could lead to changes in liquidity in the banking system, setting up a second indicator for government liquidity is important.13 This indicator would ensure that “international reserves” are adequate to repay the government’s external debt obligations. The positive relationship between international reserves and central government deposits is also seen in dollarized economies with central banks, such as a Kosovo and El Salvador (Annex II).
D. Liquidity in Panama’s Banking Sector
17. Liquidity in the banking sector is high, due both legal requirements and conservative banking practices.14 Panama’s Banking Law of 2008 stipulates that banks must hold a minimum amount of liquid assets against qualifying deposits as the statutory liquidity requirement set by the Superintendency of Banks (SBP).15 Pursuant to the Banking Law of 2008, the SBP defines the statutory liquidity requirement as “Legal Liquidity Index” (LLI),16 set at a minimum of 30 percent of qualifying deposits. This compares well with other dollarized economies. For example, the minimum requirements in Kosovo and El Salvador are 10 and 21.6 percent of total deposits, respectively. Since 2009, the LLI in Panama had been significantly above the minimum requirement of 30 percent, between 50-70 percent. As of end-2021, the LLI stood at 60 percent, and the total amount of liquid assets in the banking sector amounted to 51 percent of GDP.
18. Further measures are underway to complement the Legal Liquidity Index. The authorities have gradually phased-in Basel III liquidity coverage ratio (LCR) in 2022. As of November 2022, all general licensed banks have met the LCR requirement. In addition, the authorities are considering implementing the Net Stable Funding Ratios (NFSR), in addition to other Basel III capital measures such as capital conservation buffer and surcharge for domestic systemically important banks.
Panama: Statutory Liquidity Reserves
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
Sources: Superintendency of Banks and national authorities.E. Measuring Panama’s International Reserves Adequacy
19. Our proposed synthetic measure of international reserves for Panama appears to be relatively high.17 Specifically:
Reserves as a percent of GDP: Panama’s (synthetic) international reserves amounts to 52 percent of GDP, compared to 14 percent of GDP when computed as the net foreign assets of BNP. Within a sample of 76 emerging economies, Panama’s synthetic reserves to GDP ratio ranks among countries in the third quartile, indicating relatively high levels of reserves.
International Reserves in 20211/
(In Percent of GDP)
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
Sources: IMF, Staff computations.1/ For Panama, reserves are computed as the sum of banking liqudity and central government cash deposit.ARA Metric: Acknowledging a caveat that the ARA metric derives its relative risk weights according to only two exchange rate regimes (fixed and floating) whereas Panama is a fully dollarized economy, if we assume that Panama’s exchange rate is in the category of “fixed” regime, Panama’s synthetic international reserves are equivalent to 110 percent of the standard IMF’s ARA metric (within the range of 100-150 percent of the metric that is considered broadly adequate).18 If Panama’s international reserves are measured as BNP’s net foreign assets, it amounts to only 34 percent of the standard IMF’s ARA metric.
Reserves of Selected Emerging Economies 1/
(In percent of ARA Metric, 2021)
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
Sources: IMF, Staff computations.1/ For Panama,reserves are computed as the sum of banking liqudity and central government cash deposit.20. The synthetic international reserves were also in line with the standard thresholds over the last decade. Since the implementation of the statutory legal liquidity index in 2009, the banking sector’s liquid assets averaged around 60 percent of short-term liabilities, well above the minimum requirement of 30 percent.19 In addition, fiscal reserves had been above the benchmark of 1 month of expenditure, with an average coverage of 2.4 months of central government expenditure from 2009 to 2021 (above the benchmark of one month of central government expenditure for dollarized economies).20
Panama’s Synthetic Reserves, 2009-2021
(In Percent of ARA Metric)
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
Source: IMF staff computations.F. Indicator for Government Liquidity
21. The IMF Guidance Note (2016a) proposes one month of central government spending as an adequacy threshold for fiscal reserves.21 Based on this measurement, Panama’s fiscal liquidity buffers are above recommended standard. At the end of 2019, before the pandemic, CG deposits covered 2.7 months of expenditure. If we assume that $1 billion of CG deposits will be used to pre-finance debt amortizations falling due in each year and deposit withdrawals would be limited in a baseline scenario, this adequacy threshold will continue to be observed over the medium term (Table 3).
Government Deposits
(Share of GDP)
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
Source: IMF staff calculations.Panama: Central Government Deposits in Months of Government Expenditure 1
2022 estimates and 2023-27 forecasts from October 2022 WEO.
Panama: Central Government Deposits in Months of Government Expenditure 1
| 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | |
|---|---|---|---|---|---|---|---|---|---|
| CG deposits in months of expenditure | 2.7 | 4.3 | 3.1 | 2.7 | 2.5 | 2.3 | 2.1 | 2.0 | 1.8 |
| Distance to benchmark | 1.7 | 3.3 | 2.1 | 1.7 | 1.5 | 1.3 | 1.1 | 1.0 | 0.8 |
2022 estimates and 2023-27 forecasts from October 2022 WEO.
Panama: Central Government Deposits in Months of Government Expenditure 1
| 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | |
|---|---|---|---|---|---|---|---|---|---|
| CG deposits in months of expenditure | 2.7 | 4.3 | 3.1 | 2.7 | 2.5 | 2.3 | 2.1 | 2.0 | 1.8 |
| Distance to benchmark | 1.7 | 3.3 | 2.1 | 1.7 | 1.5 | 1.3 | 1.1 | 1.0 | 0.8 |
2022 estimates and 2023-27 forecasts from October 2022 WEO.
22. Fiscal liquidity buffers in Panama are broadly in line with or higher than in other dollarized economies. Panama’s Central Government (CG) deposits amounted to US$3 billion and 4.8 percent of GDP in 2021,22 as shown in Table 4).23 In historical perspective and by comparison with other dollarized economies, Panama’s CG deposits had been, on average, in line with or better than El Salvador and have recently closed the performance gap with Kosovo. As for volatility, it has been higher in Panama than in both El Salvador and Kosovo.
Panama: Selected Fiscal Reserves Indicators
Panama: Selected Fiscal Reserves Indicators
| 2020 | 2021 | |||
|---|---|---|---|---|
| Financial assets | USD billion | Share of GDP | USD billion | Share of GDP |
| CG deposits (selected metrics) | 4.4 | 8.2 | 3.0 | 4.8 |
| Deposits of decentralized institutions (including CSS) | 5.5 | 10.1 | 5.8 | 9.1 |
| FAP | 1.4 | 2.6 | 1.4 | 2.2 |
| Total | 11.3 | 20.9 | 10.2 | 16.1 |
Panama: Selected Fiscal Reserves Indicators
| 2020 | 2021 | |||
|---|---|---|---|---|
| Financial assets | USD billion | Share of GDP | USD billion | Share of GDP |
| CG deposits (selected metrics) | 4.4 | 8.2 | 3.0 | 4.8 |
| Deposits of decentralized institutions (including CSS) | 5.5 | 10.1 | 5.8 | 9.1 |
| FAP | 1.4 | 2.6 | 1.4 | 2.2 |
| Total | 11.3 | 20.9 | 10.2 | 16.1 |
23. The magnitude of the fiscal reserves is large enough that even targeting constant CG deposits would provide a sizeable buffer against tail liquidity shocks in the next several years. In view of past volatility of the fiscal liquidity metrics and the divergence between observed and smoothed values of deposits, it is worthwhile assessing the resilience of current deposits against extreme shocks. The figure here compares the baseline strategy against two risk scenarios, one stochastic and the second deterministic. In the stochastic risk scenario, 10,000 normalized shocks on CG expenditure/GDP ratio have been conducted, based on the historical average and standard deviation of this variable, and the 95th percentile of the distribution has been selected for each year for evaluating the adequacy of liquidity. In the deterministic risk scenario, expenditure is about 1.75 percent of GDP above the baseline at the peak of the shock (i.e., 1.4 standard deviations) and the level of deposits 40 percent lower than in the baseline due to refinancing constraints. In the stochastic scenario, deposits would remain well above the threshold of 1 month of CG expenditures over the whole period. In the deterministic one, deposits in terms of months of expenditure start off at their minimum in 2022 at about half a month above the threshold, and would recover thereafter as the effects of the liquidity shock gradually wane off.
CG Deposits in Months of Government Expenditure
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
Sources: MEF and IMF staffcalculations.24. If further fiscal buffers are accumulated by placing bonds, the threshold would be met by a larger margin. Accumulating additional financial assets would imply expanding debt issuances, other things being equal. In this respect four possible strategies are assessed. The baseline strategy consists in letting deposits gradually come down from 3 months in 2021 to 1.8 months in 2027, which would be consistent with a decline of debt from 58.4 percent of GDP in 2021 to 52.1 percent in 2027. If CG expenditure coverage was raised to 4 months until 2027, public debt would reduce only slightly relative to baseline in 2021 to 55.8 percent of GDP. If, on the contrary, CG deposits were fixed at 3 months of its expenditure, public debt would fall to 52.5 percent of GDP by 2027, only a modest increase relative to the end of period in baseline. In a more extreme situation that would imply taking even higher risks, lowering deposits to 1.5 months from 2022 would push debt down to 47.7 percent of GDP in 2027.
NFPS Debt/GDP under Alternative Fiscal Liquidity Buffers
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
Sources: MEF and IMF staff calculations.G. Conclusion and Policy Implications
25. In fully dollarized (or euroized) economies, the need for international reserves differs from other countries as they do not face the risk of exchange rate fluctuations and currency mismatches. In most of these economies, international reserves act a foreign exchange liquidity buffer, and are driven directly by banks’ deposits, fiscal balance, and movements in public debt. These liquidity buffers in the adopted foreign currency are needed to support domestic financial institutions and government financing.
26. Assessing reserve adequacy in fully dollarized (or euroized) economies can be challenging and very often requires judgement. These countries differ, not only because of the multiple roles played by reserves, but also the complexity of quantifying external risks and vulnerabilities, as well as the opportunity costs that they face. IMF staff had supplemented or modified the definition of the international reserves, taking into consideration country circumstances and vulnerabilities. In other cases, IMF staff had modified the metrics for gauging reserves adequacy, supported by the rationale that that fully dollarized economies’ primary need for foreign reserves is to provide liquidity to domestic financial institutions, finance government, and repay short-term external debt.
27. In the case of Panama, international reserves can be synthetically approximated by liquidity in the domestic banking system. As a fully dollarized economy, Panama does not face the risk of exchange rate fluctuations and currency mismatches. Consequently, the need for reserves arises as precautionary liquidity buffers to support domestic financial institutions in the event of a liquidity stress in the banking sector and for government financing. Over the last decade, liquidity reserves in the banking sector remained high due to legal requirements and conservative banking practices. Moreover, fiscal reserve buffers were also broadly in line with or higher than in most other dollarized economies.
Annex I. Main Characteristics of the Countries with Foreign Legal Tender
| Country | Region | Currency Used | Monetary Authority | Local Currency | Sovereign Fund | Market Access |
|---|---|---|---|---|---|---|
| Ecuador | WHD | USD | Central Bank of Ecuador | No | Liquidity Fund | Yes |
| El Salvador | WHD | USD | Central Bank of El Salvador | El Salvadoran Colon | No | Yes |
| Panama | WHD | USD | National Bank of Panama | Balboa coins | Sovereign Wealth Fund | Yes |
| San Marino | EUR | Euro | Central Bank of San Marino | No | No | No |
| Montenegro | EUR | Euro | Central bank of Montenegro | No | No | Yes |
| Kosovo | EUR | Euro | Central Bank of Kosovo | No | No | Yes |
| Republic of Marshall Islands | APD | USD | No | SOV (new digital currency, since 1998) | Yes | No |
| Federated States of Micronesia (FSM) | APD | USD | FSM Development Bank | No | FSM Trust Fund | No |
| Palau | APD | USD | National Development Bank of Palau | No | Compact Trust Fund (CTF) | No |
| Timor-Leste | APD | USD | Central Bank of Timor-Leste | Centavo coins | Yes, Petroleum Fund | No |
| Kiribati | APD | AUD | Development Bank of Kiribati | Kiribati dollar coins (issued in 1979-92) | Revenue Equalization Reserve Fund (RERF) | No |
| Tuvalu | APD | AUD | National Bank of Tuvalu | Tuvaluan dollar (issues coins since 1976) | Consolidated Investment Fund | No |
| Country | Region | Currency Used | Monetary Authority | Local Currency | Sovereign Fund | Market Access |
|---|---|---|---|---|---|---|
| Ecuador | WHD | USD | Central Bank of Ecuador | No | Liquidity Fund | Yes |
| El Salvador | WHD | USD | Central Bank of El Salvador | El Salvadoran Colon | No | Yes |
| Panama | WHD | USD | National Bank of Panama | Balboa coins | Sovereign Wealth Fund | Yes |
| San Marino | EUR | Euro | Central Bank of San Marino | No | No | No |
| Montenegro | EUR | Euro | Central bank of Montenegro | No | No | Yes |
| Kosovo | EUR | Euro | Central Bank of Kosovo | No | No | Yes |
| Republic of Marshall Islands | APD | USD | No | SOV (new digital currency, since 1998) | Yes | No |
| Federated States of Micronesia (FSM) | APD | USD | FSM Development Bank | No | FSM Trust Fund | No |
| Palau | APD | USD | National Development Bank of Palau | No | Compact Trust Fund (CTF) | No |
| Timor-Leste | APD | USD | Central Bank of Timor-Leste | Centavo coins | Yes, Petroleum Fund | No |
| Kiribati | APD | AUD | Development Bank of Kiribati | Kiribati dollar coins (issued in 1979-92) | Revenue Equalization Reserve Fund (RERF) | No |
| Tuvalu | APD | AUD | National Bank of Tuvalu | Tuvaluan dollar (issues coins since 1976) | Consolidated Investment Fund | No |
Annex II. Relationship Between International Reserves, Central Government Deposits and Banks’ Liquidity Reserves
A scatter plot analysis below shows the positive associations between international reserves and banks’ liquidity reserves and international reserves and central government deposits, in two sample dollarized economies—Kosovo and El Salvador.
International Reserves, Central Government Deposits, and Banks’ Liquidity Reserves in Kosovo and El Salvador1
Citation: IMF Staff Country Reports 2023, 129; 10.5089/9798400236662.002.A003
1/Based on monthly data from January 2010 to December 2020.Sources: Haver Analytics; national authorities.References
Hawkins J., 2003, “Central Bank Balance Sheets and Fiscal Operations”, (Basel: Bank for International Settlements).
International Monetary Fund, 2013, “Assessing Reserve Adequacy – Further Considerations,” IMF Policy Paper, November (Washington: International Monetary Fund).
International Monetary Fund, 2015, “Assessing Reserve Adequacy––Specific Proposals,” IMF Policy Paper, April (Washington: International Monetary Fund).
International Monetary Fund, 2016a, “Guidance Note on the Assessment of Reserve Adequacy and Related Considerations,” IMF Policy Paper, June (Washington: International Monetary Fund).
International Monetary Fund, 2016b, “The Republic of the Marshall Islands: 2016 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2018a, “The Republic of the Marshall Islands: 2018 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2018b, “Kiribati: 2018 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2018c, “Palau: 2018 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2018d, “Tuvalu: 2018 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2019a, “El Salvador: 2019 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2019a, “Montenegro: 2019 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2019b, “San Marino: 2019 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2019c, “The Federated States of Micronesia: 2019 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2019d, “Timor Leste: 2019 Article IV Consultation,” IMF Staff Report (Washington: International Monetary Fund).
International Monetary Fund, 2021, “Request For An Arrangement Under The Precautionary And Liquidity Line,” IMF Staff Report (Washington: International Monetary Fund).
Lindquist W., 2018, “Reserve Adequacy”, Montenegro: Selected Issues Paper, Chapter 3, IMF Country Report 18/122, (Washington: International Monetary Fund).
Levy-Yeyati, E., 2006, “Financial Dollarization: Evaluating the Consequences,” Economic Policy, Vol. 21, No. 45, pp. 61-118 (London: Centre for Economic Policy Research).
Wiegand, J., 2013, “Euroization, Liquidity Needs, and Foreign Currency Reserves,” Kosovo: Selected Issues Paper, Chapter 3, IMF Country Report 13/223, (Washington: International Monetary Fund).
Mansillo M., 2019, “Reserve Adequacy”, Ecuador: Selected Issues Paper, Chapter 3, IMF Country Report 19/80, (Washington: International Monetary Fund).
Prepared by Julian Chow, Olga Bespalova (both WHD), and Alberto Soler (FAD).
The term “fully dollarized economies” is used for countries which adopted a currency of another state as its legal tender.
The IMF’s reserve adequacy metric for Emerging Market (EM) aims at assessing the prudent level of reserves––liquid assets denominated in foreign currency plus gold, controlled by a central bank and available for external payments and exchange rate management––held by countries, taking account of the benefits and costs of holding them. IMF (2012; 2016) provides further details.
Cash buffers of the government and liquidity reserves of the banking system are not independent. To the extent that the government draws down its deposits to pay for imports, this will reduce both government deposits and liquidity in the banking system.
It is worth noting that most countries have been using standard adequacy metrics.
See Annex III “Reserve Adequacy for San Marino” in the 2019 Article IV Consultation Staff Report.
Reserves = 10 percent of X + 30 percent of STD + 15 percent of Deposits.
Hawkins (2003) notes that low capital may be desirable as there may be better uses for public funds. Moreover, a low-capitalized central bank will have to be more circumspect in its lender of last resort operations, thus minimizing moral hazard.
The remaining liquidity is held in domestic treasury bills, interbank deposits, and cash kept in branches for banking operations.
As per definition in the statutory Legal Liquidity Requirement.
Liquidity pressures in banks could result from outflows from the financial system, which can originate from various sources including a decline in exports, a sudden stop in external financing, non-resident flight, or a resident run. In addition, governments may wish to maintain additional fiscal savings as buffer against unexpected fluctuations in revenue or spending since funding in the adopted currency may be difficult in times of stress.
For example, if the central government deposits more cash in BNP, the asset side of the BNP’s balance sheet will increase in the same proportion as the increase in its deposits liability (double-entry accounting). Assuming that BNP keeps this increment as its deposits in overseas banks (or in other forms of liquid assets) instead of lending it as loans, the total liquidity in the banking system will increase.
It is worth noting that Panama is a financial center, which gives rise to a large share of banks’ liquidity buffers as well as external debt.
Qualifying deposits include private deposits, bank deposits, and deposits from other financial institutions with a maturity up to 186 days. Deposits received from the parent banks are excluded from this requirement. Liquid assets are short-term assets with maturities below 186 days.
Computed as a ratio of total balance of liquid assets to qualifying deposits.
Measured by banking sector liquidity (defined as short-term liquid assets with maturities below 186 days).
Following the IMF Guidance Note (2016), the ARA Emerging Market metric for fixed exchange rate regime (computed as net reserves divided by the sum of 30 percent of short-term debt, 10 percent of broad money, 20 percent of other liabilities; and 10 percent of exports) provides a starting point to assess the adequacy of liquidity buffer to support domestic financial institutions.
The statutory Legal Liquidity Index defines a 30 percent minimum requirement on liquid assets (including cash and certain debt securities) as a share of qualifying deposits, both with a time horizon of 186 days.
Wiegand (2013) provides further details.
Also see Wiegand (2013).
Assets worth US$1.4 billion (2.2 percent of 2021 GDP) is in the balance sheet of the Savings Fund of Panama (FAP), but fiscal legislation limit their utilization for financing government deficits in normal times.
The drop in assets as a share of GDP in 2021 is magnified due to the large denominator effect, since nominal GDP rebounded y-o-y by almost 18 percent.
