Front Matter Page

INTERNATIONAL MONETARY FUND

Country Insurance: The Role of Domestic Policies

Prepared by the Research Department

Approved by Raghuram G. Rajan

June 19, 2006

Contents

• Executive Summary

• I. Introduction

• II. Insurance Against What? Shocks and Their Costs

• III. Sound Fundamentals and Liability Structure

  • A. The External Capital Structure of Countries

  • B. Public Debt Management and Debt Structure

• IV. Self-Insurance through International Reserves

  • A. Trends in Reserve Accumulation, and Benefits and Costs of Reserve Holdings

  • B. A Framework for Assessing the Optimal Level of Reserves

  • C. Trends in Optimal Reserves for Country Groups

• V. Conclusion

• References

• Boxes

• 1. The Asian Bond Funds

• 2. Argentina’s GDP-Linked Securities

• 3. State-Contingent Reserves Based on the VIX

• Tables

• 1. Output Events: Frequency, Duration and Loss, 1970-2001

• 2. Frequencies and Costs of Shocks

• 3. The Cost of Reserves in Emerging Market Countries, 2001-05

• 4. Changes in Fundamentals and Optimal Reserves, Simulations for Emerging Markets

• 5 Types of Insurance and Crisis-Prevention Measures

• 6. Economies by Group

• 7. Financial Account and its Sub-Components, 1970-2003

• 8. Calibration Parameters

• 9. Probit Estimation of the Probability of a Sudden Stop

• Figures

• 1. A “Concluded” Output Event

• 2. Expected Cost of Shocks

• 3. Composition of Financial Flows Around All Sudden Stops, 1980-2004

• 4. Central Government Domestic Debt Composition, Emerging Markets, 1980-2004

• 5. Share of Long-Term and Medium-Term Fixed Rate Domestic Currency Debt, Emerging Economies, 1990-2003

• 6. International Reserves by Country Group, 1990-2005

• 7. International Reserve Ratios by Country Group, 1990-2005

• 8. Reserves as a Share of GDP in Asia and Latin America, 1980-2003

• 9. Optimal Level of Reserves as a Function of Various Factors

• Annexes

• I. Annex to Section II: Data Sources and Definitions

• II. Annex to Section III: Behavior of Different Types of Financial Flow

• III. Annex to Section IV: A Model of Optimal Reserves

Executive Summary

Member countries are routinely faced with a range of shocks that can contribute to higher volatility in aggregate output and, in extreme cases, to economic crises. The presence of such risks underlies a potential demand for mechanisms to soften the blow from adverse economic shocks—”country insurance” for short. Protective measures that countries can take themselves (“self-insurance”) include sound economic policies, robust financial structures, and adequate reserve coverage. Beyond self insurance, countries have also established regional arrangements that pool risks, while at the multilateral level the IMF has a central role in making its resources temporarily available to attenuate the costs of economic adjustment when shocks create balance of payments difficulties for a member. This paper analyzes a number of mechanisms through which countries can self-insure, leaving the role of collective regional and multilateral arrangements to subsequent papers.

The paper begins with an analysis of the nature of the shocks that countries face. An understanding of which shocks are relatively frequent and costly—and for which members—is essential to be able to tailor insurance solutions appropriately. Output drops are found to be associated primarily with real shocks (notably terms of trade declines) in developing countries, while financial shocks (such as “sudden stops”) appear to play a lead role in emerging market countries. While relatively infrequent over the entire sample, wars and episodes of political turmoil are found to be extremely costly when they occur, particularly for developing countries.

Following the analysis of shocks, the paper considers some of the actions that member countries can take to self insure. Sound policies and supporting institutions have direct benefits as countries’ first line of defense against the adverse effects of external shocks; they may also facilitate the issuance of long-term, domestic currency debt, and may foster increases in the share of equity-like liabilities in countries’ balance sheets. This may reduce vulnerability and facilitate international risk sharing of the cost of crises. Underutilized financial instruments may also have a useful role to play in providing country insurance. Relevant examples include: catastrophe bonds for smaller, disaster-prone countries; instruments aimed at hedging against commodity price fluctuations for countries with heavily concentrated production structures; and GDP growth-indexed bonds for a broader segment of the IMF membership.

Turning to the asset side of country balance sheets, the paper develops an analytical framework to help guide judgments about the desirable level of self-insurance through reserves. In the framework, the consumption-smoothing benefits of reserves are traded off against the financial costs of holding them. The results suggest that, while reserve accumulation observed in Asian emerging markets since the early 1990s was initially commensurate with the increasing needs for insurance, more recently it seems to have been in excess of what could be justified on the basis of plausible changes in fundamentals; and, although Latin American emerging markets seemed to be underinsured in the early 1990s, their reserves are now assessed as providing a broadly appropriate degree of self-insurance given the fundamentals faced by this region.