Caribbean economies face a binding foreign exchange constraint that requires prudent management of foreign reserves for protection against external shocks and to engender market stability and confidence.
Small open countries face a binding foreign exchange constraint that requires prudent management of foreign exchange reserves to mitigate against adverse economic challenges and to engender market confidence and stability. The build-up of adequate foreign reserves has become especially relevant given the prolonged and uncertain nature of the global economic environment.
In general, countries accumulate foreign exchange reserves primarily for precautionary and mercantile purposes. Precautionary motives reflect the need for protection against external shocks and to provide sufficient coverage for crisis prevention and management.
The accumulation of foreign exchange reserves for mercantile purposes is closely related to the pursuance of policies to promote exports and to attract foreign direct investment inflows. In the Caribbean, foreign exchange reserves arguably serve both purposes, with the predominance accorded to the precautionary purpose of reducing external vulnerability.
While the literature does not clearly define reserves adequacy, there is consensus on the various indicators, methods and factors that may be used to determine the adequacy or optimal holdings of foreign reserves.
An important consideration in the debate is whether Caribbean countries are accumulating reserves beyond adequate or optimal levels, since large or excessive reserve holdings have costs.
From a practical perspective, the approaches adopted by individual countries, which involve choosing relevant benchmarks and designing appropriate stress tests, should reflect country-specific economic circumstances.
The evolution of the literature on foreign exchange reserve adequacy has been influenced by changing global monetary systems, past financial crises and the acceleration of reserve accumulation, particularly in the emerging market economies in South and East Asia.
The main drawback of [previous] econometric and forecasting research is that the results are model-dependent and accurate only within sample. The Korean experience during the 2008 global financial crisis shows the limitation
of using such an approach. Despite the country being assessed as having excess reserves, both the Korean currency and stock market came under severe pressure during the third quarter of 2008, triggering fears of a repeat of the 1997-98 Asian financial crisis.
These issues suggest a case can be made for a more contingency-based approach, possibly using stress tests, that takes into account severe negative shocks a country may face when assessing foreign exchange reserve adequacy.
The overall findings suggest that Caribbean countries should pursue economic policies aimed at enhancing foreign exchange-earning capacity needed to boost foreign reserves. This is imperative in light of significant slowdown in economic growth, particularly in the service-based Caribbean countries, stemming from the prolonged challenging economic circumstances gripping the region.
The Caribbean, unlike developing Asia, has not amassed unprecedented levels of reserves and should continue to exercise prudence in reserve management. The informal ratios narrowly focus on either current or capital account vulnerabilities, whereas Caribbean countries face vulnerabilities related to both accounts.
The above was captured from a 2013 paper on the topic An Assessment Of Reserve Adequacy In Caribbean Economies authored by the late Professor Roland Craigwell, formerly of the University of the West Indies; Central Bank of Barbados chief research economist Darrin Downes; and Skeeta Carasco while she was an intern at the Central Bank.