Optimal Precautionary Reserves for Low-Income Countries: A Cost-Benefit Analysis
IMF Working Papers, October 1, 2011
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Bibliographic details
- Authors: Era Dabla-Norris, Jun I Kim, Kazuko Shirono
- Published: October 1, 2011
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781463923280.001
Summary
- Develops a cost-benefit approach to quantify the optimal level of international reserves in low-income countries (LICs).
- Focuses on the role of reserves in preventing and mitigating absorption drops triggered by large external shocks.
- Approach applied to a sample of 49 LICs over the period 1980-2008 to yield estimates of the likelihood and severity of a crisis.
- Calibration results suggest that the standard metric of three months of imports is inadequate for countries with fixed exchange rate regimes.
- Results highlight the role of overall policy frameworks and availability of Fund-support in determining optimal reserve levels, questioning the uniform applicability of standard rules of thumb across countries.
Methodology and Calibration
- Cost-benefit framework that evaluates reserves insofar as they prevent and mitigate absorption drops from large external shocks.
- Empirical calibration applied to a cross-country sample:
- Sample size: 49 LICs
- Sample period: 1980-2008
- Uses estimates of the likelihood and severity of a crisis derived from the calibration exercise.
Key Findings and Statistics
- The standard metric of three months of imports is found to be inadequate for countries with fixed exchange rate regimes.
- Overall policy frameworks and availability of Fund-support materially affect optimal reserve levels.
- Emphasizes heterogeneity across countries, casting doubt on uniform rules of thumb for reserve adequacy.
Policy Implications and Recommendations
- Reserve adequacy assessments for LICs should account for exchange rate regime, particularly fixed exchange rate regimes where standard metrics may be insufficient.
- Policymakers should consider country-specific overall policy frameworks when setting precautionary reserve targets.
- Availability of Fund-support should be incorporated into optimal reserve calculations rather than assuming uniform applicability of simple benchmarks.