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Optimal Precautionary Reserves for Low-Income Countries; A Cost-Benefit Analysis

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Listed author(s):
  • Era Dabla-Norris
  • Jun I Kim
  • Kazuko Shirono
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    Abstract

    This paper develops a cost-benefit approach that helps to quantify the optimal level of international reserves in low-income countries, focusing on the role of reserves in preventing and mitigating absorption drops triggered by large external shocks. The approach is applied to a sample of 49 LICs over the period 1980-2008 to yield estimates of the likelihood and severity of a crisis. The calibration results suggest that the standard metric of three months of imports is inadequate for countries with fixed exchange rate regimes. The results also highlight the role of overall policy frameworks and availability of Fund-support in determining optimal reserve levels, raising questions about the uniform applicability of standard rules of thumb across countries.

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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 11/249.

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    Length: 35
    Date of creation: 01 Oct 2011
    Handle: RePEc:imf:imfwpa:11/249
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    Keywords: Foreign exchange; Reserve adequacy; optimal level of reserves; low-income countries; exchange rate; exchange rate regime; exchange rate regimes; external shocks; commodity exporters; Macroeconomic Analyses of Economic Development;

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    1. Durdu, Ceyhun Bora & Mendoza, Enrique G. & Terrones, Marco E., 2009. "Precautionary demand for foreign assets in Sudden Stop economies: An assessment of the New Mercantilism," Journal of Development Economics, Elsevier, vol. 89(2), pages 194-209, July.
    2. Joshua Aizenman & Jaewoo Lee, 2008. "Financial versus Monetary Mercantilism: Long-run View of Large International Reserves Hoarding," The World Economy, Wiley Blackwell, vol. 31(5), pages 593-611, 05.
    3. Fabian Valencia, 2010. "Precautionary Reserves; An Application to Bolivia," IMF Working Papers 10/54, International Monetary Fund.
    4. Francesco Caselli & James Feyrer, 2007. "The Marginal Product of Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 122(2), pages 535-568.
    5. Norman V. Loayza & Romain Rancière & Luis Servén & Jaume Ventura, 2007. "Macroeconomic Volatility and Welfare in Developing Countries: An Introduction," World Bank Economic Review, World Bank Group, vol. 21(3), pages 343-357, October.
    6. Aizenman, Joshua & Marion, Nancy, 2003. "The high demand for international reserves in the Far East: What is going on?," Journal of the Japanese and International Economies, Elsevier, vol. 17(3), pages 370-400, September.
    7. International Monetary Fund, 2008. "Foreign Reserve Adequacy in Sub-Saharan Africa," IMF Working Papers 08/150, International Monetary Fund.
    8. Broda, Christian, 2004. "Terms of trade and exchange rate regimes in developing countries," Journal of International Economics, Elsevier, vol. 63(1), pages 31-58, May.
    9. David Hauner, 2006. "A Fiscal Price Tag for International Reserves," International Finance, Wiley Blackwell, vol. 9(2), pages 169-195, 08.
    10. Regis Barnichon, 2009. "The Optimal Level of Reserves for Low-Income Countries: Self-Insurance against External Shocks," IMF Staff Papers, Palgrave Macmillan, vol. 56(4), pages 852-875, November.
    11. Romain Ranciere & Olivier D Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries; Formulas and Applications," IMF Working Papers 06/229, International Monetary Fund.
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    Cited by:

    1. Dabla-Norris, Era & Bal Gündüz, Yasemin, 2014. "Exogenous Shocks and Growth Crises in Low-Income Countries: A Vulnerability Index," World Development, Elsevier, vol. 59(C), pages 360-378.

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