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.
A simple way to think of the reserves is as a backup foreign currency savings account. 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.
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 on the international reserves in fixed exchange rate economies.
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 the three-month or 12-weeks rule: reserves should be able to cover 12 weeks or three 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 chequing and savings deposits in a country). Consider the basic commercial banking model.
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. Our international reserves benchmarks are far too low to be meaningful as a signal of distress.
It should be stated that small states are more vulnerable to natural disasters and therefore 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, and 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.
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. 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 the minimum level that we need to comfortably meet our obligations.
Dr Winston Moore is a senior lecturer in the University of the West Indies’ Economics Department