Outline 4/22/2011. Koc University April, 2011

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1 4/22/211 Koc University April, 211 Outline Main messages Crisis experience and focus Reserves trends Review of existing approaches Proposed new approach and metric Cost of reserves Reserve alternatives Conclusions 2 1

2 4/22/211 Main messages Crisis reinforces message that reserves matter, but with diminishing returns However, clear guidance is lacking on how much are needed Traditional metrics and newer approaches give wide range of answers Proposed hybrid approach and new risk-weighted metric may be a (modest) improvement But reserves are only part of the story Main Messages 3 Reserves have mattered in past crises, Difference from pre-crisis average Consumption growth: Impact of EMP "Crisis" Years from "Crisis" RES/STD < 5 RES/STD 5-1 RES/STD 1-15 RES/STD > 15 Crisis Experience and Focus 4 2

3 4/22/211 in part due to the fiscal space they provided. Difference from pre-crisis average Cyclically adjusted primary balance: Impact of EMP "Crisis" Years from "Crisis" RES/STD < 5 RES/STD 5-1 RES/STD 1-15 RES/STD > 15 Crisis Experience and Focus 5 Reserve loss varied considerably during the recent crisis, 12 Percent of GDP Q1 28Q4-12 LBN THA ISR JOR PAN CHN CZE ZAF CRI SLV URY COL GTM ARG PHL CHL MEX TUR IDN LTU VNM PAK EST HUN BRA IND ROM MAR POL KAZ HRV BIH PER KOR ARM VEN LKA SRB ECU LVA MYS BGR UKR RUS Crisis Experience and Focus 6 3

4 4/22/211 but short-term debt was not a good predictor. 5 Percent of GDP Short-term debt LBN THA ISR JOR PAN CHN CZE ZAF CRI SLV URY COL GTM ARG PHL CHL MEX TUR IDN LTU VNM PAK EST HUN BRA IND ROM MAR POL KAZ HRV BIH PER KOR ARM VEN LKA SRB ECU LVA MYS BGR UKR RUS Crisis Experience and Focus 7 We focus on precautionary reserves How much reserves should emerging market countries hold for precautionary reasons? Crisis prevention Crisis mitigation Not directly discussing non-precautionary motivations Intergenerational savings Exchange rate policy } about NFA, not reserves Externalities arising from reserves/nfa accumulation Reserves concern liquidity Crisis Experience and Focus 8 4

5 4/22/211 Why do countries hold reserves? Reserve Trends 9 Reserves growth has outpaced traditional metrics 5, 4,5 4, 3,5 3, 2,5 2, 1,5 1, 5 ALL EM ($bn) Reserves 2% of Broad Money 1% of STD 3 Months of Imports Reserve Trends 1 5

6 4/22/211 in all regions. 1, 9 8 EUR EM ($bn) 35 3 MCD EM ($bn) % of Broad Money 1% of STD 3 Months of Imports Months of Imports 2% of Broad Money 1% of STD WHD EM ($bn) 4,5 4, APD EM ($bn) 5 4 2% of Broad Money 3,5 3, 2,5 2% of Broad Money % of STD 3 Months of Imports 2, 1,5 1, 5 3 Months of Imports 1% of STD Reserve Trends Reserves and alternate metrics 1% 9% 8% 3mths imports 1% of short-term debt 2% of M2 Wijnholds/Kapteyn Jeanne-Ranciere (standardized) Reserves demand model 7% 6% Reserves/GDP 5% 4% 3% 2% 1% % SVK SVN ECU DOM BLR VEN PAK COL LKA ZAF ATG TUR IDN MEX MNE PAN CRI AZE ARE CHL BRA ARG SLV HND GTM GAB VNM JAM EGY BLZ ALB LTU AGO POL GEO SYC MDV IND URY MUS CZE UKR HRV ARM MKD BIH KAZ PRY PHL KNA TUN PER MAR MNG ROM EST KOR SYR ISR RUS MDA BGR LVA HUN SRB JOR BOL CHN MYS THA IRQ LBN DZA TKM LBY Review of Existing Approaches 12 6

7 4/22/ ranges for selected metrics 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % SVK SVN ECU DOM BLR VEN PAK COL LKA ZAF ATG TUR IDN MEX MNE PAN CRI AZE ARE CHL BRA ARG SLV HND GTM GAB VNM JAM EGY BLZ ALB LTU AGO POL GEO SYC MDV IND URY MUS CZE UKR HRV ARM MKD BIH KAZ PRY PHL KNA TUN PER MAR MNG ROM EST KOR SYR ISR RUS MDA BGR LVA HUN SRB JOR BOL CHN MYS THA IRQ LBN DZA TKM LBY Review of Existing Approaches 13 What approaches are used? (percent of total respondents) % 1% 2% 3% 4% 5% 6% TRADITIONAL METRICS Ratio to imports Ratio to ST debt at r.m. Ratio to monetary aggregates SCENARIOS/COMBINATION RULES PEER COMPARISON OPTIMALITY MODELS Review of Existing Approaches 14 7

8 4/22/211 Are country reserves adequate? 1% 91% (of total respondents) 75% 5% 25% % 9% % % % Very Somewhat About right Somewhat Significantly inadequate inadequate higher than higher than needed needed Review of Existing Approaches 15 Possible new approach New combination metric proposal Identify risk-weighted liability stock Estimate reserve holdings needed against this stock Supplement with scenario analysis Future work can consider imbedding in a cost-benefit framework Attractive in principle, hard to apply in practice 16 8

9 4/22/211 4 BoP flows in crisis: Brazil 3 2 Percent of GDP Capital flight Short-term debt Equity liabilities Short-term debt 98Q1 98Q2 98Q3 98Q4 99Q1 99Q2 99Q3 8Q1 8Q2 8Q3 8Q4 9Q1 9Q2 9Q3 9Q BoP flows in crisis: Russia Stock of reserves Percent of GDP Percent of GDP Capital flight Short-term debt Capital flight -4 Short-term debt -9 98Q1 98Q2 98Q3 98Q4 99Q1 8Q1 8Q2 8Q3 8Q4 9Q1 9Q2 9Q3 9Q

10 4/22/211 Tail risks from past crises guide risk weights Broad Money Float Probability density 1th percentiles Fixed Source: WEO Percent change 19...across different potential losses Probability density 1th percentile Float Broad Money Fixed Probability density 1th percentile Float Exports Fixed Percent change Percent change Short-term debt (RM) Float Other liabilities Probability density 1th percentile Float Probability density 1th percentile Fixed Fixed Percent change In percent of other liabilities 2 1

11 4/22/211 We base a risk-weighted liability stock on the above FX drains. Based on the 1 th percentile of historical outflows: Pegs: 3 percent of STD, plus 15 percent of other external liabilities (excl. FDI), plus 1 percent of broad money, plus 1 percent of exports Floats: 3 percent of STD, plus 1 percent of other external liabilities (excl. FDI), plus 5 percent of broad money, plus 5 percent of exports 21 But outperforms them in predicting pressure. Logit Analysis: Probability of External Pressure (1) (2) (3) (4) (5) (6) (7) (8) Exchange Market Pressure events Crisis events Alternate Metric -.784** *** *** *** *** *** -1.27** -1.54*** CAPB Res/ST Debt 1.4E-4 Res/Broad Money -2.88E-4** Res/mths of imports.14 Res/Wijnholds-Kapteyn.372 Max(STD,BM,M)/GDP Constant -2.25*** *** *** *** *** *** *** -3.35*** 22 11

12 4/22/211 In the second stage, we need to judge how much coverage is adequate. Percent EMP event probability (for zero cyclically adjusted primary balance) Change in real consumption (percent) Consumption drops in crisis Lagged Reserves / New Metric (in percent) Source: Staff calculations Lagged Reserves / New metric (in percent) Source: WEO and staff calculations. 23 Around one-third of countries are within 1-15 percent of the metric. 3% Reserves against risk-weighted metric (reserves as percent of metric, 21) 25% 2% 15% suggested adequacy range 1% 5% % PAN ECU BLR DOM LTU LVA CRI JAM VEN HRV UKR ZAF TUR HND TUN BGR ARG CHL GEO SLV PAK MYS BIH MEX HUN EGY AGO IDN MAR POL MUS KAZ BRA GTM ROM MDA PRY COL CHN URY RUS IND SRB PHL ARM THA PER BOL Source: WEO and staff calculations

13 4/22/211 Reserves demand regression suggest similar factors. 12% 1% 8% 6% 4% Contributions to cumulative reserves increase Residual (percent of GDP) Peg Past Crisis Portfolio Liability/GDP Broad Money/GDP Export volatility Lending rate differential Partmers' growth volatility Terms of trade volatility Import/GDP Reserve/GDP 2% % -2% * * out of sample prediction Source: WEO, IFS and staff calculations. 25 Applying this any metric requires judgment. Composition of short-term debt Capital controls Dollarization Remittances Fundamentals 26 13

14 4/22/211 How much do reserves cost? Possible measures: 1. Net financial cost 2. Costs from maturity of reserves vs. sovereign liabilities 3. Sterilization costs 4. Actual or potential exchange rate valuation losses 5. Opportunity cost of foregone consumption or investment Net financial cost appropriate for EMs with market access At the margin, reserves are effectively financed by external debt Default risk and not just maturity structure Not costs from monetary and exchange rate policy decisions EM spreads (during normal times) as good proxy for NFC How to account for the effect of reserves in reducing sovereign spreads? Cost of Reserves 27 and how have costs changed? EMBI Spreads and Marginal Cost of Holding Reserves, 2-1 (median values) EMBI spreads, bps Median cost, bps Cost of Reserves 28 14

15 5 4/22/211 Which can play the role of reserves? (percent of total respondents) % 25% 5% 75% 1% Central bank swap lines Contingent credit lines: IFIs Contingent credit lines: banks Commodity price hedging SWF assets Reserve Alternatives 29 Conclusions Assessing reserve adequacy remains an inexact science Proposed new risk-weighted metric is probably an improvement But ultimately a good policy framework is critical And country-specific circumstances critical Adjustment of metric for country characteristics Scenario analysis of possible drains on reserves Country authorities own assessments of risks Existence of potential reserve substitutes and other country insurance Conclusions 3 15

16 4/22/211 Thank you 31 For further information James Roaf: Nathan Porter: 32 16

17 4/22/211 Market reaction to swap lines was instant, but short-lived for EMs, until G-2 London summit/imf lending reforms Federal Reserve liquidity swaps and Market Reaction (USD billion) Fed swap lines to BRA, MEX, KOR, SGP G-2 London Summit IMF lending reforms EMBI spread, RHS VIX, RHS CDS spread for BRA, MEX, KOR, SGP (RHS) Mar-1 Jan-1 Dec-9 Oct-9 Sep-9 Aug-9 Jun-9 May-9 Apr-9 Feb-9 Jan-9 Nov-8 Oct-8 Sep-8 Jul-8 Jun-8 Apr-8 Mar-8 Feb-8 Dec-7 Policy responses to systemic crises 33 USD bn Federal Reserve dollar liquidity swaps and market reaction (USD billion and bps) Fed swap lines to BRA, MEX, KOR, SGP EMBIG G-2 London Summit IMF lending reforms bps VIX CDS (AUS, DNK, NZL, SWE) CDS (BRA, KOR, MEX) Mar-1 Jan-1 Oct-9 Jun-9 Apr-9 Feb-9 Jan-9 Oct-8 Jul-8 Jun-8 Apr-8 Mar-8 Feb

18 4/22/211 (also excluding China and oil exporters) 5, 4,5 4, 3,5 3, 2,5 2, 1,5 1, 5 $bn ALL EM Excluding China 3 Months of Imports 1 Percent of STD 2 Percent of Broad Money Unlike other financial account stocks, FDI does not leave. FDI liabilities Probability density Float Fixed In percent of FDI liabilities Sources: WEO and BOP Statistics 36 18

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