Credit malija/iStock by Getty Images
Credit malija/iStock by Getty Images
Credit malija/iStock by Getty Images
Credit malija/iStock by Getty Images
Participants at Saudi Arabia’s Al-Ula conference in February rightly lauded emerging market economies’ impressive resilience since the global financial crisis, thanks in part to improved macroeconomic frameworks. Yet the global environment is increasingly fragmented and was challenging even before the recent escalation in the Middle East. It is important for emerging market and developing economies to strengthen their resilience still further, including by building adequate levels of foreign exchange reserves. Doing so requires efforts to overcome domestic resistance to reserve accumulation. These can be supported by new cooperative solutions to help countries better build these buffers.
A common characteristic of crisis-prone countries is the low level of reserves. Just like households, countries need access to adequate liquid resources, which can be sold quickly to help manage unexpected shocks. Countries with very low reserves are seen as especially risky and have few options if markets turn against them, as in Aesop’s fable of the grasshopper that sang and danced in summer as the ant stored food for winter.
The importance of reserves transcends the choice of exchange rate regime. Countries with fixed exchange rates tend to require more reserves to back their currencies, but reserves are also critical for countries with more flexible exchange rates. They help to contain excessive currency volatility and the associated macroeconomic costs.
Sound policies and consensus building
While official reserve holdings have increased considerably over the past 25 years, they remain highly concentrated. A few countries have accumulated vast amounts of reserves—sometimes in excess of measurable needs to insure against external shocks. The issue for these countries is having too many reserves, not too few.
But for many other economies, especially low-income ones, the different layers of the global financial safety net—which include access to IMF resources, bilateral or regional swap lines, as well as countries’ own official reserves—remain insufficient to manage severe shocks. Higher reserves levels would help these countries become more resilient, according to the IMF’s reserve adequacy metric.
Yet despite well-known benefits such as greater insurance and lower funding costs, countries with low reserves sometimes struggle to make the necessary policy adjustments. This often reflects political-economy considerations, such as when the pressure to achieve short-term political gains leads authorities to postpone desirable policy adjustments and deplete reserves.
Countries that managed to break these political-economy constraints and turn the page on instability have been those that succeeded in building consensus on basic macroeconomic principles of fiscal and external discipline.
The process of building reserves takes time and is most effective when done organically rather than by short-term foreign-exchange borrowing from private or official creditors. Successful stabilization programs of the late 1980s and early 1990s show that there is no shortcut. Reserves must be purchased over sustained periods.
In most cases, reserve accumulation is initially supported by fiscal and current account surpluses, with net private capital inflows playing a greater role as the stabilization process becomes entrenched. In fact, countries that relied too heavily on volatile financial flows and insufficient exchange rate flexibility (often with an overly appreciated exchange rate) terminated their stabilization programs abruptly once capital flows stopped and reversed. In the end, balance of payments sustainability depends on whether countries can run sufficiently large trade surpluses to cover dividends and interest payments on external private and public liabilities while simultaneously building or maintaining an adequate level of reserves.
The high-price hurdle
Yet reserves are also expensive. Because safety and liquidity come at a premium, reserve assets offer typically a much lower return than those from alternative uses of those resources. This high opportunity cost—the price of self-insurance—discourages reserve accumulation. Reserve accumulation can also stoke inflation if not sterilized.
While countries must do their part, we should also explore ways to reduce the cost of building reserve buffers globally. Increasing the menu of suitable investment options for central banks would lower the cost of reserve accumulation and encourage countries to build adequate reserve buffers.
An increase in the supply of dollar reserve assets could, for instance, be achieved by expanding the menu of certified reserve assets to carefully selected portfolios comprising longer-term dollar bonds as well as other dollar assets, in addition to short-term US Treasuries. Investing such dollar reserves through a common fund would reduce transaction costs while preserving liquidity. The benefits for reserve-holding countries can be large, potentially adding substantially to the annual return on dollar reserve assets, for similar levels of risk. This would make adequate reserve accumulation a much more attractive proposition.
No shortcuts
Just as it is important for governments to invest in productivity-enhancing infrastructure, health and education, it is critical that they invest in macroeconomic stability—building sufficient buffers—and in the institutions to support it. This process is often long and arduous. It requires patience and avoiding shortcuts or overreliance on financial engineering. Fortunately, many emerging and developing economies have strengthened their economies by appropriately balancing policy objectives—inflation, external stability, sustained growth—and building societal consensus around basic principles grounded on sound economic discipline.
These efforts should be supported globally by making it easier, not harder, for countries to accumulate reserves in a sustainable way. To do so, we should explore channels where countries can work together to reduce the cost of self-insurance.
