THE LEVEL OF FOREIGN RESERVES IN EU ACCESSION COUNTRIES Jerome - PDF document

THE LEVEL OF FOREIGN RESERVES IN EU ACCESSION COUNTRIES Jerome Vacher IMF Institute Paper presented at the conference “Exchange rate strategies during EU enlargement”, ICEG European Center, Budapest, November 27-30 2002 This version: November 2002 Draft. Please do not quote Abstract The views expressed in this paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. This paper describes research in progress by the author(s) and are published to elicit comments and to further debate. This paper focuses on the level of foreign reserves in the 10 transition economies candidate to EU accession. The level of reserves is shown to be adequate according to a benchmark based on short term external debt and money supply, as well as according to a more traditional measure. This high level reached during transition can be explained by the effects of trade openness, financial development, lower interest rates and real convergence. In the medium to long run, some determinants of the demand for reserves and the comparison with the European Union point to a lower level of reserves. However, some strong counter forces will push reserves in the other direction on the way to EMU, depending to a large extent on the exchange rate policies followed, but above all on the magnitude of capital flows and the possibility of speculative attacks, notably during the ERM-II period. JEL Classification Numbers: F30, O57, P27 Keywords: Foreign reserves, vulnerability, currency crisis, EU candidate countries Author ’ s E-Mail Address: jvacher@imf.org

2 I. Introduction ............................................................................................................................3 II. The level of foreign reserves: recent issues ..........................................................................5 A. Currency crises and reserve adequacy ......................................................................5 B. The demand for foreign reserves and optimal reserves: a recent renewal ................7 III. Reserves and reserve adequacy in the 10 EU candidate countries ....................................10 A. The evolution of reserves: some facts.....................................................................10 B. Reserve adequacy in the EU candidate countries....................................................14 C. The demand for reserves: some evidence ...............................................................20 IV. The level of reserves: some implications for the road to EU and EMU............................25 A. Reserves and convergence ......................................................................................25 B. The specifics of the road to EMU: implications for the level of reserves...............28 V. Conclusion ..........................................................................................................................34 VI. References..........................................................................................................................36 VII. APPENDIX ......................................................................................................................43 ......................................................................................................................................52

3 I. I NTRODUCTION Foreign reserves play an essential role in all economies and more so in emerging economies dependent on capital flows and illiquid domestic markets. Often, when compared to GDP, they represent a volume of significant economic importance. The level of reserves plays a substantial and growing role for the private sector to assess sovereign creditworthiness and country risk. Recently, there has been a renewed attention to foreign reserves and liquidity that can be linked with several developments in emerging economies and economic analysis. First, the recent emerging market crises showed how reserves, which in many cases were considered to stand at a satisfactory level, could be wiped out in a matter of weeks or even days and force governments to costly devaluations. Sovereign liquidity was not properly evaluated by many market participants (e.g. Mexico, Thailand, notably because of a lack of transparency). Second, in the same vein, it was also noted that some countries which resisted well during the Asian crisis were holding large amounts of reserves 1 ; this has led to some calls for “self protection” or “self insurance” (Feldstein, 1999), in the form, for example, of a higher level of reserves. After the different crisis episodes, some countries also committed to rebuild reserves, even in the case of newly floating regimes (e.g. Korea). Third, the economic analysis of currency crises, especially in an attempt to identify predictive indicators (early warning systems) also led to greater emphasis on liquidity and reserves. Consequently, the effort is now on trying to better 1 Fischer (1999) pinpointed how countries with high reserves survived the Asian crisis (e.g. Taiwan).

4 assess an adequate, if not optimal, level of reserves given the increasing openness of capital accounts, financial liberalization and development. Transition countries candidate to the EU 2 are now, for the majority of them, among the most advanced emerging economies. They had to move, in a short period of time, from no openness and inconvertibility of their currencies, to the status of emerging economy, “converging” economy for some, and finally, member of the EU in a few years’ time (probably 2004 at the earliest). Not only are they moving very quickly from one stage to an other but they have experienced a great variety of economic policies, and more specifically of exchange rate policies: in particular, all the exchange rate arrangements were experimented at some point or another (pegs, currency boards, crawling pegs and bands, floats). A comparative analysis of the level of reserves per se in transition countries candidate to the EU is now needed, with the hindsight of a few years’ of transition . After a short review of recent issues on the level of foreign reserves (Part II) , it is shown that the level of reserves is high in EU candidate countries and can be characterized as adequate, even if there are substantial differences in levels between countries; the overall high demand for reserves can be explained by several determinants (Part III). In the long run, it can be inferred that the level of reserves will go down and converge to the EU level. However, how fast this level will go down, will depend on the transition path to EMU and the different exchange rate policies adopted, the size of capital flows to be expected in the region, the risk of speculative attacks, factors mostly pushing for a high level of reserves (Part IV). 2 Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia.

5 II. T HE LEVEL OF FOREIGN RESERVES : RECENT ISSUES A. Currency crises and reserve adequacy The role of reserves and liquidity was emphasized in studies which tried to explain external vulnerability and to point out the most efficient economic signals to predict currency crises (early warning systems - EWS). This led to a depart from the traditional reserve adequacy measure in terms of imports which can still be applied as the main benchmark for the least advanced economies less integrated in the world financial markets, but along with other measures for emerging economies. As a consequence, reserves in emerging economies are now routinely compared to two main measures of reserve adequacy: - reserves/ short term external debt: the contribution of higher external liquidity to a decrease in vulnerability would suggest full coverage of total short term external debt as a practical rule for reserve adequacy for countries which could be faced with redemption or absence of rollover at short notice. A real exchange rate overvaluation and high current account deficits would call for even higher levels of reserves (Bussière and Mulder, 1999). As a policy answer to this specific factor of external vulnerability, the “Greenspan-Guidotti rule” proposes that a country should be capable of living without foreign borrowing up to one year, with an average maturity of external liabilities exceeding a certain threshold e.g. 3 years, and, if possible, a liquidity at risk standard 3 . - reserves/ M2: additionally to an “external drain”, led by a high level of short term external debt and roll over problems, monetary authorities may have to face an “internal drain”, as well. 3 Greenspan (1999). Liquidity at risk rests on the idea of applying value at risk models used in commercial banks to sovereign analysis, focusing on liquidity and maturity of assets and liabilities; just as a bank would be vulnerable to a run on its deposits (mostly short term), a country could be vulnerable to a run on its external debt especially if it is mostly market determined (e.g. bonds).