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Foreign exchange reserve adequacy and exogenous shocks

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  • Winston Moore
  • Adrian Glean

Abstract

One of the traditional benchmarks in international macroeconomics is that a country should maintain reserves that can cover at least 12 weeks of imports. The notion of reserve adequacy, however, is not static and is intimately associated with the occurrence of financial crises as well as exogenous shocks, with many observers using the reduction in reserves below this benchmark as a sign of fragility. This article provides a benefit-cost type approach to evaluating reserve adequacy. The benefits of holding reserves are evaluated using a dynamic random effects probit model of financial crises while the cost of reserve holdings (output loss due to an over-investment in reserves) is obtained from a panel growth equation. Using the methodology outlined above, the study finds that in small states, the optimal holding of foreign exchange reserves is approximately 25 weeks of imports, approximately 13 weeks higher than the international rule-of-thumb. This estimate of optimal reserve holdings is interrelated with the economic characteristics of the country, particularly its fiscal stance. Indeed, this article finds that countries with a prudent public expenditure management framework in place are able to hold a smaller stock of reserves without necessarily impacting the expected growth for the country.

Suggested Citation

  • Winston Moore & Adrian Glean, 2016. "Foreign exchange reserve adequacy and exogenous shocks," Applied Economics, Taylor & Francis Journals, vol. 48(6), pages 490-501, February.
  • Handle: RePEc:taf:applec:v:48:y:2016:i:6:p:490-501
    DOI: 10.1080/00036846.2015.1083085
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    File URL: http://hdl.handle.net/10.1080/00036846.2015.1083085
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    References listed on IDEAS

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    1. Guillermo Calvo & Alejandro Izquierdo & Rudy Loo-Kung, 2013. "Optimal Holdings of International Reserves: Self-insurance against Sudden Stops," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(1), pages 1-35, January-j.
    2. Wendell A. Samuel & Emilio Pineda & Mario Dehesa, 2009. "Optimal Reserves in the Eastern Caribbean Currency Union," IMF Working Papers 09/77, International Monetary Fund.
    3. Era Dabla-Norris & Jun I Kim & Kazuko Shirono, 2011. "Optimal Precautionary Reserves for Low-Income Countries; A Cost-Benefit Analysis," IMF Working Papers 11/249, International Monetary Fund.
    4. RĂ©gis Barnichon, 2008. "International Reserves and Self-Insurance against External Shocks," IMF Working Papers 08/149, International Monetary Fund.
    5. Roland Craigwell & Kevin Greenidge & Harold Codrington & Rupert D Worrell, 2003. "Economic Resilience with An Exchange Rate Peg; The Barbados Experience, 1985-2000," IMF Working Papers 03/168, International Monetary Fund.
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