Jaewoo Lee

The ongoing integration of the international capital market has been accompanied by a new breed of capital account-driven financial crises and a subsequent rise in international reserve holdings by several emerging market economies. This article summarizes recent IMF research that sheds light on the role of international reserves in an era of increasing capital mobility.

International reserves are at the core of the IMF work: the change in international reserves over time reflects the net flow in the balance of payments, and a minimum level of net international reserves is an important element of IMF conditionality. Measurement of international reserves needs to be kept current and relevant, especially in light of the globalization of financial markets and the development of new financial instruments. The IMF’s most recent guidelines on how to measure reserves are summarized by Kester (2000). Two core criteria for classifying external assets as reserves are to be “readily available to” and “controlled by” the monetary authorities.

The new guidelines also seek to ensure that statistics on international reserves—deemed critical for preventing financial crisis—are transparent in the face of a plethora of financial derivatives and off-balance-sheet activities.

Measured properly, what long-term trend have international reserves been exhibiting? The answer, according to Flood and Marion (2002), is a steady increase. In percent of world GDP, international reserves increased threefold between the early 1960s and the late 1990s. While greater financial volatility over the last decade may have contributed to this upward trend, econometric estimates by Flood and Marion show that buffer-stock models explain only a small portion of reserves volatility during the Bretton Woods as well as the floating exchange rate period.

Taking a more eclectic approach, Edison (2003) uncovers several variables that are closely correlated with international reserves in a cross section of countries. Over the 1980s and 1990s, international reserve holdings of individual countries were positively associated with economic size (both income and population) and current account vulnerability (measured by the ratio of imports to GDP), and negatively associated with exchange rate volatility. Going beyond reduced-form correlations, Hviding, Nowak, and Ricci (forthcoming) find that a higher level of reserves contributes to lowering exchange rate volatility—through a signaling channel—even after controlling for differences in exchange rate regimes.

Indeed, a key reason for holding international reserves has been to stabilize the exchange rate through intervention in the foreign exchange market. Canales-Kriljenko and others (2003a, 2003b) examine current practices of official intervention and distill several lessons that may help conduct daily intervention operations under flexible exchange rate regimes. Turning to an econometric study of the real exchange rate changes in both advanced and emerging market economies, Dutta and Leon (2002) confirm that intervention remains an often-used policy tool of central banks.

Notwithstanding the prevalence of sterilized intervention—use of reserves exclusively for exchange rate management, without affecting the overall conduct of monetary policy—little theoretical support has existed for its efficacy. Kumhof and Van Nieuwerburgh (2002) contribute to narrowing this gap, by proving the effectiveness of sterilized intervention in a model where fiscal non-neutrality results in imperfect substitutability between domestic and foreign bonds. In a different vein, Black, Christofides, and Mourmouras (2001) develop a model of currency substitution in which the authorities accumulate reserves to meet precautionary demand for foreign currency, which is triggered by concerns about convertibility of domestic currency.

The financial market-driven crises of the 1990s have reemphasized the importance of an additional rationale for holding international reserves. For emerging markets confronted by volatile financial flows, maintaining a high level of reserves may be viewed as an act of self-protection, and appropriate operational guidelines have been considered in several IMF studies. Mulder (2000) endorses the short-term external debt as the first pass at the appropriate benchmark for reserves to be held by emerging markets, and Bussière and Mulder (2001) recommend factoring in the current account deficit and corporate debt as well. Wijnholds and Kapteyn (2001) suggest further enhancements to the recommended level of reserves that allow for the possibility of domestically driven capital outflow.

Lending analytical support to these policy guidelines, Detragiache and Spilimbergo (2001) find that reserves reduce the likelihood of crisis, after accounting for the endogeneity involved in the level of short-term debts. While affirming the importance of liquidity measures—including reserves—in predicting crisis, they call for further analysis of the causal link between short-term debt and the probability of crisis. Disyatat (2001) shows that higher reserves enable a government to defend a currency under attack at smaller costs—thereby reducing the likelihood of crisis—because the government’s financing cost otherwise usually increases with the market pressure against the currency.

Looking forward, stockpiling reserves need not be the most efficient preventive measure. Using a simple model of the insurance value of reserves, Lee (forthcoming) quantifies the extent to which emerging market economies appear to hold reserves in excess of the near-optimal level held by advanced economies—an excess that is attributed to the absence of cost-effective insurance arrangements. In an analysis of the IMF as a means of coinsurance, Chami, Sharma, and Shim (forthcoming) propose contractual arrangements that address the dual objective of safeguarding IMF resources and enhancing the welfare of the borrower. The authors show that the precommitted loan contracts create the right incentives for borrowers, but that precornmitment creates a new problem of time inconsistency.

In addition to research on the level of reserves, the composition and management of reserves have also been extensively examined. Comparing the 1990s with the previous decades, Eichengreen and Mathieson (2000) find a remarkable stability in the relationship between the currency composition of international reserves and its key determinants, that is, trade flows, financial flows, and currency pegs. Williams, Polius, and Hazel (2001) analyze the experience of pooling reserves, including factors that enhanced the benefit of pooling, among countries in the Eastern Carribean Currency Union and the CFA Franc Zone. Clark and Polak (2004) reconsider the role of the SDR, which was first created as the solution to the likely shortage of international liquidity. The need for the SDR has weakened substantially as the joint supply of reserve currencies—dollar, euro, yen, and pound—has become fully elastic. However, the authors concur with the argument that SDR allocation can be a costless way to meet the demand for international reserves.