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.
The nature of exogenous shocks that LICs face—and for which they may seek insurance—is worthy of examination in itself. It can provide a clear notion of which shocks are relatively frequent and costly. Information on the nature of shocks and their costs for countries with different structural characteristics is also crucial for tailoring policy advice. In particular, decisions about the appropriate or warranted level of official reserves for a country are likely to depend on policy fundamentals, the likelihood of facing various external shocks, and the consequences of such shocks.2
Against this background, the paper begins with a discussion of the impact of external shocks on macro-economic growth, volatility, and welfare. A large body of evidence suggests that weakly diversified economic structures and reliance on international trade to import large quantities of essential goods render LICs vulnerable to significant macroeconomic fluctuations in the event of external shocks (Loayza and others, 2007; IMF, 2011). To further analyze their impact, the paper presents an in-depth anatomy of the frequency and economic costs of the most important external shocks faced by LICs. The event study analysis finds that LICs with reserve coverage above three months of imports were better able to smooth consumption and absorption in the face of external shocks, including the recent global financial crisis, relative to those with lower reserve holdings. The analysis also points to the importance of country characteristics and vulnerabilities in assessing reserve adequacy. It finds that the shock-mitigation effect of reserves is particularly pronounced, for instance, in heavily-indebted economies, small islands, commodity exporters, and countries with fixed exchange rate regimes.
Following the anatomy of external shocks, the paper documents recent trends in reserve accumulation in LICs. To assess whether the recent accumulation in LICs has been in line with fundamentals, we estimate a cross-country empirical model of precautionary demand for reserves. Reserve demand regressions seek to exploit countries’ revealed preferences on the basis of precautionary variables and can indicate whether reserve holdings are out of line with peer countries; but using such regressions to provide guidance on the adequacy of individual countries’ reserves depends on an assumption that there are no systematic biases toward over- or underinsurance for the sample as a whole.
In determining a desired level of reserves, countries need to trade off the financial costs of holding reserves against the consumption (absorption)-smoothing benefits of having a ready stock of reserve assets. To help guide judgments about the desirable level of self-insurance through reserves, the paper develops a simple cost-benefit analytical framework of precautionary reserve holdings for the level of reserves warranted according to country characteristics and fundamentals. The crisis prevention and mitigation benefits of reserves in the event of adverse external shocks—where a crisis is defined as a sharp drop in absorption—are empirically estimated using data on past severe shock episodes for the 1990–2008 period, controlling for policy fundamentals and country characteristics. For LICs with limited access to international markets, the net financial cost of reserves is implied by forgone investment opportunities or the differential between domestic and foreign real interest rates. The regression estimates for the benefits of holding reserves are combined with country-specific data on fundamentals and assumptions about risk neutrality and the marginal cost of holding reserves to determine optimal reserve levels for different country groups. The framework explicitly internalizes the interactions among policy fundamentals, access to IMF financing in the event of a shock, and optimal reserve holdings.
The framework yields a number of insights about the degree to which reserve accumulation in different countries is warranted by fundamentals captured in the model. In particular, the analysis suggests that the standard metric of reserves equivalent to three months of imports is an imprecise benchmark, as optimal reserve holdings depend crucially on country characteristics and policy fundamentals. Calibrated optimal reserves vary from about one to seven months of imports, with higher estimated reserves for fragile states and commodity exporters than for other countries. In addition, optimal reserves are generally higher for fixed exchange rate regimes, in the absence of IMF support in the event of a shock, and for countries facing a lower cost of reserves. The calibration results also suggest that stronger policy fundamentals are associated with lower optimal reserves, illustrating the importance of country-specific fundamentals in the determination of optimal reserves.
The remainder of the paper is organized as follows: Chapter 2 lays out the motivation for this study by examining the impact of external shocks on macroeconomic performance in LICs. Chapter 3 conducts an event study analysis of large external shocks to document their impacts and to assess whether the macroeconomic costs associated with external shocks were larger in LICs with lower international reserve holdings prior to a shock event, including the recent global financial crisis. Chapter 4 provides an overview of recent developments in reserve accumulation in LICs and presents results of a reserve demand regression. Chapter 5 presents the framework for estimating optimal reserve holdings and reports estimation results of parameters to be used for the calibration analysis in Chapter 6, which explains assumptions used in the calibration analysis and reports the calibration results of optimal reserve holdings. Chapter 7 concludes the discussion.
In this paper, “low-income countries” refers to all countries shown on the IMF’s list of countries eligible for the Poverty Reduction and Growth Trust (PRGT) at the end of December 2010.
It should be noted that the paper focuses on the precautionary aspect of holding reserves. This reflects the key distinguishing characteristic of reserves—their availability and liquidity for potential balance of payments needs. Although reserves may also be accumulated or held for nonprecautionary reasons (such as exchange rate policy or intergenerational savings), these lie beyond the scope of this paper.