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ON THE RIGHT: Foreign reserves not set in stone


Professor Winston Moore

ON THE RIGHT: Foreign reserves not set in stone

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Is Barbados facing a foreign reserves crisis?

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 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, 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 whether the peg is sustainable, and therefore the risk of exchange rate-related losses if they were to invest in the country.

Economists have two popular indicative rules of thumb. One of the most quoted in local debates is reserves should be able to cover 12 weeks or three months of projected imports.

There is no statistical justification for this ratio; it is just a figure that has become a focal point for economists. 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).

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 per cent of broad money.

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; 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 – an ideal target of 22 weeks for the ratio of reserves to imports.

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.

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.

 

Professor Winston Moore is head of the Department of Economics at the University of the West Indies, Cave Hill Campus, and a former president of the Barbados Economic Society.

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