Demand for and Adequacy of International Reserves in Sri Lanka

Abstract

During the last few decades, especially emerging economies have opted to accumulate large stocks of international reserves to withstand unexpected external turbulences and also to reinforce external sector performances through maintaining exchange rate stability. Substantial reserve accumulation entails several benefits as well as direct and indirect costs. Particularly, holding excess reserves for a long time could generate welfare losses which is an important policy consideration. In this context, the key objectives of our study are twofold: first to develop a reserve demand model based on historical data; and second, to assess the reserve adequacy for Sri Lanka based on conventional and recent methodological innovations in the reserve adequacy literature. Based on data for the period 1996-2012, we observe that international reserves in Sri Lanka are broadly determined by import propensity, trade openness, short-term debt and liabilities and money supply. In terms of key conventional measures of reserve adequacy, we find that Sri Lanka has held adequate reserves, despite some variations in some years. At the same time, based on the new risk-weighted reserve adequacy metrics proposed by the International Monetary Fund, we observe that Sri Lanka has had adequate levels of reserves except in the years 2000, 2008 and 2011.