Reserve Adequacy Measures for Emerging Market Economies

The optimal level of reserves has been a controversial issue from the times of fixed exchange rate regimes to the recent times of exchange rate flexibility. Earlier literature such as that of Heller (1966) points out that reserve accumulation has been driven by a precautionary motive against balance of payments imbalances. Similarly, Clark (1970) notes that even in the presence of a temporary deterioration of the balance of payments, international reserves enable a country to follow its domestic policy goals and reserves are beneficial because they provide a country with leeway to adopt suitable policies in the event of a permanent deterioration. Amongst others in recent times, Lee (2004) mentions that international reserves may mitigate international liquidity constraints encountered by a country. Yet again in recent times, reserve accumulation has been considered to be motivated by a need to insure a country against balance of payments risks. This is evident in the view of using reserves as an insurance mechanism against sudden stops. For example, Jeanne and Ranciere (2006) argue that reserves can smooth domestic absorption in the event of a sudden stop when debt is not rolled over and instead reserves can be used to repay the debt. In a similar perspective, such a possibility and theoretical construct is outlined by Aizenman and Lee (2007) where long-term investment projects are financed using foreign assets and, in the event of sudden stops and capital flight, international reserves can help long-term investment projects to continue rather than be liquidated.