This Selected Issues Paper focuses on economic condition, energy subsidies, and oil prices in Jordan. Energy price subsidies pose a serious fiscal risk in the present context of increasing and volatile international prices. The macroeconomic situation in Jordan is closely tied to that of other countries in the Middle East. From a policy perspective, macroeconomic and structural policies in Jordan should be conducted in such a way that the vulnerability of the country to sudden stops or reversals of external income flows is reduced.
III. Assessing Reserve Adequacy in Jordan1
This chapter analyses the adequacy of international reserves in Jordan using three alternative methodologies: i) the traditional rules of thumb; ii) a reserve optimizing model; and iii) a risk-weighted metric recently developed by the IMF.2 The empirical results show that Jordan’s actual reserve levels are higher than the minimum suggested by all these approaches.
1. Jordan is a small open economy with close trade/financial linkages with the rest of the world. The country is highly dependent on remittances, grants and foreign direct investment inflows, and at the same time is very susceptible to commodity price shocks and regional/global economic conditions. Given that any sudden stop or reversal of capital/current inflows could expose Jordan to significant risks, holding an adequate level of international reserves is essential for the country to reduce its vulnerability to these disturbances and to support the pegged exchange rate. However, there is little consensus on what constitutes an adequate level of reserves from a precautionary perspective. The traditional rule of thumb measures are narrowly based and often provide conflicting signals, the model-based approaches are constrained to stylized modeling assumptions and calibrations, and reserve regressions suffer from simultaneity problems while inferring optimization from observed data. This chapter uses different methodologies to form as complete a picture as possible by relying on the advantages of each approach.
B. Traditional Measures
2. Jordan’s international reserve coverage has been comfortable in recent years, based on traditional reserve adequacy metrics (such as import cover, short-term debt, broad money, and combination measures).
Import cover, which is generally applied to countries where shocks arise from the current account, is often seen as a measure of the number of months imports can be sustained should all inflows cease. As shown in Figure 1, the often-used 3-months of imports cover is exceeded by a wide margin by Jordan, especially in recent years.
Short-term debt (STD) is an indicator of crisis risk for market access countries such as Jordan. The “Greenspan-Guidotti” rule proposes a 100 percent cover for public and private external debt maturing over the next 12 months. As can be seen from Figure 2, Jordan has had enough reserves to provide such a cover since the 1988–89 crisis.
Reserves to broad money is usually intended to capture the risk of capital flight, given that many recent capital account crises have been accompanied by outflows of domestic residents’ deposits. It may also be seen as a measure of potential need for bank support in or after a crisis. Figure 3 shows that Jordan meets the 20 percent benchmark comfortably.
Finally, combination metrics—such as an expanded Greenspan-Guidotti rule of STD plus the current account deficit—seek to reflect a broader range of sources of risk. Figure 4 shows that Jordan fell short of this rule at times when the current account deficit was high.
C. The Reserve Optimizing Model of Jeanne and Ranciere (2006)
3. This model describes reserve accumulation in a small open economy as an optimization problem in which risk-averse policy makers choose the level of reserves to provide optimal insurance against a sudden stop in consumption given the costs of holding reserves. When a sudden stop occurs, external debt cannot be rolled over and output falls below its long-run growth path. A buffer stock of reserves can mitigate the fall in output and smooth consumption. However, there is a cost to holding reserves as they yield a lower return than other assets in the economy. In this model the optimal level of reserves is determined by the size and probability of the sudden stop, the potential loss in output and consumption, the opportunity cost of holding reserves, and the degree of risk aversion.
4. Based on this model, the optimal level of reserves for Jordan is calibrated to be much below the actual holdings post the 1988-89 balance of payments crisis. As seen in Figure 5, actual reserve levels in most cases exceed those spelled out by Jeanne and Ranciere model, especially in the last decade.
D. The IMF’s Risk-Weighted Metric
5. This section uses a two-stage “risk-weighted” approach that encompasses a broad set of risks to assess the optimal level of reserves in Jordan. Cross-country experience shows that balance of payment pressures can arise from a range of different sources including external liabilities as well as current account variables and some measure of potential capital flight (these sources include export income, short term debt at remaining maturity, other portfolio liabilities, and liquid domestic assets). Therefore in the first stage, we employ a metric that reflects the relative risk levels of different potential sources of balance of payments pressure—the relative risk weights are based on tail event outflows associated with periods of exchange market pressure in different countries; and in the second stage we assess how much reserves might be needed relative to this risk weighted measure to cover the outflows from different sources. For Jordan (with a fixed exchange rate regime) the metric is constructed as follows:
30% of short-term debt + 15% of other portfolio liabilities + 10% of M2 + 10% of imports.
Coverage in the region of 100–150 percent of the metric can be regarded as adequate for countries similar to Jordan.
6. Based on this approach and consistent with other methodologies, the level of reserves for Jordan is comfortably higher than suggested by the IMF’s risk-weighted metric. Figure 6 shows Jordan’s reserve coverage against the proposed adequacy range of 100–150 percent (dashed lines). In the last decade, the actual level of reserves in Jordan has been well above this range.
7. To conclude, according to these three approaches, Jordan’s level of foreign reserves is more than adequate to cover a broad set of conventional risks. However, no one measure is complete and can capture the full range of factors that bear on a country’s resilience against shocks, and international reserves are only one part of a country’s defense against such shocks. As a complement to these approaches, regression analysis of observed reserve holdings against a range of precautionary variables can be used to infer the degree to which Jordan’s actual reserve levels are consistent with those of peers. Other factors to consider are central bank swap lines, sovereign wealth funds, and access to IMF credit lines, which can also provide contingent protection. A sound macroeconomic and prudential policy framework is probably more important than reserves in limiting country vulnerabilities. Low and sustainable levels of public debt, monetary and exchange policies that maintain both low inflation and a real exchange rate near equilibrium, and effective supervision that limits systemic risks from the banking sector, are all factors that will substantially reduce the probability of a crisis.
Jeanne, O., and R. Rancière, 2011, “The Optimal Level of International Reserves For Emerging Market Countries: A New Formula and Some Applications,” The Economic Journal, Vol. 121, pp. 905–30.
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Prepared by Mehdi Raissi.
See IMF (2011), Assessing Reserve Adequacy, http://www.imf.org/external/np/pp/eng/2011/021411b.pdf