Over the last few months we have all listened to the robust debate between our politicians and other interested observers regarding whether Barbados is holding an adequate level of foreign exchange reserves. While the debate has been useful, there is an implicit assumption that the international benchmark of an adequate level of international reserves is a good indicator. That may not be the case.
Why do we care about the reserves?
Before we can debate the benchmark, we need to understand why we even care about the level of the reserves. A simple way to think of the reserves is as a backup foreign currency savings account. Consider this simple example:
- Barbados receives money from selling its goods and services to other countries or when other countries invest in Barbados (foreign exchange inflows);
- Barbados has to spend money on goods and services it purchases from other countries or when it invests in other countries (foreign exchange outflows);
- If it spends more than it earns, it needs to make up the difference with savings (reserves).
- If you run out of savings, how will you pay your foreign currency bills?
In fixed exchange rate economies like Barbados, international reserves allow the central bank to make the implicit guarantee that it will be able to convert local currency to foreign currency on demand. Think about what would happen if the Central Bank of Barbados could no longer fulfil its promise to exchange two Barbados dollars for one United States dollar. This would mean that in order to purchase materials from abroad, you would have to obtain foreign exchange from a foreign exchange dealer and pay whatever price the dealer demands for foreign currency. In these circumstances, the market exchange rate would deviate from the pegged rate – i.e. the market exchange rate would no longer be 2:1 – forcing the authorities to abandon the peg. When you consider that we import almost all of what we consume, instability in the foreign exchange market would have wide-reaching consequences.
It is therefore not difficult to understand why so much emphasis is placed the international reserves in fixed exchange rate economies. It indicates to investors (both local and foreign) whether the peg is sustainable, and therefore the risk of exchange rate-related losses if they were to invest in the country.
Why it is important to have the right benchmark level?
I like to think of the current reserves debate as similar to steering a ship while tracking the development of a hurricane. We rely on our meteorologists to keep a close eye on every patch of cloud in the sky and watch how it develops. We expect to get warnings long before a harmless cloud becomes a hurricane. We expect to be told how quickly it was developing and when and where to expect it to hit. We may not fully understand how they do it, but we assume meteorologists have thresholds that they compare developing storms to.
But what if their thresholds are wrong? Or, what if their thresholds only signalled an approaching hurricane when we were already in the midst of it? There is nothing wrong with having thresholds. The challenge is obviously if the thresholds are adequate and give us enough time to prepare. That is the concern I have about the internationally accepted benchmark of an adequate level of reserves. I think we all accept that the country’s external position is at a very vulnerable point, but is it too late now to do anything about it?
The current benchmarks
So what level of reserves is needed to maintain the peg and support investor confidence? Economists have two popular indicative rules of thumb. One of the most quoted in local debates is 3 month or 12 weeks rule: reserves should be able to cover 12 weeks or 3 months of projected imports. It is important to know that there is no statistical justification for this ratio; it is just a figure that has become a focal point for economists. It is also subject to criticism as it ignores financial flows and focuses solely on the flow of goods and services. In a country like Barbados, this is an important failing, because while we import more goods and services than we export, we have historically attracted more capital than we have been sending abroad.
Another widely used indicator is the ratio of reserves to broad money (or the amount of printed currency as well as checking and savings deposits in a country). Consider the basic commercial banking model. Banks accept deposits from people that have surplus funds and then lend these funds to people that are in deficit and need to finance their activities. Banks therefore never have all of the deposits that they have collected in their vaults. The model works, since only a fraction of depositors would demand access to their funds on any given day. The same thing applies with reserves. If you think of the amount of money in a country as the deposits, only a fraction of these ‘depositors’ or holders of local currency would want to convert their local currency into foreign currency on any given day. The benchmark considered adequate in this instance is that reserves should be around 20 percent of broad money, i.e. only 20 percent of the money supply would need to be converted into foreign currency in the short- to medium-term, whether it is for goods purchases or investment purposes.
An alternative benchmark level
While I think that these two ratios are useful, I disagree with the benchmark levels that have been treated as sacrosanct in local debates because they ignore the many other factors that need to be considered when determining the benchmark in the first place. It’s similar to if we are only informed of an approaching hurricane when rain has already started to fall and winds are already creating 20-foot waves. Our international reserves benchmarks are far too low to be meaningful as a signal of distress.
Now let’s go back to the question we raised in the beginning: are the level of reserves Barbados currently holds adequate?
Looking at the benchmark indicators, you could conclude that the level of reserves appears to be adequate. The reserves currently cover 13.3 weeks of imports of goods and services and at March 2013 were 22% of broad money. In both cases the country is above the benchmark levels so we should be in the clear. However, the story is a bit more complicated.
Consider these three facts:
- Small states are more vulnerable to natural disasters and therefor require larger amounts of foreign currency to finance recovery efforts;
- Foreign currency flows quite freely in and out of the country and we have limited ways to control it;
- We have a very large public sector that drives a large proportion of the country’s foreign currency consumption.
This would imply that we would need to have a larger cushion than countries that do not have these characteristics. We have derived an ideal target of 22 weeks for the ratio of reserves to imports (see the recent paper where we determined the optimal level of reserves based on a statistical cost benefit analysis for more information). This is almost twice the rule-of-thumb of 12 weeks and is a direct result of the high probability of natural disasters in small states.
Even this target, however, should not be viewed as sacrosanct. We found that small states that were able to implement a prudent government expenditure management framework would be able to hold a smaller stock of reserves, without leading to a disruption of normal import and export activities or any negative impact on short- to medium-term growth. Though the latest Central Bank of Barbados press release showed declining expenditure levels, the fiscal deficit was still estimated at a relatively high 8% for the 2012/13 fiscal year.
In short, it is important that we monitor the level of international reserves in countries such as Barbados. It is equally important that we independently determine what level is the minimum that we need to comfortably meet our obligations.
 Moore, W. and Glean, A. (2013), Optimal Foreign Exchange Reserve Holdings in Small-Island Developing States, presented at the Central Bank of Barbados’ Annual Economic Review, Bridgetown.