This paper was prepared by cross-departmental teams led by James Roaf (SPR) and Era Dabla-Norris (LICs analysis, SPR) and comprising Jukka Pihlman, Yinqiu Lu (MCM), Rex Ghosh, Jun Il Kim, Charalambos Tsangarides (RES), Manuela Goretti, Kai Guo, Mustafa Jamal, Bikas Joshi, Nathan Porter, Manrique Saenz, Ferhan Salman and Kazuko Shirono (SPR), with additional contributions from Valerio Crispolti, George Tsibouris (AFR), Charles Amo-Yartey (WHD), Joonkyu Park, Han van der Hoorn (MCM), Suman Basu, Jaewoo Lee (RES), Trung Bui, Gavin Gray, and Hitoshi Sasaki (SPR), under the guidance of Udaibir Das (MCM), Jonathan D. Ostry (RES), Hugh Bredenkamp and Ranjit Teja (SPR). Analytical work in the paper has benefitted from discussion with Joshua Aizenman, Olivier Jeanne, and Eduardo Levy-Yeyati during an academic seminar in October, 2010, and from feedback from participants in the Third IMF Roundtable of Sovereign Asset and Reserves Managers in January, 2011.
On these issues, see SM/10/116 (5/7/2010) and SM/10/86 (4/13/2010).
For further on these issues, see Becker et al., 2007, “Country Insurance: The Role of Domestic Policies,” Occasional Paper No. 254 (Washington, DC: International Monetary Fund).
A survey of reserve managers from a range of EMs, LICs, and AMs was conducted in late 2010. Twenty seven submissions were received, a response rate of 53 percent.
See SM/00/65 for a comprehensive discussion of many of these metrics.
See e.g., Pringle, Robert and Nick Carver, 2007, “Trends in Reserve Management—2007 Survey Results,” in RBS Reserve Management Trends 2007, ed. by Robert Pringle and Nick Carver (London: Central Banking Publications). Borio, Claudio, Gabriele Galati, and Alexandra Heath, 2008, “FX Reserve Management: Trends and Challenges,” BIS Papers, No 40.
See work by Rodrik (2006), Edwards (1985), Lee (2004), Garcia and Soto (2004), Wijnholds and Kapteyn (2001), Hauner (2005) and Jeanne and Rancière (2005) for use of alternative definitions of sovereign spreads as a measure of the cost of holding reserves.
Jeanne and Rancière (2009) exclude the default risk premium from their costs analysis. However, the country’s probability of default is separately included in the calibration of their cost-benefit framework.
For a more comprehensive discussion, see Pihlman and van der Hoorn (2010): they estimate that reserve managers pulled out roughly US$500 billion of deposits from the banking sector between December 2007 and March 2009.
Another way to look at this is that the original “three months of imports” rule is aimed at protecting against the symptoms of balance of payments problems, whereas subsequent metrics have all been aimed at the potential sources of the problems.
While data on resident deposits would have been a preferable proxy, since non-resident deposits are included in the other liability measures, availability of such data only for a very limited set of countries and years necessitate the use of broad money instead. Nonetheless, available data suggest that the extent of such double counting is small, with broad money predominately domestic local currency deposits. The estimated loss is calculated removing valuation effects resulting from exchange rate changes during the crisis.
This point is highlighted by the Russian experience summarized in the chart above, where heavy reserves losses in late 2008 appear to have been in large part associated with speculation against the ruble following the collapse in oil prices. A possible lesson from this and similar episodes is that rather than relying solely on reserves, countries highly dependent on volatile commodity prices should focus on ensuring strong policy frameworks and economic flexibility so as to be able to allow the nominal exchange rate to bear the brunt of the adjustment.
As with bank risk capital weighting, potential correlations between risks are not taken into account, implying a more conservative approach than if it were assumed, say, that an export shock was unlikely to coincide with an episode of capital flight. Lack of data preclude estimating such correlations, but in any case it is not clear that correlations should affect the relative risk coefficients, rather than entering as part of the assessment of reserves need against the metric in the second stage. And the study of individual crisis episodes above certainly suggests a range of balance of payments drains can occur at the same time.
Following Eichengreen and others (1997), the exchange market pressure index is a weighted average of reserves loss, exchange rate depreciation, and increases in the interest rate, with deviations from the average of more than 1.5 times its standard deviation considered a period of significant pressure.
The short-term debt metric is not reported because of the poor quality of short-term external debt data in a large number of LICs. For LICs with reliable short-term debt data, reserve holdings were found to be significantly above the rule of thumb, reflecting their limited market access and reliance on concessional longer-term financing from official sources.
This is based on an event study analysis of external shocks over 1980-2007. A shock event was identified when the annual percentage change in the shock variable (terms of trade, external demand, FDI/GDP, aid/GDP) fell below the bottom 10th percentile of the country-specific distribution.
There is a marked difference in real absorption growth between the crisis and non-crisis samples (of over 8 percentage points).
A large number of candidate variables were considered, including the degree of financial development, inflation, and trade openness, but were found to be statistically insignificant.
Lack of sufficient observations on remittances preclude inclusion in the regression. Other explanatory variables, including a dummy for access to Fund support were also considered, but were found to be statistically insignificant.
These are based on existing estimates of the marginal product of capital, which is an important measure for LICs given their large investment needs, as well as the differential between domestic and foreign real interest rates. Caselli and Freyer (2007) calculate a range of 3 to 8 percent for the marginal product of capital in LICs.
Assuming risk-neutral utility may appear at odds with the precautionary motive for holding reserves. But precautionary reserves holdings are not equivalent to precautionary savings which would not arise under risk-neutral utility. In the analysis, the precautionary motive for holding reserves refers to an incentive to guard against the inability to finance tail shocks due to limited and uncertain market access.
The categorization of fragile states relies on definitions of “fragility” adopted by the World Bank.
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