WP/11/144 International Reserve Adequacy in Central America Kristin Magnusson Bernard © 2011 International Monetary Fund WP/11/144 IMF Working Paper Western Hemisphere Department International Reserve Adequacy in Central America Prepared by Kristin Magnusson Bernard1 Authorized for distribution by David Vegara June 2011 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Countries’ absolute and relative international reserves adequacy has recently attracted considerable attention. The analysis has however concentrated on the largest and most advanced economies. We apply various methodologies for assessing reserve adequacy in Central America, taking into account the region’s high degree of deposit dollarization. We find that reserve cover is low both in an absolute and relative sense, suggesting further reserve accumulation is an important policy option for reducing vulnerabilities. JEL Classification Numbers: F31, F32, F37, F41 Keywords: Foreign reserves, balance of payments crises, financial dollarization Author’s E-Mail Address: [email protected] 1 This paper greatly benefited from discussions with Luis Cubeddu, Rodolfo Luzio, Ola Melander, Marco Piñon, Miguel Savastano, seminar participants at the International Monetary Fund as well as the IMF Central American country teams. Alejandro Carrion-Menendez provided excellent research assistance. We are grateful to Bikas Joshi for giving us access to his panel data set used in the reserve demand regressions. 2 Contents .............................................................. Page I. Introduction ............................................................................................................................ 3  II. Rules-of-Thumb for Reserve Cover ..................................................................................... 4  III. Reserve Demand Regressions ............................................................................................. 6  IV. Models of Optimal Reserves ............................................................................................... 8  A. Parameters ................................................................................................................... 11  B. Results ......................................................................................................................... 12  C. Sensitivity analysis ...................................................................................................... 14  V. Concluding Remarks .......................................................................................................... 16  References ............................................................................................................................... 17  Tables 1.   Reserve Demand Regressions. Dependent Variable: GIR/GDP ........................................ 8  2  Non-country Specific Model Parameters ......................................................................... 11  3.  Actual vs. Optimal Reserves (% of GDP), Time Averages 2003–08 .............................. 13  Figures 1. Optimal Versus Actual Reserve Levels ........................................................................... 14 2. Risk Aversion Parameter and Term Premium ................................................................. 15 3. Probability of a Crisis and Size of Output Loss ............................................................... 15 Appendices A1.   Data Sources .................................................................................................................... 19  A2.   Results from Reserve Demand Regressions .................................................................... 20  A3.   The Jeanne and Ranciere (2006) Model .......................................................................... 21  A4.   Optimal Reserves According to the Jeanne and Rancière (2006) Model ........................ 26 3 I. INTRODUCTION International reserve accumulation has recently grown rapidly, reaching 13 percent of global GDP in 2009, which represents a three-fold increase over ten years. During this time, emerging market holdings rose to 32 percent of GDP.2 This extensive accumulation of foreign reserves has naturally prompted questions regarding what benefits countries have from international reserves holdings, and whether current levels can be justified on economic grounds. One long-standing view of the rationale for holding international reserves is to insure against balance of payments shocks. Commonly used rules-of-thumb for reserve adequacy investigate whether international reserves cover some external commitments, e.g. three months of imports for countries with limited access to capital markets, or measures of potential capital flight, such as short-term external debt at residual maturity and current account deficits. Alternatively, the actual demand for international reserves has been studied using variants of the “buffer stock model”, treating reserves as a resource for smoothing consumption in the face of sudden stops of external credit and the output falls that often accompany it (Frenkel and Jovanovic, 1981). This strand of literature typically finds that the size of reserve holdings is positively related to income volatility, openness and financial depth (Edwards, 1983, Flood and Marion, 2002, Obstfeld et al, 2008). Previous literature has also tried to find an “optimal” level of international reserves by weighing the aforementioned benefits of international reserves for mitigating falls in domestic consumption during balance of payments crises with the costs of holding reserves, such as the interest rate differential between long-term debt issued to finance reserves and the return on reserves (Jeanne and Rancière, 2006, Gonçalves, 2007, Valencia, 2010). Using the above-mentioned frameworks, several authors have come to the conclusion that the recent reserve holdings of most emerging markets are hard to justify on economic grounds, and that other factors such as export-oriented growth strategies might be at play (Dooley et al, 2003). Recent evidence from Asia and Latin America suggests that the over-accumulation of international reserves in one country might then have prompted others to follow suit through an attempt to “keep up with the Joneses” (Cheung and Qian, 2009, Cheung and Sengupta, 2011). Most research on the international reserve coverage has so far concentrated on large emerging markets and advanced economies. This paper instead focuses on small non-dollarized economies in Central America, i.e. Costa Rica, the Dominican Republic, Honduras, Guatemala and Nicaragua.3 Our motivation to do so is two-fold. First, the aforementioned lack of studies on 2 26 percent if China is excluded. 3 El Salvador and Panama have been fully dollarized for the period we study and the notion of international reserves is hence not readily applicable to them. Belize belongs to Central America but was excluded due to its smaller size than the other economies in the sample. 4 reserve coverage for the region, and smaller emerging markets in general.4 Second, to shed light on the appropriateness of the different commonly used methods for assessing reserve adequacy for smaller and less financially integrated emerging markets than those previously studied, including the possible presence of “keeping up with the Joneses” effects. Our focus region also displays other features which makes it an interesting testing ground for assessing reserve adequacy. Compared to some of their larger and more advanced emerging market peers, the Central American economies have relatively little short-term external debt, suggesting a smaller vulnerability along that dimension. On the other hand, the share of dollar- denominated deposits to total deposits is about 45 percent on average in the region, well above the levels of dollarization in the five largest economies in Latin America and other emerging markets. This gives rise to risks of large deposit withdrawals during crises which need to be taken into account when assessing reserve adequacy, but has achieved less attention in the literature.5 The rest of the paper is organized as follows. Section II investigates international reserve coverage using traditional rules-of-thumb. Section III presents results from reserve demand regressions. Section IV contains a model of optimal reserve coverage and its predictions. Section V concludes. II. RULES-OF-THUMB FOR RESERVE COVER Central America has increased its reserve cover in recent years, though the extensions of coverage were much smaller than that of other emerging markets.6 While gross international reserves increased by over 50 percent during 2000–2008 in Central America, it jumped three-fold in the five largest Latin American economies and six-fold in a larger global sample of emerging markets, as seen from the figure to the right. In fact, the rules-of- thumb that follow suggest that Central America’s reserve cover could be strengthened further. 4 An exception is Canales-Kriljenko (2008) who uses a version of the Jeanne and Rancière model to assess optimal reserve adequacy for the Dominican Republic. 5 Gonçalves (2007) is a notable exception. 6 International reserve holdings are defined in the standard way, i.e. as the sum of gold, SDR holdings, and foreign exchange. Since our analysis does not cover 2009, the exception al SDR allocation in that year does not affect this measure. 5 Maybe the most traditional rule of thumb, 10 GIR in months of imports 2000 2008 generally used for countries with limited access 8.1 8 to capital markets, is that international reserves 7.1 should equal three months of imports. As seen 6 from the figure to the left, this level is barely reached by the Central American economies, but 4 2.7 exceeded by a wide margin both by the larger 2 economies in Latin America and the full sample of emerging markets. 0 CA-7 LA-5 Emerging markets Alternatively, the so-called Greenspan-Guidotti rule states that gross international reserves should cover short-term external debt measured on a residual maturity basis, i.e. public and private external debt maturing over the next 12 months (Greenspan, 1999). This rule is often extended to also take into account current account deficits to proxy for total external financing needs and give a more extensive picture of possible capital flight. As seen from the figure to the right, Central America falls short of the benchmark, despite their relatively modest external debt levels, and in contrast to other emerging markets. Another often used rule of thumb is to compare international reserves to the stock of broad money, usually M2. While traditionally a cover of 5–20 percent of broad money has been considered adequate, more recently e.g. Obstfeld et 45 al (2008) have argued that a sufficient “war chest” GIR in percent of Broad Money 40 38.0 should cover up to 50%. Regardless of the precise 2000 34.8 35 2008 level deemed appropriate, the figure to the left shows that Central America again are below 30 28.3 comparators in this dimension. Moreover, one 25 needs to take into account the relatively low level of 20 financial intermediation in the region; in Central 15 America, the ratio of broad money to GDP stands at roughly 40 percent, compared to an average of 10 CA-7 LA-5 Emerging markets 70 percent for the larger sample of emerging economies. Taken together, the above benchmarks suggest that Central America’s reserve cover is on the low side both in an absolute sense, and compared to emerging market peers on the Latin American continent and elsewhere. 6 III. RESERVE DEMAND REGRESSIONS While the aim of the rules-of-thumb presented in the previous section is to give a benchmark regarding the adequacy of international reserves, another angle for analyzing international reserves is to try to explain what has motivated a country to accumulate a certain stock. Indirectly, this approach can also shed light on whether the time variation in international reserve coverage can be justified on accounts of changes in e.g. macroeconomic fundamentals, or whether there is excessive accumulation or run-down of reserves during certain time periods. This strand of literature has often used variants of the “buffer-stock model” (Frenkel and Jovanovic, 1981) that considers international reserves a resource for smoothing consumption in the face of sudden stops. How much reserves a country demands naturally varies with its characteristics. Countries experiencing relatively higher income volatility over extended periods may opt for higher reserves holdings due to their larger utility from income insurance. As pointed out by Edwards, 1983, Flood and Marion, 2002, countries with fixed exchange rate regimes also need larger reserve holdings to defend the parities of their domestic currencies to the one they have pegged to. The secular move towards more exchange rate flexibility during the last decades should then ceteris paribus have resulted in lower international reserve holdings around the world, while in fact the opposite happened. One reason for reserve holdings to remain high is that de facto exchange rate flexibility could be lower than de jure measures, or that some countries classified as floaters hold international reserves to occasionally intervene in the foreign exchange market and influence their floating exchange rates. Other factors argued to matter for reserve demand more directly correspond to balance-of- payments needs. Closely linked to the Greenspan-Guidotti rule, Radelet and Sachs (1998) argued that short-term foreign-currency debt is an important source of vulnerabilities, and hence a potentially important determinant of reserve demand. Calvo (1996) first suggested that a country’s vulnerability to crisis should be measured by the size of its money supply, as it is a natural upper limit on the extent of possible asset withdrawal. Obstfeld et al (2008) further investigated the need to protect the domestic banking system and credit markets through international reserves. They argue that the rationale for holding reserves increases in more financially open economies, as risks multiply with the possible combination of currency mismatches and deposit withdrawals, both of those currently held in foreign currencies and through an increased demand for exchanging domestic deposits into hard currency. Given that domestic bond markets are often thin in emerging markets, international reserves are then argued to be one of the very few means of financing available to a government in times of crisis. Key variables for reserved demand would then be measures of financial depth and openness of the economy, which the authors investigate both in a theoretical model and an econometric analysis. Reserve demand might also stem from other motives than economic fundamentals. Peer or “Joneses” effects are meant to capture that precautionary or mercantilist hoardings by one 7 economy may induce competitive hoarding by other economies in the same region, as found by Cheung and Qian (2009). If a market is viewed as having inadequate reserve coverage compared to its peers, it might be more vulnerable to capital outflows by market participants in times of economic crisis. We follow the methodology of Obstfeld et al (2008) and investigate reserve demand in a panel of 52 emerging economies for the period 1993-2008.More specifically, we estimate the following models: (cid:1851) (cid:3404) (cid:1850)′ (cid:2009) (cid:3397)(cid:2012)(cid:1830)1 (cid:3397)(cid:2011)(cid:1830)1 (cid:1499)(cid:1836) (cid:3397) (cid:2016)(cid:1830)2 (cid:3397)(cid:2013) ,(cid:1861) (cid:3404) 1…(cid:1840);(cid:1872) (cid:3404) 1….(cid:1846) (cid:3036)(cid:3047) (cid:3036)(cid:3047) (cid:3036) (cid:3036) (cid:3036)(cid:3047)(cid:2879)(cid:2869) (cid:3036)(cid:3047) (cid:3036)(cid:3047) where i denotes economies (N = 52) and t denotes time (T=16). (cid:1851) is the reserves-to-GDP ratio (cid:3036)(cid:3047) of economy i at time t. (cid:1850)′ is the vector of economic variables used to explain reserve demand. (cid:3036)(cid:3047) (cid:1830)1 is a dummy taking on the value one for Central American countries. (cid:1830)2 takes on the value (cid:3036) (cid:3036)(cid:3047) one in years when country i experienced a crisis, defined as a reversal of the current account to GDP ratio by more than five percentage points. The presence of peer effects are investigated by defining “Joneses” variables for economy i as follows: (cid:1836) (cid:3404) (cid:3533) (cid:1851) (cid:3036)(cid:3047) (cid:3038)(cid:3047) (cid:3036)(cid:2999)(cid:3038) where (cid:1851) is the reserves to GDP ratio of economy k at time t. For smaller countries, it is (cid:3038)(cid:3047) however not clear whether “size matters” and the relevant comparators are other smaller emerging markets or the largest countries in the region. To allow for both possibilities, we sum respectively over the other small emerging markets in the region, and only the five largest economies.7 Following Cheung and Qian (2009), we lag the “Jones” variable to take into account lack of contemporaneous data on other countries’ reserve levels. In line with previous studies, we find that reserve demand is positively related to openness and GDP volatility, and negatively related to exchange rate flexibility. The largest effect on reserve demand comes from exchange rate flexibility; raising the period standard deviation of the nominal national currency/dollar exchange rate by one unit is associated with an decreased reserve/GDP ratio of about 25 percentage points. The effects of a one percentage point increase in the openness of the economy, defined as the ratio of exports and imports to GDP, or the FDI/GDP ratio have effects on the reserve to GDP ratio close to that size. Contrary to previous studies, we find no significant effect of financial depth on reserve demand. The level of total external debt as well as crisis dummies, have the expected positive sign but are not found to significantly affect reserve demand in a consistent manner, which is also in line with existing work (Obstfeld, 2008). Raising the short term debt to GDP ratio is however found to increase the reserve to GDP ratio by around three percentage points, suggesting that the 7 Brazil, Chile, Colombia, Mexico and Peru. 8 maturity structure of debt matters. The “Jones” variables have the expected positive sign, suggesting that increased reserve accumulation by peers affect country i’s reserve demand upwards. However, only the reserve levels in the large emerging markets seem to matter, in that an increase in the reserve to GDP ratio of the five largest economies in Latin America on average increases the reserve to GDP ratio of a Central American economy by half a percentage point the following year, but there is no significant effect of reserve accumulation in other Central American economies. Taken together, Central America stands out as having lower reserve ratios after controlling for the standard demand drivers in the literature, as indicated by a significant, negative coefficient of a dummy for the region that can be interpreted as the reserve-to-GDP ratio on average being about two percentage points lower in Central America, after controlling for other relevant factors. Table 1. Reserve Demand Regressions. Dependent Variable: GIR/GDP Variable Coefficient T-stat. Log (Population) -0.008* -1.97 Openness /1 0.117*** 9.82 Exchange rate flexibility/2 -0.241* -1.87 GDP volatility/3 0.101* 1.37 Central America dummy -0.024* -1.40 FDI/GDP 0.191*** 2.90 Short term debt/GDP 0.031* 1.71 Jones2*CA dummy 0.004*** 3.55 1/ Defined as (exports + imports)/GDP. 2/ Defined as the period standard deviation of the NCU/dollar exchange rate, over the period average. 3/ Defined as the period standard deviation of real GDP, over the period average. 4/ Defined as M2/GDP. ***, **, * denote results significant on the 1, 5 and 10% significance levels (one-sided t- tests). All estimated coefficients, as well as different specifications and robustness checks, can be found in the Appendix. IV. MODELS OF OPTIMAL RESERVES The econometric analysis in the previous section can be criticized for lacking microfoundations, i.e. not discussing whether actual reserve holdings are optimal from the perspective of rational utility-maximizing agents. This section hence focuses on reserve optimality from a consumption insurance perspective, balancing the benefits of holding reserves when sudden stops in external credit occur with the quasi-fiscal costs of doing so. However, the focus on external debt links this framework to the Greenspan-Guidotti rule and the reserve demand models in the previous section. Although the early literature discussing reserve optimality emphasized vulnerabilities stemming from external short-term debt, recent works has widened the definition. As an important source of 9 fragility in Central America as earlier mentioned is bank dollar deposits, we use Gonçalves (2007) dollar deposit extension of the Jeanne and Rancière (2006) framework for assessing the role of reserves for consumption insurance. As pointed out by Valencia (2010), another reason for accumulating precautionary reserves is to insure against volatile terms-of-trade developments. This option is however mainly relevant as a tool for revenue management for commodity exporters, which the Central American economies we focus on are not.8 The model features an intertemporal optimization problem of a small open economy hit by sudden stops in capital flows. Notice that this model does not study the role of reserves for actually reducing the likelihood or cost of a crisis, nor the effects on borrowing costs. These benefits are however typically found to be insignificant or only present at low reserve-to-GDP ratios, and hence the costs and benefits of holding reserves can thought to be well approximated by the model (Blanchard et al, 2010, Llaudes et al, 2010). In the model, reserves are held to smooth consumption over time. This role of international reserves can be inferred from a few accounting relationships. First, note that real domestic absorption in an open economy can be written as the difference between real domestic output and the trade balance: (cid:1827) (cid:3404) (cid:1851) (cid:3398)(cid:1846)(cid:1828) (1) (cid:3047) (cid:3047) (cid:3047) where the trade balance, in turn, can be written as (cid:1846)(cid:1828) (cid:3404) (cid:3398)(cid:1837)(cid:1827) (cid:3398)(cid:1835)(cid:1846) (cid:3397)∆(cid:1844) (2) (cid:3047) (cid:3047) (cid:3047) (cid:3047) where (cid:1837)(cid:1827) is the financial account, (cid:1835)(cid:1846) is income and transfers from abroad, and ∆(cid:1844) (cid:3404) (cid:1844) (cid:3398) (cid:3047) (cid:3047) (cid:3047) (cid:3047) (cid:1844) is the change in reserves. Eqs. (1) and (2) can be combined to obtain an expression for (cid:3047)(cid:2879)(cid:2869) decomposing domestic absorption into domestic output, the financial account, income from abroad, and accumulation or decumulation of reserves: (cid:1827) (cid:3404) (cid:1851) (cid:3397)(cid:1837)(cid:1827) (cid:3397)(cid:1835)(cid:1846) (cid:3398)∆(cid:1844) (3) (cid:3047) (cid:3047) (cid:3047) (cid:3047) (cid:3047) A sudden stop is characterized by a cut of external credit, resulting in a sharp fall of the capital account (cid:1837)(cid:1827) , ceteris paribus inducing a fall in domestic absorption. If the sudden stop is (cid:3047) accompanied by a fall in output, (cid:1851), the effects on domestic absorption will be amplified. (cid:3047) Reserves can however be used to e.g. repay external debt that is not rolled over, alleviating the need to cut domestic absorption, and thus providing consumption insurance. 8 In theory, commodity importers could naturally also use reserves to insure against terms-of-trade shocks, in practice they have less frequently been used against volatile commodity prices.