Information about Asia and the Pacific Asia y el Pacífico
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CHAPTER 5 Adequacy of Indonesia’s Foreign Exchange Reserves

Editor(s):
Thomas Rumbaugh
Published Date:
January 2012
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MARTA RUIZ-ARRANZ and MILAN ZAVADJIL 

Indonesia has seen a sharp increase in its international reserves holdings in recent years. Reserves have increased from less than $10 billion (6 percent of GDP) in the early 1990s to $120 billion (14.8 percent of GDP) as of June 2011. The pace of accumulation has picked up in the past two years owing to large capital inflows, as well as consistent current account surpluses. This trend is not unique to Indonesia. For emerging Asia as a whole, reserves have increased seven times in nominal terms since the Asian financial crisis of 1997–98. Even excluding China, reserves increased by the equivalent of 10 percentage points of GDP during the 2000–10 period (Figure 5.1).

Figure 5.1International Reserves, 1990–2010

Sources: IMF, World Economic Outlook database ; Bank for International Settlements; CEIC Data Co., Ltd.; and IMF staff calculations.

The buildup of international reserves has contributed to reducing Indonesia’s vulnerabilities. The economy is now better prepared to weather sudden capital account reversals than it was a decade ago and, therefore, is less vulnerable to shifts in investor sentiment. Together with moderate current account surpluses and declining domestic and external debt ratios, the solid level of reserves helped to maintain financial stability during the 2007–09 global financial crisis, when capital outflows rose significantly. During this crisis, Indonesia’s reserves were somewhat lower than those in many other emerging Asian economies, and some private sector analysts believe this may have contributed to the relatively high volatility of Indonesian markets.

Countries hold reserves to provide liquidity in the event of temporary shortfalls in exports or capital inflows, and thus to avoid disruptive changes in the exchange rate or in investment and consumption. In addition, reserves can protect the domestic banking system—and more broadly, domestic credit markets—from outflows of domestic or external resources (Obstfeld, Shambaugh, and Taylor, 2008).

Based on these motivations, emerging markets in Asia, and Indonesia in particular, had ample cause to increase reserves holdings over the past decade. Much of the recent increase in reserves can be explained by the precautionary motive, with the increase paralleling the sharp expansion of trade and capital flows as well as the rise in the volatility of gross capital flows (IMF, 2007). These factors have increased the disruptive potential of sudden stops. In addition, accelerated financial intermediation, including the development of local bond and equity markets, has raised the risks associated with possible outflows from the domestic financial system. Finally, the buildup of reserves in Indonesia and some other Asian countries was a natural response to the disruptions and the disastrous impact of the crises of the late 1990s on the economic, political, and social fabric of these countries, which has understandably increased their risk aversion. Thus, despite moves toward more flexible exchange rates and better capital market access, like many other emerging-market central banks, Indonesia has used the opportunities provided by current account surpluses and capital inflows since the 1997–99 crises to build reserves.

Empirical analysis suggests that although foreign exchange reserves in Indonesia are currently comfortable, they are not excessive. Measured by traditional adequacy indicators, Indonesia’s reserves have been “adequate” for some time. However, they have only recently exceeded levels predicted by an optimal insurance model under which reserves provide a steady source of liquidity to cushion the impact of a sudden stop in capital inflows on output and consumption. Furthermore, when the increase in the size and volatility of foreign liabilities—against which reserves provide insurance—is taken into consideration, the case for maintaining current reserves levels is further strengthened. Finally, Indonesia continues to benefit in that its higher reserves have resulted in reduced spreads on privately held external debt.

Going forward, further accumulation of reserves no longer seems essential from a financial stability point of view. At the current juncture, the rupiah has room to appreciate and support monetary policy in containing inflation. Thus, a more modest pace of reserves accumulation, if any, is called for. However, reserves accumulation may still provide some benefit in reducing credit spreads.

DEVELOPMENTS IN RESERVE ADEQUACY INDICATORS

Indonesia’s reserves are high relative to traditional reserve adequacy indicators, but not by the standards of emerging Asia. At the end of 2010, reserves covered 7.5 months of imports of goods and services—more than twice the traditional benchmark of 3 months of imports and Indonesia’s level in 1997, but below the average of 8 months of imports in emerging Asia. The ratio of reserves to short-term external debt was more than twice the recommended 100 percent under the Greenspan-Guidotti rule, albeit significantly lower than the average in Asia (excluding China). Indonesia’s reserves level was also above the Wijnholds and Kapteyn (2001) recommended holding of 5–20 percent of broad money (M2) (Figure 5.2).1

Figure 5.2Indonesia: Reserve Adequacy Indicators Relative to Other Asian Countries, 2010

Sources: IMF, International Financial Statistics; and BIS, International Investment Position data.

Indonesia’s reserve adequacy indicators resumed an upward trend in 2009–10, after a dip in 2008. Since the Asian financial crisis, Indonesia’s reserve adequacy indicators have broadly mirrored trends in other emerging markets, excluding China, rising sharply immediately after the crisis. However, from 2003 to 2008, reserves in Indonesia declined or were stagnant relative to imports, short-term debt, and total external liabilities, reflecting the acceleration of trade and capital flows in this period. Indonesia’s reserve adequacy indicators as of early 2011 are broadly similar to averages in various emerging-market groupings.

Reserves in Indonesia are not seen as excessive against historical levels given the size of gross liabilities and the increased volatility of these flows. Indonesia’s very high levels for the traditional reserve indicators overstate the extent to which Indonesia is insured against sudden stops, especially in view of the sharp increase in portfolio flows ((Box 5.1). Reserves currently cover about 21 percent of external liabilities in

BOX 5.1Why Scale Reserves by Gross External Liabilities?

Over time, the nature of balance of payments shocks has evolved. The ratio of reserves to imports was developed to measure resilience to the kinds of trade shocks that tended to predominate before the liberalization of financial systems and capital accounts. Subsequently, with the increase in cross-border capital flows and the rising possibility of sudden stops and capital outflows, the ratio of reserves to external debt maturing within a year became a key indicator of reserve adequacy. This measure reflected, in part, the nature of the financial crisis in Asia and elsewhere in the late 1990s, when banks and corporations built up large short-term foreign exchange liabilities with which they financed long-term investments that did not generate foreign exchange. Foreign exchange reserves were not sufficient to finance outflows of short-term capital when they occurred. The ratio of reserves to short-term debt was thus highly suitable for assessing vulnerability to these types of currency and maturity mismatches and was indeed a good predictor of crisis.

Capital flows to emerging Asia have evolved considerably since the crisis of the late 1990s. The share of debt, including short-term debt, has decreased (Figure 5.3) while portfolio flows have risen. Portfolio flows have proved to be volatile in Indonesia— recent episodes of global risk aversion, such as May–June 2006, August 2007, or October–November 2008, have been felt primarily in domestic bond and equity markets. The volatility of direct investment flows has also increased (IMF, 2007). Moreover, long-term liability holders rarely remain passive when balance of payments problems arise. As noted by Wyplosz (2007), speculation mostly takes the form of short-term liabilities, but long-term holders can quickly build up hedges, and the potential for such a buildup is captured by looking at the overall liability position.

Of course, reserves do not need to cover external liabilities entirely, as would be mandated by the Greenspan-Guidotti rule. The appropriate coverage adequacy ratio should clearly be lower for some components (foreign direct investment, portfolio equity) than for others (short-term debt).

In sum, the ratio of reserves to gross external liabilities appears to best capture vulnerability to sudden stops and capital account reversals, especially in light of the growing complexity of capital market instruments.

Figure 5.3International Reserves and External Liabilities

Sources: IMF, World Economic Outlook database; BIS, International Investment Position data; and Lane and Milesi-Ferretti (2007).

Indonesia compared with about one-third in emerging Asia (excluding China) (Figure 5.3). Reflecting greater real and financial integration with the global economy, cross-border capital flows in emerging Asia—both in and out—have grown sharply since 2000, resulting in a buildup in external assets and liabilities in all the economies of the region. The ratio of reserves to external liabilities increased through 2002 as emerging Asia rebuilt its reserves following the crisis, but then eased before rising again during 2009–10. In addition to the increase in size, the volatility of gross capital flows has risen (IMF, 2007).

AN INSURANCE MODEL OF OPTIMAL RESERVES

In assessing the appropriateness of current reserves levels, it is useful to analyze how the recent buildup of reserves compares with the results of an insurance model of optimal reserves. In the model, based on the work by Jeanne (2007), reserves enable an economy to cushion the impact of a sudden stop in capital flows on domestic consumption and output by providing a ready source of liquidity. However, holding liquid reserves assets results in an opportunity cost equal to the difference between the return on capital and the return on reserves. The optimal level of reserves is derived from this cost-benefit analysis and depends on the probability and size of a sudden stop (or crisis), the output loss in the event of a sudden stop, the opportunity cost of holding reserves, and the degree of risk aversion. 2

The model is calibrated on economy-specific data for the emerging-market economies in Asia, including Indonesia, and results are compared with actual levels of reserves at the end of 2010.

  • Estimating output loss. The 1997–98 Asian crisis provides a useful benchmark for assessing the size of an output loss in the event of a sudden stop in capital flows. The cost to output during the period 1997–99 is estimated by cumulating the output gap in these years under the assumption that output would have grown at the same rate as the average before the crisis. 3 Results suggest that the cumulative output loss for the six Asian economies most affected by the crisis was 19 percent of GDP, on average (Table 5.1). This was significantly higher in Indonesia and Thailand, where the cumulative cost amounted to about 30 percent of GDP. These estimates may, however, underestimate the total output loss of the Asian crisis if the recession actually lowered the level of output permanently, rather than being a temporary deviation from trend. 4 The exercise in this chapter assumes a potential output loss of 19 percent of GDP, in line with the average output loss estimate from the Asian crisis experience, although a higher estimate would also be reasonable.

  • Estimating the probability of a sudden stop. Consistent with the benchmark calibrations in Jeanne and Rancière (2006) and Jeanne (2007), the average probability of crisis is set to 10 percent, equal to the unconditional frequency of sudden stops in a large sample of emerging economies during the period 1975–2003. 5 In this exercise, the probability of crisis is assumed to be exogenous and thus independent of the level of reserves. It is, however, plausible that reserves could have a crisis-prevention role by reducing the likelihood of crises. If this were the case, the optimal level of reserves could be significantly larger.

  • Estimating the size of a sudden stop. The stock of short-term external debt could be a good predictor of the potential immediate rollover needs and, therefore, of the size of the capital outflows in a sudden stop. For Indonesia, this stock is estimated to be about 4.8 percent of GDP. For other Asian countries, short-term liabilities average 10 percent of GDP, except in Hong Kong SAR and Singapore, where they are well above this level. Nevertheless, the potential size of capital flight in Indonesia could be significantly larger than 4.8 percent of GDP given that gross external liabilities exceed 50 percent of GDP. As discussed in (Box 5.1, total foreign liabilities may capture Indonesia’s vulnerability to reversals in capital flows better than short-term debt.

  • Estimating the opportunity cost of holding reserves. The opportunity cost of reserves is the difference between the return on reserves and the return on capital or an alternative investment. In the absence of a broad consensus about how best to capture this cost, several measures have been used in the literature. The baseline scenario in this analysis assumes the opportunity cost of reserves is equal to the interest spread on foreign debt. 6 In this case, the opportunity cost of reserves can be viewed as the return that the government has to pay in excess of the return on liquid foreign assets to finance the purchase of reserves. This is proxied by the sovereign risk premium (as measured by the Emerging Markets Bond Index [EMBI] or the 10-year government bond spread). As shown in Table 5.2, sovereign interest rate spreads for foreign debt vary widely; they have also fluctuated sharply during the 2007–10 period. In Indonesia, EMBI spreads averaged slightly less than 200 basis points (bps) in 2007–10, although in 2008 they even reached 1,000 bps briefly. An alternative method of computing the opportunity cost of reserves—the fiscal cost of sterilizing reserves—suggests that the opportunity cost could be even larger. In particular, in Indonesia the difference between the policy rate and the yield on the one-year U.S. Treasury bill averaged 6.2 percent in 2010 (Table 5.3).

TABLE 5.1Output Loss in Asian Crisis
EconomyAverage Growtha (percent)Difference Between Actual Growth and Average Growth (percentage points)Cumulative Output Loss
1970-961997199819991997–99
Hong Kong SAR7.4-2.2-12.8-3.418.4
Indonesia6.9-2.2-20.0-6.128.2
Korea, Rep. of8.1-3.5-15.01.417.1
Malaysia7.6-0.3-14.9-1.416.6
Philippines3.61.6-4.2-0.24.4
Thailand7.6-9.0-18.1-3.230.3
Average6.9-2.6-14.2-2.219.2
Source: IMF staff estimates.

Real GDP series have been detrended using a Hodrick-Prescott filter. Results are robust to different time period of averages.

Source: IMF staff estimates.

Real GDP series have been detrended using a Hodrick-Prescott filter. Results are robust to different time period of averages.

TABLE 5.2Interest Rate Spreads (Monthly average, 2007–10)
EconomyBasis points
Hong Kong SAR-74
India402
Indonesia341
Korea, Rep. of156
Malaysia164
Philippines263
Singapore-103
Thailand43
Sources: IMF, International Financial Statistics ; CEIC Data Co., Ltd.; and IMF staff estimates.Note: EMBI spreads for Indonesia, Malaysia, the Philippines, and China; 10-year government bond spreads for others.
Sources: IMF, International Financial Statistics ; CEIC Data Co., Ltd.; and IMF staff estimates.Note: EMBI spreads for Indonesia, Malaysia, the Philippines, and China; 10-year government bond spreads for others.
TABLE 5.3Estimated Sterilization Financing Cost (As of December 2010)
EconomyDomestic financing costs (Sterilization rate, percent)Net carry (percent interest on foreign reserves minus sterilization rate)Carry income on total reserves (percentage of GDP)
China2.25-1.96-0.94
India5.25-4.96-0.96
Indonesia6.50-6.21-0.84
Korea, Rep. of2.50-2.21-0.65
Malaysia2.75-2.46-1.08
Philippines4.00-3.71-1.22
Singapore0.200.090.09
Hong Kong SAR0.50-0.21-0.25
Thailand2.00-1.71-0.90
Sources: Country authorities; IMF, APDCORE database, World Economic Outlook database; and IMF staff calculations.Note: The rate on foreign reserves is assumed to be the yield on the one-year U.S. Treasury note (0.29 percent at the end of 2010).
Sources: Country authorities; IMF, APDCORE database, World Economic Outlook database; and IMF staff calculations.Note: The rate on foreign reserves is assumed to be the yield on the one-year U.S. Treasury note (0.29 percent at the end of 2010).

The findings suggest that reserves in Indonesia now exceed the optimal level by a modest amount. By mitigating the potentially large welfare costs of crises, reserves accumulation can provide benefits through insurance that more than compensate for the opportunity cost of holding liquid assets. Until recently, reserves accumulation in Indonesia largely reflected this favorable trade-off, but the level of reserves is now above the optimal level (Figure 5.4).

Figure 5.4The Optimal Level of International Reserves, 2010

Source: Authors’ calculations.

The need for further reserves buildup has diminished. As noted, current reserves levels are comfortable and have contributed to reducing vulnerabilities in the past few years. As of mid-2011, however, the rupiah appears to have room to appreciate and support monetary policy in containing inflation, which would call for limiting reserves accumulation. However, the use of reserves to smooth volatility in the face of the recent turmoil in the financial markets appears appropriate. The model suggests that a reserves level of about $75 billion is optimal. However, these estimates should be interpreted with caution—the model is sensitive to the assumptions used and therefore should be only one of several inputs into determining adequate reserves levels.

Optimal reserves adequacy ratios predicted by the model are higher than the standard rules of thumb. Optimal ratios estimated by the model for Indonesia exceed seven months of imports, more than twice as large as the traditional benchmark. With regard to short-term external debt, Indonesia’s estimated optimal reserves level is also higher than the Greenspan-Guidotti rule’s 100 percent. Similarly, the estimated optimal level of reserves to broad money is about 30 percent, exceeding the 5–20 percent range usually proposed in the literature (Figure 5.5). The model also predicts excessively high ratios for other countries in Asia, suggesting that the traditional rules of thumb may no longer be relevant and that economy-specific indicators that take into account a particular country’s vulnerabilities and opportunity costs may be preferable to standardized rules.

Figure 5.5Optimal Levels of International Reserves and Traditional Reserves Adequacy Indicators, 2010

Sources: BIS, International Investment Position ; IMF, World Economic Outlook database ; and Lane and Milesi-Ferretti (2007).

The evolution of reserves cannot be assessed independently of the trade and capital account flows against which reserves provide insurance. The difference between current and optimal levels seems to be smaller when expressed as a proportion of months of imports, broad money, short-term debt, or gross external liabilities than when presented in nominal terms. In light of these results, it can be concluded that the recent increase in reserves in Indonesia can be explained by the precautionary motive, and that the increase has paralleled the expansion of trade and capital flows. If this trend continues, it would be desirable from an insurance point of view that reserves keep up with these flows.

A THRESHOLD MODEL OF SPREADS-RESERVES ELASTICITY

To the extent that reserves lower the spreads on the economy’s privately held external debt, the opportunity cost of holding reserves is reduced and the incentives to accumulate reserves become higher. Alternatively, one could argue that holding reserves reduces the probability of a sudden stop. In either case, the desired level of reserves holdings is increased. Reserves coverage is also a key variable used by rating agencies to assess credit risk and, therefore, an important determinant of borrowing costs. This section estimates the significance of this “prevention” effect and whether current reserves levels can be justified by the benefits of reduced borrowing costs.

The analysis estimates spreads-reserves elasticities for a panel of 34 emerging economies, including Indonesia, for the period 1997–2006 applying threshold estimation. Because the marginal effect of reserves on spreads might be different at different levels of reserves, the analysis looks for a nonlinear relationship between spreads and international reserves. This methodology can endogenously determine the threshold level(s) of reserves (and confidence intervals) at which the relationship between reserves and spreads changes. In particular, these threshold levels will provide information about the maximum level of reserves at which no further gains from lower spreads could be realized. They can then be compared with the optimal levels found in the previous section as well as with the traditional rules of thumb.

Threshold estimation takes the form

where S is J.P. Morgan’s EMBI spreads; R is a reserves ratio indicator, which is used both as a regressor and as the threshold variable that splits the sample into two groups; γ is the endogenously determined threshold level; and X is a vector of control variables. The vector of control variables includes (a) two exogenous global factors: the international risk-free asset (proxied by the 10-year U.S. Treasury rate) and global risk aversion (proxied by Credit Suisse First Boston’s High Yield spread); and (b) the country’s GDP growth rate and ratio of debt to GDP to control for country-specific and time-varying characteristics. All the variables are estimated in logs and are lagged one period to reduce potential endogeneity concerns. The regressions also include country-specific fixed effects. A description of the variables and their sources can be found in Tables 5.1.1 and 5.1.2 in Appendix 5.1.

The objective of the analysis is to estimate the threshold level beyond which the marginal impact of reserves on spreads is no longer significant. If needed, the analysis performs multiple threshold regressions proceeding sequentially. First, a threshold model is fitted to the data to estimate a first reserves ratio threshold level and the least-squares coefficients of each subsample. Confidence intervals are computed for the parameters, including the reserves threshold coefficient, and an asymptotic simulation test is provided of the null hypothesis of linearity against the alternative of a threshold. If the spreads-reserves elasticity beyond the threshold is not statistically significant, the procedure stops. If the analysis finds evidence of a first threshold, it proceeds to the second stage (provided the number of observations allows doing so). The second stage consists of dropping the sub-sample below the threshold and repeating the procedure just described but applying it to the rest of the sample in search of a second threshold. This allows the computation of estimates for the two remaining subsamples and testing of the null hypothesis of no second reserves threshold.

Results suggest that holding reserves has a significant impact in the form of reducing borrowing spreads, and this effect continues to be important even at relatively high levels of reserves. The elasticity of spreads with respect to reserves is estimated to be between 30 percent and 50 percent, depending on the adequacy ratio employed. That is, a 1 percent increase in the reserves ratio leads to a 0.3–0.5 percent decline in spreads. The estimated thresholds beyond which there are no gains in holding reserves (i.e., that is, the cost of borrowing is not reduced further) are significantly above the levels suggested by the standard rules of thumb and closer to the optimal reserves levels found in the previous section. For instance, the threshold level of reserves to imports is estimated at 6.3 months, twice as large as the traditional rule of thumb. Similarly, the threshold of reserves to broad money is found to be 28 percent, close to the average optimal level of 32 percent predicted by the model in the previous section. The findings for six different reserves adequacy indicators are presented in Tables 5.45.6.

TABLE 5.4Thresholds in the Spreads-Reserves Relationship
Threshold 1Threshold 2
MeasurementEstimateConfidence intervalEstimateConfidence intervalReserve adequacy benchmark
Reserves to
GDPa (percent)49[23, 51]n.a.n.a.n.a.
Months of importsb6[2,9]n.a.n.a.3
Broad moneyb (percent)28[6, 85]n.a.n.a.5-20
Short-term debtb (percent)125[112, 692]534[534, 535]100
Foreign liabilitiesc (percent)12[12.0, 12.4]52[52, 66]n.a.
Financial system deposits and13[12, 14]30[14, 40]n.a.
equitiesc (percent)
Source: Authors’ calculations.

The marginal impact of reserves is negative and significant below threshold 1; there are insufficient observations to estimate the impact above the threshold.

The marginal impact is negative below threshold 1 and not significant above the threshold.

The marginal impact is not significant below threshold 1, negative between thresholds 1 and 2, and insignificant above threshold 2.

Source: Authors’ calculations.

The marginal impact of reserves is negative and significant below threshold 1; there are insufficient observations to estimate the impact above the threshold.

The marginal impact is negative below threshold 1 and not significant above the threshold.

The marginal impact is not significant below threshold 1, negative between thresholds 1 and 2, and insignificant above threshold 2.

Indonesia has benefited from higher reserves because the higher reserves have reduced borrowing costs. The analysis shows that Indonesia’s current level of reserves is below the threshold estimates, suggesting that additional reserves accumulation continues to have a positive impact in reducing spreads (Figure 5.6). Results suggest that this benefit could be somewhat larger for Indonesia than for other emerging-market countries with relatively higher reserves holdings. This exercise is likely to provide a lower bound estimate of the benefits of reserves as measured by lower financing costs because it does not incorporate similar gains in the private sector. This is particularly relevant in the current context, in which borrowing costs for corporations have increased significantly as a result of tighter global liquidity.

Figure 5.6International Reserves and Threshold Estimates

Sources: IMF, World Economic Outlook database; BIS, International Investment Position; and IMF staff calculations.

TABLE 5.5Threshold Estimates of the Elasticity of EMBI Spreads with Respect to International Reserves, Traditional Indicators
GDPMonths of importsBroad moneyShort-term debt
Thresholds< 49< 6.3> 6.3< 28.3> 28.3< 125[125,534]> 534
Spreads-reserves-0.425***-0.329***0.004-0.463**0.167-0.31-0.311*-0.531
elasticity(0.11)(0.12)(0.37)(0.17)(0.25)(0.20)(0.19)(0.37)
Observations2861761121511448016938
R-squared0.530.50.460.420.460.240.60.7
Source: Authors’ calculations.Note: Robust standard errors in parentheses.

significant at 10 percent.

significant at 5 percent.

significant at 1 percent.

Source: Authors’ calculations.Note: Robust standard errors in parentheses.

significant at 10 percent.

significant at 5 percent.

significant at 1 percent.

TABLE 5.6Threshold Estimates of the Elasticity of EMBI Spreads with Respect to International Reserves, New Indicators
Total foreign liabilitiesFinancial system deposits and equities
Thresholds< 12[12, 52]> 52< 13[13, 30]> 30
Spreads-reserves elasticity-0.13-0.419**-0.2680.035-0.609*0.259
(0.15)(0.19)(0.71)(0.18)(0.32)(0.24)
Observations82182124713274
R-squared0.330.600.770.460.490.60
Source: Authors’ calculations.Note: Robust standard errors in parentheses.

significant at 10 percent.

significant at 5 percent.

significant at 1 percent.

Source: Authors’ calculations.Note: Robust standard errors in parentheses.

significant at 10 percent.

significant at 5 percent.

significant at 1 percent.

Finally, a word of caution with regard to the use of threshold estimates (or the estimated optimal levels in the previous section) as benchmark values for policy purposes. As discussed earlier, the estimates are sensitive to the assumptions used, and the confidence intervals for some of the threshold parameters are sufficiently large to suggest uncertainty regarding their true values.

CONCLUSIONS

In assessing reserves adequacy in Indonesia, the empirical analysis concludes that reserves levels are comfortable, and further accumulation is relatively unnecessary. Although the estimates are sensitive to parameters and assumptions, the study suggests that current reserves levels are somewhat above the levels predicted by a simple model of optimal reserves, thus indicating further accumulations will result in little benefit with regard to reducing vulnerabilities. Limiting accumulation could also help alleviate inflationary pressures. However, reserves accumulation continues to have a positive impact by reducing borrowing costs for both the government and the private sector.

APPENDIX 5.1. A MODEL OF OPTIMAL RESERVES

Jeanne (2007) derives the optimal level of reserves by minimizing a loss function that equals the opportunity cost of reserves plus the expected welfare cost of a crisis:

where δ is the opportunity cost of reserves; R is reserves holdings; π is the probability of a crisis or sudden stop; and f(.) is the welfare cost of a crisis, which increases with the size of the sudden stop and the output loss (L and ΔY). Assuming constant risk aversion (σ) and an exogenous probability of crisis, the optimal level of reserves is given by

That is, the optimal level of reserves is larger the greater the size and output cost of a crisis, the higher the probability of a sudden stop, the lower the cost of holding reserves, and the higher the degree of risk aversion.

DATA FOR THE THRESHOLD ESTIMATION

TABLE 5.1.1Variable Definitions and Sources
VariableDescriptionSource
SpreadJ.P. Morgan EMBI spread in bpsBloomberg, Datastream
10-year U.S. T-bondU.S. Treasury note, 10-year maturityU.S. Treasury
Risk aversionCSFB high yield spreadBloomberg
ReservesInternational reservesIMF, WEO
GDP growthGDP growthIMF, WEO
DebtSovereign debt stockIMF, WEO
ImportsImports of goods and servicesIMF, WEO
Broad moneyM2IMF, WEO
Short-term external debtExternal debt maturity within 1 yearBIS
Foreign external liabilitiesGross external liabilitiesMilesi-Ferretti IIP database
Financial systemTotal deposits andWorld Bank
deposits and equitymarket capitalization
Source: Authors’ compilation.Note: CSFB = Credit Suisse First Boston; WEO = World Economic Outlook database; BIS = Bank for International Settlements; IIP = International investment position.
Source: Authors’ compilation.Note: CSFB = Credit Suisse First Boston; WEO = World Economic Outlook database; BIS = Bank for International Settlements; IIP = International investment position.
TABLE 5.1.2Summary Statistics
MeasurementObservationsMeanStandard DeviationMinMax
Sovereign spread320514.9823.8-260.96,182.0
U.S. 10-year bond rate3204.70.74.06.3
High yield spread320584.7240.6329.2950.8
GDP growth3204.13.9-11.018.3
Debt to GDP31093.5265.54.92,101.7
Reserves to GDP32022.019.91.5104.5
Reserves to months of imports3206.44.10.335.3
Reserves to short-term debt320395.4659.46.57,530.8
Reserves to broad money32035.522.92.9146.3
Reserves to foreign liabilities29825.836.82.0490.5
Reserves to financial system deposits and equities24828.522.21.6113.9
Source: Authors’ calculations.
Source: Authors’ calculations.
REFERENCES

    CerraV. and S.Saxena2005Did Output Recover from the Asian Crisis?Staff Papers International Monetary Fund Vol. 52 No. 1.

    International Monetary Fund (IMF)2007Regional Economic Outlook: Asia and Pacific World Economic and Financial Surveys (Washington; October).

    JeanneO2007International Reserves in Emerging Market Countries: Too Much of a Good Thing?Brookings Papers on Economic Activity Vol. 1 pp. 179.

    JeanneO and R.Rancière2006The Optimal Level of International Reserves for Emerging Market Countries: Formulas and Applications,IMF Working Paper No. 06/229 (Washington: International Monetary Fund).

    LaneP. and G.M.Milesi-Ferretti2007The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities,Journal of International Economics Vol. 73 No. 2 pp. 22350.

    Levy-YeyatiE.2006The Cost of Reserves,CIF Working Paper No. 10/2006 (Buenos Aires: Universidad Torcuato Di Tella). Available via the Internet: http://www.utdt.edu/listado_contenidos.php?id_item_menu=7520.

    ObstfeldM.J.C.Shambaugh and A.M.Taylor2008Financial Stability, the Trilemma, and International Reserves,NBER Working Paper No. 14217 (CambridgeMassachusetts: National Bureau of Economic Research).

    RodrikD.2006The Social Cost of Foreign Exchange Reserves,NBER Working Paper No. 11952 (CambridgeMassachusetts: National Bureau of Economic Research).

    WijnholdsJ. O and A.Kapteyn2001Reserve Adequacy in Emerging Market Economies,IMF Working Paper No. 01/143 (Washington: International Monetary Fund).

    WyploszC2007The Foreign Exchange Reserves Buildup: Business as Usual?paper presented at the “Workshop on Debt Finance and Emerging Issues in Financial Integration”LondonMarch 6–7 (Geneva: Graduate Institute of International Studies and CEPR).

Lutzardo Tobing and Leo Putera Rinaldy also assisted in the preparation of this chapter.

These measurements use debt at remaining maturity. The ratio of reserves to short-term debt with an original maturity of less than one year is about 300 percent.

The model is explained in more detail in Appendix 5.1.

Results are robust to using averages corresponding to different time periods. The real GDP series are detrended with a Hodrick-Prescott filter.

Cerra and Saxena (2005) find evidence of permanent losses in the levels of output in six Asian economies following the 1997–98 crisis. The magnitude of the permanent losses is found to be economically significant for all economies, except perhaps the Philippines. For instance, in Indonesia, the contemporaneous output loss is estimated at 22 percent of GDP, and the total loss including the losses beyond the crisis period reached 42 percent of GDP.

Jeanne (2007) identifies sudden stops as those years in which net capital inflows fell by more than 5 percent of GDP.

Levy-Yeyati (2006), Rodrik (2006), and others have argued that the alternative use of one dollar of reserves is one dollar less of foreign debt or, alternatively, reserves can be accumulated by issuing foreign debt.

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