By Ray Charles Musau
September 2011
The recent global financial crisis has clearly highlighted the importance of an adequate level of reserves for reducing the costs associated with a foreign exchange liquidity shortage. The issue of reserve adequacy has been broadly discussed for a number of years and this trend is likely to continue. Conceptually reserve adequacy is the level of reserves that ensures smooth balance of payments and macroeconomic adjustment in unpredictably changing economic environment, e.g. external price shocks, reversals in short-term foreign capital flows. However, there is no common approach for estimation of reserve benchmark level.

Given the inevitability of increasing internationalization, and the ever changing range of financial instruments, the expected levels of capital flows into and out of a country have become particularly important in determining foreign exchange reserve adequacy.

The most versatile approach proposed by Alan Greenspan several years ago was to identify all balance of payments risks and to develop stochastic tests (stress-tests) measuring balance of payments losses with a given probability. However, the implementation of this approach is extremely cumbersome and thus countries continue to use more conventional indicators of reserve adequacy such as ratios of reserves to imports, reserves to money aggregates and reserves to measures of external debt. Essentially all these indicators are rules of thumb with certain economic interpretation.

Until recently the most widely spread indicator of reserve adequacy was reserves expressed in months of imports of goods and services. In this context the level of reserves covering three months of imports was deemed as the most appropriate. Reserves equivalent to three months import cover was considered sufficient for adjusting imports without shocks to the economy. But as the Asian financial crisis of 1998 and the current global crisis proved, this indicator was insufficient to avoid Balance of Payments problems and should therefore be augmented with other criteria that take account of changes in demand. This measure of reserve adequacy may actually look good at times when demand for imports collapses but turns out to be inappropriate in times of financial stress when the reserves are required most.

Following the increased internationalization of financial markets, especially through the opening of capital accounts, concern for holding adequate international reserves has transcended current account considerations. In some emerging markets where the confidence of resident investors in the domestic currency has not been particularly high or financial markets are underdeveloped, risks of resident capital flight have been high. For such countries important indicators of reserve adequacy are ratios of reserves to base money or other money aggregates. These indicators are also relevant for countries with hard exchange rate arrangements, especially a currency board.

Market watchers, rating agencies and countries are nowadays concerned about their respective net liability or short-term debt positions as well. As such, external debt servicing needs to also explain international reserve holdings among countries. This has become much more important given that the amount of international reserve holdings by a country is a major consideration in the country’s sovereign credit rating (i.e. a measure of the financial capacity and willingness that a country has to pay external debts). Therefore, adequacy of international reserves should also be measured in terms of a country’s short-term foreign currency denominated debt.

This study aims to analyse the indicators for reserves adequacy and their application in the determination of optimal reserve adequacy for Kenya.