This paper provides a historical perspective on the role of international reserves in low-income countries as a cushion against large external shocks over the last three decades - including the current global crisis. The results suggest that international reserves have played a role in buffering external shocks, with the resulting macroeconomic costs varying with the nature of the shock, the economy’s structural characteristics, and the level of reserves.
1. This paper is part of the International Monetary Fund’s multi-departmental research project to study reserve adequacy in low income countries (LICs).1 It provides a historical perspective on the role of international reserves as a buffer against large external shocks over the course of the last three decades—including the current global crisis. In particular, the paper seeks to assess whether the macroeconomic costs associated with external shocks were larger in LICs that had lower international reserve holdings prior to a shock event. The following questions are thus addressed: (i) what are the relevant external shock episodes in LICs?; (ii) what are the macroeconomic costs associated with them?; (iii) do such costs vary depending on structural characteristics of the economy, including the level of international reserves?
2. Recent studies on LICs suggest that international reserves may effectively help limit the macroeconomic volatility stemming from exogenous shocks. Though LICs are subject to a wide variety of shocks, it is generally recognized that they are particularly vulnerable to external shocks and natural disasters (Becker et al. 2007). Moreover, the economic costs associated with such shocks are large and seem to vary with the structural characteristics of the economy (Berg et al., 2011). Against this background, international reserves may play an important role in mitigating the impact of shocks and containing macroeconomic volatility (IMF, 2011; Drummond and Dhasmana, 2008).
3. The paper extends previous research on the role of international reserves by examining a wide range of external shocks over the last three decades and by differentiating LICs according to their structural characteristics. For the period 1980–2007, an event-study analysis approach is used to determine the losses in terms of forgone growth of real GDP and consumption per capita associated with different types of shocks (i.e. external-demand, terms-of-trade, climatic, FDI, and aid shocks) and structural characteristics of the economy (i.e. exchange rate regime, export and import concentration, level of indebtedness, and presence of an IMF program). Such losses were then compared across countries with different international reserve holdings in the year prior to the shock episode. For the current crisis period (2008–2010), a four-year event window centered in 2008 was used to assess the impact of the current crisis on several key macroeconomic variables, including real GDP, real per-capita consumption, real p r-capita investment, and external current account.
4. The structure of the paper is as follows. Section II describes the methodology used to identify shock episodes during the period 1980–2007, presents the results of the event study analysis for LICs, and checks for robustness. Section III focuses on the current global crisis (2008–2010). Section IV provides concluding remarks.
IMF.World Bank. Author/Editor:Crispolti, Valerio; Tsibouris, George C.