The stylized facts presented in this study suggest that LICs are subject to a wide variety of external shocks that can have significant, enduring consequences for growth and economic welfare. Against this background, reserves are an essential part of countries’ self-insurance toolkit and can play an important role in both preventing such shocks from causing excessive economic disruption and in mitigating their impact. This paper has presented a tractable cost-benefit approach for the optimal level of reserves for LICs, based on the assumption that the main benefit of reserves is to smooth domestic absorption and consumption against the disruption induced by large exogenous shocks. The role of reserves in reducing the probability and severity of absorption losses is robustly established through empirical analysis.
The in-depth event study analysis presented in this paper indicates that the macroeconomic costs associated with external shocks vary based on the nature of the shock, the structural characteristics of the economy, and the level of international reserve holdings. During the years following any shock event, macroeconomic performance weakened significantly, with median real GDP growth and external accounts deteriorating, particularly in countries with a high level of debt, fairly concentrated export base, and limited exchange rate flexibility. Also, costs with respect to pre-shock trends were considerable both in terms of forgone real GDP and per capita consumption or absorption growth. After a terms-of-trade shock, costs were rather large and persistent in commodity-exporting economies (including oil exporters), islands, and countries without an IMF program in proximity to the shock event. Against this backdrop, the analysis suggests that countries with international reserve holdings greater than three months of imports in the year before the shock event were generally able to better cushion economic activity compared with those with lower reserve levels. However, higher reserve coverage is not a panacea—especially in countries with an exchange rate peg—suggesting that the standard rule of thumb of three months of imports is at most a lower bound and that the appropriate level of reserve holdings may vary with the structural characteristics of the economy.
The analytical framework provided in this paper may be useful in clarifying judgments about the trade-offs between the costs of holding reserves in LICs and the benefits they provide for smoothing the impact of external shocks. The calibration exercise shows that the optimal reserves level can be sensitive to country fundamentals and exchange rate regimes, and the model needs to be carefully calibrated to evaluate each country’s needs. As a result, rules of thumb, such as maintaining reserves equivalent to three months of imports, can only give imprecise benchmarks.
This paper further suggests that reserves only provide a temporary and partial solution to the vulnerabilities that stem from low-income countries’ lack of economic diversification and weak policy and institutional frameworks. To durably reduce risks, countries need to implement economic reforms that address these issues directly. Accordingly, strengthening policy frameworks, increasing exchange rate flexibility, and diversifying economies could result in declining reserve needs in line with ensuing reductions in external vulnerability.
As a basic test of adequacy that can be applied consistently across countries, the framework provided in this paper appears to have advantages over the traditional rules of thumb. However, in making a full assessment of needs at the individual country level, it can still serve only as a starting point, beyond which detailed examination of risk factors and resources to address these risks—of which reserves are only one element—are needed.