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Optimal Foreign Reserves: The Case of Croatia

  • Ana Maria Ceh

    (Croatian National Bank, Zagreb, Croatia)

  • Ivo Krznar

    (Croatian National Bank, Zagreb, Croatia)

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    This paper develops a simple model of precautionary foreign reserves in a dollarized economy subject to a sudden stop shock that occurs concurrently with a bank run. By including specific features of the Croatian economy in our model we extend the framework of Goncalves (2007). An analytical expression of optimal reserves is derived and calibrated for Croatia in order to evaluate the adequacy of the Croatian National Bank foreign reserves. We show that the precautionary demand for reserves is consistent with the trend of the strong accumulation of foreign reserves over the last ten years. Whether this trend has been too strong or whether the actual reserves are lower than the optimal reserves depends on the possible reaction of the parent banks during a crisis. We show that for plausible values of parameters, the Croatian National Bank has enough reserves to fight a possible crisis of the magnitude of the 1998/1999 sudden stop with a banking crisis episode. This result holds regardless of the parent banks’ reaction. We also show how use of the two standard indicators of “optimal” reserves, the Greenspan-Guidotti and the 3-months-of-imports rules, might lead to an unrealistic assessment of foreign reserves optimality in the case of Croatia.

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    Article provided by Institute of Public Finance in its journal Financial Theory and Practice.

    Volume (Year): 32 (2008)
    Issue (Month): 4 ()
    Pages: 421-460

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    Handle: RePEc:ipf:finteo:v:32:y:2008:i:4:p:421-460
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    1. Jeanne, Olivier & Rancière, Romain, 2008. "The Optimal Level of International Reserves For Emerging Market Countries: A New Formula and Some Applications," CEPR Discussion Papers 6723, C.E.P.R. Discussion Papers.
    2. Joshua Aizenman & Jaewoo Lee, 2005. "International reserves: precautionary versus mercantilist views, theory and evidence," Proceedings, Federal Reserve Bank of San Francisco.
    3. Ricardo J. Caballero G. & Stavros Panageas, 2005. "Contingent Reserves Management: an Applied Framework," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 8(2), pages 45-56, August.
    4. Marco E. Terrones & Enrique G. Mendoza & Ceyhun Bora Durdu, 2008. "Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Mercantilism," 2008 Meeting Papers 56, Society for Economic Dynamics.
    5. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries; Formulas and Applications," IMF Working Papers 06/229, International Monetary Fund.
    6. Robert P. Flood & Nancy P. Marion, 2002. "Holding International Reserves in an Era of High Capital Mobility," IMF Working Papers 02/62, International Monetary Fund.
    7. Frenkel, Jacob A & Jovanovic, Boyan, 1981. "Optimal International Reserves: A Stochastic Framework," Economic Journal, Royal Economic Society, vol. 91(362), pages 507-14, June.
    8. Olivier Jeanne, 2007. "International Reserves in Emerging Market Countries: Too Much of a Good Thing?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 38(1), pages 1-80.
    9. Maurice Obstfeld & Jay C. Shambaugh & Alan M. Taylor, 2010. "Financial Stability, the Trilemma, and International Reserves," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(2), pages 57-94, April.
    10. Fernando M. Gonçalves, 2007. "The Optimal Level of Foreign Reserves in Financially Dollarized Economies; The Case of Uruguay," IMF Working Papers 07/265, International Monetary Fund.
    11. Ralph De Haas & Iman Van Lelyveld, 2008. "Internal capital markets and lending by multinational bank subsidiaries," Working Papers 105, European Bank for Reconstruction and Development, Office of the Chief Economist.
    12. Sándor Gardó & Antje Hildebrandt & Zoltan Walko, 2008. "Walking the Tightrope: A First Glance on the Impact of the Recent Global Financial Market Turbulence on Central, Eastern and Southeastern Europe," Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank), issue 15, pages 119-140.
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