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Reserves adequacy
Page Content The most commonly asked question is “what is an adequate level of reserves?” Gupta and Agarwal (2004) and Wijnholds and Kapteyn (2001) discuss a number of factors that affect the appropriate level of official reserves, and propose a benchmark for each factor, where appropriate. These factors include:
- Economic size
Although there is no explicit reserves/GDP ratio guideline, reserves are expected to rise with population and real GDP per capita. However, since the reserves/GDP ratio does not consider the structure of the economy, it is not really an appropriate benchmark for an optimal level of official reserves.
- Current account vulnerability
The higher the trade openness of a country, the higher the need for reserves. The conventional benchmark in this regard is that official reserves should cover at least three months’ worth of imports, although some studies suggest percentages of reserves/imports of between 30 and 50 per cent. The more volatile the trade flows of a country, the higher the requirement. This criterion is more important for low-income developing countries with a fairly low involvement in international financial markets. Therefore, as long as official reserves cover three months’ of imports, this measure can be ignored in further analyses.
- Capital account vulnerability
Greater financial openness can be associated with higher crisis vulnerability, and thus influences the demand for official reserves. Ratios that are used to measure the adequacy of official reserves for capital account vulnerability include reserves/foreign portfolio investment and reserves/total or short-term foreign debt. The IMF includes in its definition of short-term debt any loans with an initial maturity of less than one year, longer-term loans with a remaining maturity of less than one year, servicing cost (capital and interest) on longer-term loans as well as investments by foreigners in domestic debt securities.
- Possibility of capital flight
The greater the potential for resident-based capital flight from domestic currency, the higher the required level of official reserves. Ratios of reserves to monetary aggregates can be used to provide for this. Since potential capital flight is difficult to quantify, some kind of proxy has to be used for this risk. One approach, followed in the IMF model (Wijnholds and Kapteyn), is to include a specified percentage of the domestic money supply as part of the optimal level of reserves. The argument is that residents would have to convert their Rand deposits to foreign currency before taking it out of the country. The percentage of domestic money supply can vary, but five per cent is regarded as sufficient for a country with a floating exchange rate and a relatively low risk of capital flight.
- Exchange rate flexibility
The greater the exchange rate flexibility, the smaller the need for official reserves. However, even with floating exchange rates, official reserves can be used to reduce exchange rate volatility, either by actually strategically intervening in foreign exchange markets, or merely by virtue of the availability of official reserves providing the ability to intervene to dampen volatility.
- Opportunity cost
The opportunity cost of official reserves can be represented by the difference between the yield earned on reserves and the marginal productivity of an alternative investment. The higher the opportunity cost, the lower the level of reserves should be. Gupta and Agarwal (2004) use the differential between domestic borrowing rates and foreign investment rates as a proxy for opportunity cost.
When all these factors are considered, there seems to be no certain solution for what an adequate level of reserves is. Some authors suggest managing the level of reserves within certain bands. Guided by all the abovementioned factors that could suggest an optimal level of reserves, the Bank does not target a specific level of reserves. The Bank is focusing on the professional management of reserves while taking care that the reserves are maintained at a sustainable level.
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