Friday, November 2, 2007

A Measure of Sterilization for Brazil: 2003 - 2007

(with Ayah El-Said)

The increase in international reserves is no longer limited to Asia. In Latin America, the net reserve holdings have sharply increased from 10% of GDP 14% over the period 20003- mid 2007. This rise has led to a renewed focus on the costs and benefits of holding large amounts of reserves, and new research that tries to assess the scale of reserve holdings needed to limit emerging markets’ exposure to a sudden stop in private capital flows.

Historically, the literature has worked with three intuitive indicators: 1) reserves/imports; 2) reserves/M2 and 3) reserves/short-term external debt. The first indicator is justified by the possibility of an unexpected decrease in the demand for exports such that the country should hold enough reserves to cover at least 4 months of imports. The second indicator implies that countries should have reserves equal to 20% of their M2 in case of an unexpected capital outflow. The third indicator (known as the Greenspan-Guidotti rule) implies that countries should have enough reserves to cover 100% of their short-term external debt.

Using the third indicator (Guidotti-Greenspan rule) we notice a sharp increase in excess reserves between 2003 and 2007. In the case of Brazil, for example, the country’s excess reserves is equal to $177 billion in 2007, an amount almost twice as large as the short term debt.



There are two related questions that analysts are posing more and more often:
- What is the opportunity – cost of holding reserves?
- How much of such increase in international reserves is being sterilized by the government?
Whereas both are relevant questions, we chose to provide a tentative answer for the second question. In another piece we will present our calculations for the opportunity costs of reserves.
A Measure of Sterilization for Brazil
There are two related questions that analysts are posing more and more often:
- What is the opportunity – cost of holding reserves?
- How much of such increase in international reserves is being sterilized by the Brazilian government?

Whereas both are relevant questions, we chose to provide a tentative answer for the second question. In another piece we will present our calculations for the opportunity costs of reserves.

A Measure of Sterilization for Brazil

The latest World Economic Outlook provided a measure of sterilization given by:



We follow this methodology and run a simple OLS regression for Brazil over the period 2003-2007 in order to find the coefficient δ.



The latter turns out to be statistically significant with the regression being robust (the values in brackets are the t-statistics). We then substitute the δ in the monthly ∆NFA data, as a way to find out the degree of sterilization. By doing such procedure we are able to compare the left hand side of equation (1) to the right hand side. In turn, if the change in M2 is less than the right hand side of (1) the country is ‘over sterilizing’(represented as a negative value in the figure below). The reason for ‘over sterilization is best explained by Higgins & Klitgaard: “Sterilized reserve purchases face no clearly defined limit since the central bank can allow its net domestic assets to fall below zero by issuing new liabilities.”
If the change in M2 is greater than the right hand side of (1) then the country is not fully sterilizing its inflows (displayed as a positive value in the figure below). Finally if both sides of (1) are equal then the country is fully sterilizing its international reserves and hence the outcome is zero. The following graph depicts the results for Brazil.



In the above chart we notice that Brazil is sterilizing its inflows on a monthly basis since 2003. However, since 2005, the above figure shows that Brazil is sterilizing almost the whole increase in international reserves such that the change in M2 tends to zero.

Sterilization and Optimum Level of Reserves: A Few More Thoughts
Building on the work by Garcia and Soto, Jeanne and Ranciere developed a formal model to assess the optimal level of reserves. For Jeanne and Ranciere, developing countries should hold 10% of their GDP as international reserves to prevent sudden stops. According to this measure, Latin American countries in 2003 pursued the right strategy by increasing their reserves, whereas emerging Asia had more than 10% of its GDP as reserves.

Holding reserves is costly, but without reserves, a sudden stop in capital flows leads to sharp falls in consumption and output. Their model implies that the optimal level of reserves is a function of the probability of a sudden stop, the output loss in the event of a sudden stop, the level of private external debt to GDP (the roll-off of short-term private debt in their model triggers the fall in output), the term premium and the country’s level of risk aversion. A high level of risk aversion, a high risk of a sudden stop and large expected output losses all increase the optimal level of reserves, a rise in the term premium increases the cost of holding reserves and thus reduces desired holdings.

Their benchmark calibration for these parameters implies an optimal level of emerging market reserves of 10% of GDP during 1973-2003 period. Interestingly enough, this works out to average holdings of reserves equal to 92% of short-term debt – more or less what the Greenspan-Guidotti rule implies. The authors’ work found that the probability of a sudden stop is reduced by strong growth, and increases with real exchange rate appreciation, a rising ratio of public debt to GDP, a high level of openness to financial flows and high levels of liability dollarization in the economy. For example, the baseline 8% probability of a sudden stop in the model implies holding reserves equal to 8.6% of GDP. However, a 20% real appreciation increases the sudden stop probability by 4.3% and raises the optimal level of reserves by 2.7% of GDP. A rise in the public debt to GDP ratio from 40% to 60% of GDP increases the optimal reserve level by 1.7% of GDP. Consequently, the optimal level of reserves varies according to a country’s – and a region’s -- vulnerability.

Our index is a simple measure that tries to capture the degree of sterilization of a country. This is a first step to build a broader measure of optimum level of reserves. In our next exercise we intend to present the sterilization costs in terms of GDP. In brief, our goal is to start thinking on a broader measure of sterilization that can be used for any country as a way to find out the optimum level of reserves.

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