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

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  • Era Dabla-Norris
  • Jun Il 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
    Date of revision:
    Handle: RePEc:imf:imfwpa:11/249
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    Keywords: Economic models; External shocks; Low-income developing countries; Reserves adequacy; exchange rate; exchange rate regime; exchange rate regimes; commodity exporters; reserve holdings; fixed exchange rate; flexible exchange rate; flexible exchange rate regime; fixed exchange rate regimes; terms of trade; oil exporters; fixed exchange rate regime; trade shocks; exchange rate volatility; trade growth; short-term debt; flexible exchange rate regimes; terms-of-trade shocks; foreign exchange; exchange rate flexibility; exchange rate policy; terms of trade shocks; current account deficit; currency unions; exchange policy; world economy; de facto exchange rate regime; export growth; international trade; floating exchange rate regimes; access to market; partner country; foreign exchange policy; external funding; undervalued exchange rate; floating exchange rate; trade openness;

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    1. David Hauner, 2005. "A Fiscal Price Tag for International Reserves," IMF Working Papers 05/81, International Monetary Fund.
    2. 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.
    3. Enrique G. Mendoza & Ceyhun Bora Durdu & Marco Terrones, 2007. "Precautionary Demand for Foreign Assets in Sudden Stop Economies; An Assessment of the New Merchantilism," IMF Working Papers 07/146, International Monetary Fund.
    4. 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.
    5. 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.
    6. Francesco Caselli & James Feyrer, 2005. "The Marginal Product of Capital," NBER Working Papers 11551, National Bureau of Economic Research, Inc.
    7. Drummond, Paulo & Dhasmana, Anubha, 2008. "Foreign Reserve Adequacy in Sub-Saharan Africa," MPRA Paper 9729, University Library of Munich, Germany.
    8. Fabian Valencia, 2010. "Precautionary Reserves; An Application to Bolivia," IMF Working Papers 10/54, International Monetary Fund.
    9. 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.
    10. 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.
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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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