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

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  • 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
    Date of revision:
    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. Fabian Valencia, 2010. "Precautionary Reserves; An Application to Bolivia," IMF Working Papers 10/54, International Monetary Fund.
    2. Ceyhun Bora Durdu & Enrique G. Mendoza & Marco E. Terrones, 2007. "Precautionary demand for foreign assets in sudden stop economies: an assessment of the new mercantilism," International Finance Discussion Papers 911, Board of Governors of the Federal Reserve System (U.S.).
    3. Francesco Caselli & James Feyrer, 2005. "The Marginal Product of Capital," NBER Working Papers 11551, National Bureau of Economic Research, Inc.
    4. Joshua Aizenman & Nancy Marion, 2002. "The high demand for international reserves in the Far East: what's going on?," Pacific Basin Working Paper Series 2002-08, Federal Reserve Bank of San Francisco.
    5. Aizenman, Joshua & Lee, Jaewoo, 2007. "Financial versus Monetary Mercantilism-Long-run View of Large International Reserves Hoarding," Santa Cruz Department of Economics, Working Paper Series qt5r95t1xf, Department of Economics, UC Santa Cruz.
    6. David Hauner, 2006. "A Fiscal Price Tag for International Reserves," International Finance, Wiley Blackwell, vol. 9(2), pages 169-195, 08.
    7. Norman V. Loayza & Romain Rancière & Luis Servén & Jaume Ventura, 2007. "Macroeconomic Volatility and Welfare in Developing Countries: an Introduction," Post-Print halshs-00754201, HAL.
    8. Drummond, Paulo & Dhasmana, Anubha, 2008. "Foreign Reserve Adequacy in Sub-Saharan Africa," MPRA Paper 9729, University Library of Munich, Germany.
    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 D Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries; Formulas and Applications," IMF Working Papers 06/229, International Monetary Fund.
    11. 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.
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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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