Optimal foreign exchange reserves in small open economies: the case of the Caribbean

The amount of external reserves that countries view as optimal generally differs across countries and over time. The vulnerability of small open economies to a range of international shocks and structural weaknesses implies that they are more exposed to capital flight and therefore need more international reserves relative to larger more resilient economies. The amount of reserves deemed optimal for small open economies is ultimately a function of the probability of and the way in which they respond to domestic and external shocks, their access to and cost of alternative sources of international liquidity, the relative costs of international reserves, the risk preference of the local authorities and idiosyncratic factors which are often difficult to measure. In this context, this chapter seeks to determine the optimal level of reserves for select small open economies in the Caribbean using a cost-benefit approach for the period 1990 to 2019. The study focuses on the structural features of these economies, such as their low international competitiveness, high exposure to natural disasters, dependence on international commodity cycles and high levels of indebtedness which drive their relative need for international liquidity and insurance that international reserves provide. The study finds that only a few Caribbean countries have consistently had reserve levels at or above the optimal level for the region, suggesting the need for more reserves as well as greater efforts to deal with structural weaknesses.