Journal Issue

V. Reserve Adequacy Assessment

Olivier Basdevant, Chikako Baba, and Borislava Mircheva
Published Date:
December 2011
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The gross official reserves of the Central Bank of Swaziland have been on a downward trend since early 2010 (Figure 7). This decline has been driven by the fiscal crisis, the inability of the government to rein in expenditure, and the lack of financing. As a result, the government has continued to make recourse to central bank financing, with a corresponding drain on the gross official reserves of the central bank. This clearly cannot continue without jeopardizing external stability. Under these conditions, it is important to define the appropriate level of gross official reserves that would be deemed adequate to maintain external stability.

Figure 7.Swaziland: Reserves Compared with Other Countries

Sources: Swaziland authorities, and IMF staff estimates.

A. Standard Measures of Reserve Adequacy

A few standard measures are commonly used to assess reserve adequacy: the gross official reserves as a ratio of months of imports, stock of short-term debt, stock of reserve money, and stock of broad money. The ratio of reserves to GDP is also used as a measure in some cases but does not have a theoretical or empirical underpinning.

The most widely used rule of thumb is that a country with a fixed exchange rate should maintain reserves equal to at least three prospective months of imports of goods and services. That is, if all balance of payments inflows cease, a country would have enough gross official reserves available to pay for three months of imports. Swaziland has been below this benchmark since November 2010 and stood at 2.4 months of import cover at end-November 2011. Compared with other member countries of the Southern Africa Customs Union (SACU) and member countries of monetary unions in Africa (except Chad), Swaziland has the lowest level of reserves as a measure of import cover.

The level of gross official reserves to short-term debt measures the adequacy of reserves against debt service outflows over the next 12 months. For Swaziland, data on short-term debt are unavailable. It is therefore not possible to measure the adequacy of reserves against this measure.

The ratio of gross official reserves to base or reserve money (typically M0) gives a measure of the backing of currency in circulation. This measure is usually most relevant in currency boards, where the law requires the central bank to maintain a high percentage of reserves (60–100 percent) to be freely available to be exchanged for domestic currency in circulation. For Swaziland, the ratio of gross official reserves to reserve money at end-September 2011 was high (about 300 percent), and therefore not subject to significant concerns.

The reserve coverage of broad money (typically M2) is another popular measure. The metric is intended to capture the risk of capital flight, and a ratio of 20 percent is commonly used as the minimum threshold for countries with a fixed exchange rate regime. Even though this indicator has been at about 40 percent for Swaziland, i.e., well above the suggested minimum level for Swaziland, it has been falling steadily, raising concerns about possible pressures arising from currency substitution or capital outflows. Compared with other countries in SACU and in the rest of Africa, Swaziland measures well according to this metric.

B. A Model-Based Approach to Reserve Adequacy

In addition to the traditional measures above, several models have been presented in the recent literature to derive the adequate level of reserves through the optimization of the net benefits of holding reserves. Typically, these models postulate the benefits of holding reserves (i.e., reducing the probability of a crisis and smoothing consumption during crisis) and compare them to the costs of holding reserves in terms of foregone investment in the economy. The model developed by Caballero and Panageas (2004) focuses on the real costs of a sudden stop in capital flows while the model by Garcia and Soto (2004) assumes that reserves affect the probability of a crisis and its costs. Jeanne and Rancière (2006) assume a small open economy where risk-averse policymakers choose a level of reserves that maximizes welfare in the event of a sudden stop in capital inflows.

A new model-based approach has also been developed by the IMF to derive the optimal reserve holdings.13 It has been observed that since 2002 emerging market and low-income countries have outpaced the traditional reserve adequacy metrics. Subsequently, during shocks, these reserves have provided a useful cushion against economic crises, including the current global economic crisis. Furthermore, the growth in reserves has been driven by precautionary motives, even though those motives have been different across countries.

This new model-based approach provides a framework for optimal reserves. For emerging market (EM) economies, a two-stage methodology is employed. In the first stage, the relative riskiness of different potential losses in foreign reserves is estimated. Specifically, the analysis estimates the potential outflows during periods of exchange market pressure, where the specific sources of loss identified are (i) potential loss of export earnings from a drop in external demand or a terms-of-trade shock; (ii) external liability shock to short-term debt and medium- and long-term debt and equity liabilities; and (iii) capital flight risk. In the second stage, the reserve coverage a country should hold is estimated based on the metric obtained from the first stage.

Box 5.New Approach for Estimating Reserve Adequacy1

A two-stage approach is employed:

First Stage:

The relative riskiness of different potential drains on reserves is estimated. This is done based on observed distributions of outflows from each source during periods of exchange market pressure. Subsequently, a risk-weighted liability shock is constructed. Estimates of relative risk weights are based primarily on tail event outflows associated with periods of exchange market pressure. Identified drains during such events are computed as annual percentage losses of export income, short-term debt, other portfolio liabilities, and liquid domestic assets.

Second Stage:

Based on the risk-weighted liability shock calculated in the first stage, the second stage estimates the adequate reserve coverage a country should hold. Countries with fixed and flexible exchange rate regimes are assessed separately.

1 Model developed in IMF (2011a).

The approach provides a simple metric that summarizes risk-weighted measures of the pressure on reserves. For countries with a fixed exchange rate regime, it proposes to use the following risk weights, based on tail event outflows during exchange market pressure periods: 10 percent of export income, 30 percent of short-term debt, 15 percent of other portfolio liabilities, and 10 percent of broad money, which proxies the liquid domestic assets. Subsequently, the implied optimal reserve level for Swaziland would be approximately E 5.1 billion in order to maintain external stability against the pressure of the risk-weighted sum of export income (E 16.6 billion), short-term debt (E 2.5 billion), other portfolio liabilities (E 1.5 billion), and broad money (E 8.8 billion).

In the case of Swaziland, country-specific factors would also have to be considered. Specifically, the model is developed for emerging market economies; Swaziland lacks access to international capital markets, is highly dependent on SACU revenue, and has an undiversified export base. Moreover, because of the fixed exchange rate regime, gross official reserves are at risk as a drawdown on government cash balances at the central bank, implying a 1-to-1 reduction in reserves. Swaziland is also highly exposed to terms-of-trade shocks because it is an oil importer as well as a sugar exporter. In addition, it has a fully open capital account with South Africa thus exposing it to sudden capital outflows. Lastly, as the lender of last resort, the central bank should plan ahead for possible liquidity needs in the banking sector.

The analysis under the new approach indicates that Swaziland does not currently hold an adequate level of gross official reserves. Specifically, the analysis indicates that under the assumptions described above, the optimal level of reserves is 17.7 percent of GDP (about E 5.1 billion for 2011; Table 5). Currently, gross official reserves are below the recommended optimal level at E 4.3 billion, equivalent to 14.8 percent of GDP.

Table 5.Swaziland: Optimal Level of Reserves1
Emalangeni billionsPercent of GDP
Traditional Metrics
3 months’ imports5.418.6
100 percent of STD2.58.7
20 percent of M21.86.2
Model-Based Metric5.117.7
Gross Official Reserves, end-Nov. 20114.314.8
Source: IMF staff calculations.

Information for Lesotho is not available to calculate the new metric.

Source: IMF staff calculations.

Information for Lesotho is not available to calculate the new metric.

Compared to other emerging market economies with a fixed exchange rate, the new metric seems to suggest an inadequate level of reserves. The suggested adequate level of reserves for an emerging economy with a fixed exchange rate for the countries used in the example is between 12 and 25 percent of GDP (Figure 8). However, it would have to be taken under consideration that the new metric is calculated based on the external environment, current account risk, capital account risk, and cost of holding reserves which vary across economies. In addition, except for Botswana, data are not available for the countries in the Southern African region to calculate and compare the new metric.

Figure 8.Reserves Adequacy, New and Traditional Metrics, 20111

(Percent of GDP)

1 Information for Lesotho is not available to calculate the new metric.

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