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Indonesia: Selected Issues

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International Monetary Fund
Published Date:
September 2008
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II. Adequacy of Indonesia’s Foreign Exchange Reserves12

A. Introduction

24. Indonesia has seen a sharp increase in its international reserve holdings in recent years. Reserves have increased from less than $10 billion (6 percent of GDP) in the early 1990s to $59 billion (13.5 percent of GDP) currently, with the pace of accumulation picking up in the past two years owing to current account surpluses. This trend is not unique to Indonesia. For emerging Asia as a whole, reserves have quadrupled in nominal terms since the financial crisis of 1997–98. Even excluding China, reserves have increased by 10 percentage points of GDP during the 2000–07 period (Figure 1).

Figure 1.International Reserves, 1990–2007

Sources: IMF, World Economic Outlook ; Bank for International Settlement; and Fund staff calculations.

25. The recent build-up of international reserves has contributed to reduce Indonesia’s vulnerabilities. The economy is now better prepared to weather sudden capital account reversals than a decade ago and is, therefore, less vulnerable to shifts in investor sentiment. Together with moderate current account surpluses and declining domestic and external debt ratios, the high level of reserves could be a major help in maintaining financial stability during the current global credit crunch, when the possibility of capital outflows has risen significantly.

26. Fundamentally, reserves are held to provide liquidity in case of temporary shortfalls in exports or capital inflows, and thus avoid disruptive changes in the exchange rate, or 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, Taylor (2007)).

27. Based on such motivation, there appears to have been plenty of cause for Indonesia to have increased reserves over the past decade. Much of the recent increase in reserves can be explained by the precautionary motive, and has paralleled the sharp expansion of trade and capital flows, as well as the increase in the volatility of gross capital flows (Table 1). 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 stakes in case of outflows from the domestic financial system. Finally, the build-up of reserves in Indonesia was a natural response to the disruptions and the disastrous impact of the 1997–99 crises on the economic, political, and social fabric, which has understandably increased risk aversion. Thus, despite moves towards 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.

Table 1.Volatility of Capital Flows (Pre and Post the Asian Crisis)
Total Net Inflows1986–19961999–2006
Indonesia1.22.3
Average emerging Asia2.31.1
Average emerging Europe2.92.2
Average Latin America1.31.0
Average Middle East & North Africa3.11.6
Average all EMCs1.80.9
Net FDI1986–19961999–2006
Indonesia0.61.7
Average emerging Asia0.50.4
Average emerging Europe0.80.9
Average Latin America0.50.3
Average Middle East & North Africa2.01.6
Average all EMCs0.80.5
Net Portfolio1986–19961999–2006
Indonesia0.41.0
Average emerging Asia1.00.7
Average emerging Europe0.31.0
Average Latin America0.70.8
Average Middle East & North Africa0.20.6
Average all EMCs0.50.4
Net Other Flows1986–19961999–2006
Indonesia1.51.5
Average emerging Asia1.51.0
Average emerging Europe2.42.3
Average Latin America0.61.1
Average Middle East & North Africa2.01.8
Average all EMCs0.80.8
Sources: IMF, World Economic Outlook; and Fund staff calculations.Note: All flows are expressed as a percent of GDP.
Sources: IMF, World Economic Outlook; and Fund staff calculations.Note: All flows are expressed as a percent of GDP.

28. Empirical analysis suggests that while current reserves in Indonesia comfortably exceed traditional reserve adequacy levels, there is scope for some further accumulation over the medium term. Reserves have risen sharply over the last two years and current levels are considered to be adequate by traditional standards. However, they are somewhat lower than the 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 a precautionary motive behind further reserve accumulation is reinforced. Finally, Indonesia can continue to benefit from higher reserves in terms of reduced spreads on privately held external debt.

29. Going forward, continued reserve accumulation would make the economy more resilient from a financial stability point of view. However, the accumulation should be at a slower pace than in 2007, which would help alleviate inflationary pressures. As discussed in the staff report, in the current juncture there is room for the rupiah to appreciate and support monetary policy in containing inflation. This would call for a slower pace of reserve accumulation in the short-term by recycling some of the foreign exchange proceeds from oil exports. Nevertheless, from a medium-term perspective, a larger buffer of international reserves would help build resilience in the event of sizeable reversal of capital flows.

B. Developments in Reserve Adequacy Indicators

30. Indonesia’s reserves are high relative to traditional reserve adequacy indicators, but not relative to emerging Asia. At the end of 2007, reserves covered six months of imports of goods and services, twice the traditional benchmark of three months of imports and the 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), and Indonesia’s reserve level was also above the Wjinholds and Kapteyn (2001) recommended holding of 5–20 percent of broad money (Figure 2).13

Figure 2.Indonesia: Reserve Adequacy Indicators Relative to Other Asian Countries, 2007

Sources: CEIC Data Co. Ltd; Milessi-Ferreti database; and Fund staff estimates.

Note: Taiwan POC stands for Taiwan Province of China.

31. While Indonesia’s reserve adequacy indicators continue to increase, those in emerging Asia (excluding China) have begun to moderate, reflecting the acceleration in global trade and capital flows over the past few years. Despite the phenomenal increase of reserves in dollar terms, most reserve adequacy ratios in Asia (excluding China) have stabilized or declined modestly starting in 2003–04 and they are not out of line with other emerging markets. Albeit high, the ratios of reserves to imports, to short-term debt and to broad money are only modestly higher than South America’s, but lower than the average for other emerging markets (Europe and the Middle East). The moderation in the pace of accumulation in some Asian economies with very high ratios along with the rapid growth in those countries with relatively lower reserves, such as Indonesia and Philippines, has resulted in some convergence (Figure 1).

32. Reserves in Indonesia are not seen excessive against historical levels given the size of gross liabilities and the increased volatility of gross flows. The very high levels of the traditional reserve indicators overstate the extent to which Indonesia is insured against sudden stops, especially in view of the sharp increase in portfolio and direct investment flows (Box 1). Reserves currently cover less than 20 percent of external liabilities in Indonesia compared to about one-third in emerging Asia (excluding China) (Figure 3).14 Reflecting greater real and financial integration with the global economy, cross-border capital flows in emerging Asia—both in and out—have grown sharply over the past decade, resulting in a build-up 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 has since eased. In addition to the increase in size, the volatility of gross capital flows has risen (APD Regional Economic Outlook, September 2007, Table 1).

Figure 3.International Reserves and External Liabilities

Sources: IMF, World Economic Outlook; Milesi-Ferretti data; and Fund staff calculations.

Box 1:Why 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 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 reflected in part the nature of the crisis in Asia and elsewhere in the 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 type of currency and maturity mismatches and was indeed a good predictor of crisis.

Capital flows to non-emerging Asia have evolved considerably since the crisis of the 1990s. The share of debt, including short-term debt, has decreased (Figure 3). Moreover, portfolio flows have proved to be the most volatile form of capital flow, and the volatility of both gross inflows and outflows has risen sharply since 2000. Indeed, in Indonesia recent episodes of global risk aversion such as May-June 2006 or August 2007 have been most felt in domestic bond and equity markets which have been volatile in many economies. While somewhat more stable, the volatility of direct investment flows has also increased (Asia and Pacific Regional Outlook, IMF, September 2007, Table 1). 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 build-up is captured by looking at the overall liability position.

Of course, it is not suggested that reserves need to cover external liabilities entirely, as in the case of the Greenspan-Guidotti rule. The appropriate coverage adequacy ratio should clearly be lower for some components (FDI, portfolio equity) than for others (short-term debt).

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

C. An Insurance Model of Optimal Reserves

33. In assessing the appropriateness of current reserves levels, it is useful to analyze how the recent build-up of reserves compares to what would be implied by 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 reserve assets entails an opportunity cost equal to the difference between the return on capital and 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.15

34. The model is calibrated on economy-specific data for the emerging market economies in Asia, including Indonesia, and results compared with actual levels of reserves at the end of 2007.

  • Estimating Output Loss. The Asian crisis provides a useful benchmark to assess the size of the output loss in the event of a sudden stop in capital flows. The cost in terms of 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.16 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 2). This was significantly higher in the case of Indonesia and Thailand, where the cumulative cost amounted to around 30 percent of GDP. These estimates may, however, underestimate the total output loss of the Asian crisis if the recession lowered the level of output permanently, rather than being a temporary deviation from trend.17 The exercise in this paper 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 1975–2003.18 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 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. In the case of Indonesia, this is estimated to be around 6.5 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 10 percent of GDP. Nevertheless, it is worth noting that the potential size of capital flight in Indonesia could be significantly larger than 6.5 percent of GDP, as gross external liabilities exceed 50 percent of GDP. As discussed in Box 1, total foreign liabilities could 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 absence of a broad consensus over how to best capture this cost, several measures have been used in the literature. The baseline scenario in this paper assumes the opportunity cost of reserves is equal to the interest spread on foreign debt.19 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 n liquid foreign assets to finance the purchase of reserves. This is proxied by the sovereign risk premium (as measured by EMBI or the 10-year government bond spreads). As shown in Table 3, sovereign interest rate spreads for foreign debt have averaged less than 4 percent during 2007 in emerging Asia, and in some economies the risk premia has been negative. In Indonesia, EMBI spreads averaged slightly less than 200 bp. Nevertheless, it is worth noting that borrowing costs have increased in 2008 and EMBI spreads recently reached 400 bp. Furthermore, an alternative method of computing the opportunity cost of reserves, namely the fiscal cost of sterilizing reserves, suggests that the opportunity cost could be larger. In particular, the difference between the policy rate and the yield on the 1-year U.S. Treasury bill averaged 4.5 percent in 2007 and this spread has widened in 2008 (Table 4).
Table 2.Output Loss in Asian Crisis
Average GrowthDifference between actual growth and average growthCumulative output loss
1970–19961/1997198819991997–99
Hong Kong SAR7.4–2.2–12.8–3.418.4
Indonesia6.9–2.2–20.0–6.128.2
Korea8.1–3.5–15.01.417.1
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

Real GDP series have been detrended using Hodrik Prescott filter. Results are robust to different time period averages.

Real GDP series have been detrended using Hodrik Prescott filter. Results are robust to different time period averages.

Table 3.Interest Rate Spreads

(basis points)1

Hong Kong SAR–44
India332
Indonesia197
Korea73
Malaysia87
Philippines178
Singapore–175
Taiwan Province of China–230
Thailand–4

Average for 2007.

EMBI spreads for Indonesia, Malaysia, Philippines. Ten-year government bond spreads for others.

Average for 2007.

EMBI spreads for Indonesia, Malaysia, Philippines. Ten-year government bond spreads for others.

Table 4.Estimated Sterilization Financing Costs 1/
Domestic Financing Costs (Sterilization Rate)Net Carry (Interest on Foreign Reserves Minus Sterelization Rate) 2/Carry Income on Total Reserves (%GDP) 3/
India6.00–2.66–0.7
Indonesia8.00–4.66–0.6
Korea5.00–1.66–0.5
Malaysia3.50–0.16–0.1
Philippines5.25–1.91–0.4
Singapore0.982.362.5
Taiwan Province of China3.38–0.040.0
Hong Kong SAR5.75–2.41–1.8
Thailand3.250.090.0
Sources: Country authorities; IMF, APDCORE database and World Economic Outlook ; Fund staff calculations.

As of December 2007.

The rate on foreign reserve holdings is assumed to be the yield on the one-year U.S. Treasury note (3.34 percent at the end of 2007).

Sources: Country authorities; IMF, APDCORE database and World Economic Outlook ; Fund staff calculations.

As of December 2007.

The rate on foreign reserve holdings is assumed to be the yield on the one-year U.S. Treasury note (3.34 percent at the end of 2007).

35. The findings of the paper suggest that a simple insurance model performs relatively well in explaining the stock of reserves in Indonesia. By mitigating the potentially large welfare costs of crises, reserves provide benefits in terms of insurance than more than compensates Indonesia for the opportunity cost of holding liquid assets. The reserve accumulation observed so far reflects largely this favorable trade-off, which continues to exist even at the current high level of reserves. This is in contrast with some other countries in Asia, where according to the simple insurance model, this trade-off is less favorable or appears to have been exhausted (Figure 4).

Figure 4.The Optimal Level of International Reserves, 2007

(In billions U.S. dollar)

36. The current level of reserves in Indonesia seems to be modestly lower than predicted by the model. As discussed in the staff report, current reserve levels are comfortable and have contributed to reduce vulnerabilities in the past few years. At the same time, in the current juncture there appears to be room for the exchange rate to appreciate and support monetary policy in containing inflation, which would call for a slower pace of reserve accumulation in the near-term by recycling some of the oil proceeds. Furthermore, the use of reserves to smooth volatility in face of the current financial market turmoil appears appropriate and justifies the reserve accumulation. Nevertheless, from a medium-term perspective, a somewhat larger buffer of international reserves is desirable to continue to build resilience in the event of sizeable reversal of capital flows. The model suggests that a further build-up of USD10–15 billion over the medium-term would be desirable. However, these estimates should be interpreted with caution as the model is sensitive to the assumptions used and should therefore be only one input in determining adequate reserve levels.

37. It is worth noting that optimal reserve adequacy ratios predicted by the model are above the standard rules of thumb. Optimal ratios estimated by the model for Indonesia are above 7 months of imports, more than twice as large as the traditional benchmark. With regards short-term external debt, Indonesia’ estimated optimal reserve level is also above the 100 percent Greenspan-Guidotti rule. Similarly, the estimated optimal level of reserves to broad money is around 40 percent, above the 5–20 percent range usually proposed in the literature (Figure 5). This is also the case for other countries in Asia, which suggests that the traditional rules of thumb may no longer be relevant and that economy-specific indicators that take into account economy-specific vulnerabilities and opportunity costs may be preferable to standardized rules.

Figure 5.The Optimal Level of International Reserves and Traditional Reserve Adequacy Indicators

Sources: IMF, World Economic Outlook, Milessi-Feretti data; BIS; and Fund staff calculations.

Note: Taiwan POC stands for Taiwan Province of China.

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

D. A Threshold Model of Spreads-Reserves Elasticity

39. 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, this would increase the desired level of reserve holdings. Reserve 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 how significant this “prevention” effect is and whether current reserve levels can be justified in terms of the benefits of reduced borrowing costs.

40. We estimate 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, we look for a non-linear relation between spreads and international reserves applying threshold estimation as in Hansen (1996, 2000). By applying this methodology, we can endogenously determine the threshold level(s) of reserves (and confidence intervals) at which the relation between reserves and spreads changes. In particular, these threshold levels will provide information about the maximum level of reserves where no further gains from lower spreads could be realized. We will then be able to compare them with the optimal levels found in the previous section as well as with the traditional rules of thumb.

41. Threshold estimation takes the form:

where S is J.P. Morgan’s EMBI spreads; R is a reserve 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: (i) two exogenous global factors: the international risk-free asset (proxied by the 10-year U.S. Treasury rate) and global risk aversion (proxied by the Credit Swiss First Boston’s High Yield spread); and (ii) the country’s GDP growth rate and the 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 the Appendix.

Figure 6.International Reserves and Treshold Estimates

Sources: IMF WEO; Milesi-Feretti data; BIS, and Fund staff calculations.

Note: Taiwan POC stands for Taiwan Province of China.

42. The objective of the analysis is to estimate the threshold level beyond which the marginal impact of reserves on spreads stops being significant. If needed, we perform multiple threshold regressions proceeding in a sequential way. First, we fit a threshold model to the data to estimate a first reserve ratio threshold level and the least square coefficients of each subsample. We compute confidence intervals for the parameters, including the reserve threshold coefficient, and provide an asymptotic simulation test 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 we find evidence of a first threshold, we proceed to the second stage (provided the number of observations allows doing so): drop the subsample below the threshold and repeat the procedure just described but applying it to the rest of the sample in search for a second threshold. This allows us to compute estimates for the two remaining sub-samples and test the null hypothesis of no second reserve threshold.

43. Results suggest that holding reserves has a significant impact in reducing borrowing spreads and this effect continues to be important even at relative high levels of reserves. The elasticity of spreads with respect to reserves is estimated between 30 and 50 percent, depending on the adequacy ratio employed. That is, a 1 percent increase in the reserve ratio leads to a 0.3–0.5 percent decline in spreads. The estimated thresholds beyond which there are no gains in holding reserves in terms of reduced cost of borrowing are significantly above the levels implied by the standard rules of thumb and closer to the optimal reserve 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 reserve 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 reserve adequacy indicators are presented in Table 57.

Table 5Thresholds in the spreads-reserves relation
Threshold 1Threshold 2Reserve Adequacy Benchmark
Reserves toEstimateConfidence intervalEstimateConfidence interval
GDP1/49[23, 51]
Months of imports2/6[2, 9]3
Broad money2/28[6, 85]5–20
Short-term debt2/125[112, 692]534[534, 535]100
Foreign liabilities3/12[12, 12.4]52[52, 66]
Fin. system deposits and equities3/13[12, 14]30[14, 40]

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 threshold 1 and 2, and insignificant above threshold 2.

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 threshold 1 and 2, and insignificant above threshold 2.

Table 6.Threshold 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 elasticity–0.425***–0.329***–0.004–0.463***0.167–0.31–0.311*–0.531
(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
Note: Robust standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%.
Note: Robust standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%.
Table 7.Threshold estimates of the elasticity of EMBI spreads with respect to international reserves.New indicators
Total foreign liabilitiesFinancial system deposities and equities
Thresholds< 12[12, 52]> 52< 13[13, 30]> 30
Spreads-reserves elasticity–0.13–0.419**–0.2530.035–0.609*0.259
(0.15)(0.19)(0.71)(0.18)(0.32)(0.24)
Observations82182124713274
R-squared0.330.60.770.460.490.6
Note: Robust standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%.
Note: Robust standard errors in parentheses; * significant at 10%; ** significant at 5%; *** significant at 1%.

44. Indonesia could benefit from higher reserves in terms of reduced borrowing costs. The analysis shows that the Indonesia’s current level of reserves is below the threshold estimates, suggesting that additional reserve accumulation continues to have a positive impact in reducing spreads (Figure 6). Results suggest that this benefit could be somewhat larger for Indonesia than for other emerging market countries with relatively higher reserve holdings. This exercise is likely to provide a lower bound estimate of the benefits of reserves in terms of lower financing costs, since it does not incorporate similar gains in the private sector. This is particularly relevant in the current context, where borrowing costs for corporations have increased significantly with tighter global liquidity.

45. Finally, a word of caution regards 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 that there is uncertainty regarding their true values.

E. Conclusions

46. In assessing reserve adequacy in Indonesia, the empirical analysis concludes that current reserve levels are comfortable, but there is scope for some further accumulation over the medium-term. While the estimates are sensitive to parameters and assumptions, the study suggests that current reserve levels are likely somewhat below the level predicted by a simple model of optimal reserves, suggesting that some accumulation over the medium-term could help continue reducing vulnerabilities. Furthermore, reserve accumulation continues to have a positive impact in reducing borrowing cost for both the government and the private sector.

47. Finally, continued reserved accumulation would make the economy more resilient from a financial stability point of view. However, the accumulation should be at a slower pace than in 2007, which would also help alleviate inflationary pressures. As discussed in the staff report, the current policy of recycling some of the proceeds from oil exports while safeguarding international reserves is appropriate.

APPENDIX

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:

Loss=δR+πf(R)

where δ is the opportunity cost of reserves; R is the reserve holdings; π is the probability of a crisis or sudden stop; and f(.) is the welfare cost of a crisis, which is increasing in 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.20

Data for the Threshold Estimation

Table A1.Variable definitions and sources
VariableDescriptionSource
SpreadJP Morgan EMBI spread in bpsBloomberg, Datastream
10Y US T-bondUS 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 maturing withing one yearBIS
Foreign external liabilitiesGross external liabilitiesMilessi-Feretti IIP Database
Fin. System deposits and equityTotal deposits and market capitalizationWorld Bank
Table A2.Summary statistics
ObsMeanStd. Dev.MinMax
Sovereign spread320514.9823.8–260.96182.0
US 10Y bond rate3204.70.74.06.3
High yield spread320584.7240.6329.2950.8
GDP growth3204.13.9–11.018.3
Debt to GDP31093.5265.54.92101.7
Reserves to GDP32022.019.91.5104.5
Reserves to months of imports3206.44.10.335.3
Reserves to short term debt320395.4659.46.57530.8
Reserves to broad money32035.522.92.9146.3
Reserves to foreign liabilities29825.836.82.0490.5
Reserves to fin. system deposits and equities24828.522.21.6113.9
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12Prepared by Marta Ruiz-Arranz and Milan Zavadjil (APD).
13This is using debt at remaining maturity. The ratio of reserves to short-term debt with an original maturity of less than one year is about 150 percent.
15The model is explained in more detailed in the Appendix.
16Results are robust to using averages corresponding to different time periods. The real GDP series are detrended with a Hodrik Prescott filter.
17Cerra and others (2005) finds 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 the case of 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.
18Jeanne identifies sudden stops as those years in which net capital inflows fell by more than 5 percent of GDP.
19Rodrik (2006), Levy Yeyati (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.
20Risk aversion is assumed to be equal to 2, in line with the previous literature.

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