Too much of a good thing? The adequacy of international reserves in the aftermath of crises

Abstract

Reserve inadequacy was perceived as a major deficiency of the international monetary system in the 1960s and reform proposals focused on increasing the global quantity of international reserves. In retrospect, the apparent inadequacy of reserves was as much a reflection of an inadequate adjustment mechanism. Exchange rates were pegged under the Bretton Woods system and demand management policies failed to eliminate balance of payments disequilibria. Although its theoretical foundations were always weak, the adequacy of individual countries' reserves was frequently judged by consulting the reserves-to-imports ratio. While this measure may still remain indicative for countries that are vulnerable to current account shocks, its shortcomings have been underlined since the early 1990s when balance of payments crises have had more to do with volatile international capital flows than unstable export earnings. Reserves-to-imports ratios often failed to identify crisis countries ex ante, while crises themselves have been characterised by rapid reserve depletion. Dissatisfaction with the old measures of reserve adequacy has stimulated the pursuit of superior ones. Unfortunately it remains difficult to convert sound theory into operational indicators since there are problems in measuring many of the theoretical determinants of reserve adequacy. Whilst rules-of-thumb may therefore be unavoidable, proposals have been made to augment the reserves-to-imports ratio with other ratios that reflect a country's vulnerability to reduced capital inflows or capital outflows. The evidence presented in this paper supports the claim that these capital account related measures would have been helpful in identifying reserves that were inadequate in the event of a loss of market confidence; although it is also suggested that dynamic measures of changes in reserve levels would be helpful in signalling the need for changes in economic policy. Before the event, therefore, countries may need to hold reserves slightly in excess of their short-term external debt in order to provide a window of opportunity for policy change in advance of reserves imploding in the context of a full-blown crisis.