INTERNATIONAL RESERVES MANAGEMENT

International Reserves Management In Africa: Realising The Return Aspect

International Reserves Management In Africa: Realising The Return Aspect

Introduction

African countries have accumulated substantial foreign currency reserves in recent years, mostly from higher commodity exports as well as aid flows. In the context of macroeconomic stabilization, which remains at the forefront of national economic policymaking and aid conditionality, African countries are induced to hold reserves to allow monetary authorities to intervene in markets to control the exchange rate and inflation. Adequate reserves also allow the country to borrow from abroad and to hedge against instability and uncertainty of external capital flows. However, reserve accumulation can have high economic and social costs, including a high opportunity cost emanating from low returns on reserve assets, losses due to reserve currency depreciation, and forgone gains from investment and social expenditures that could be financed by these reserves. Therefore, African countries need to have a better understanding of the determinants and economic costs of reserve accumulation and to design optimal reserve management strategies to minimize these costs and maximize the gains from resource inflows. This study uses panel data from 21 African countries to examine the sources, motivation and economic implications of reserve accumulation with a focus on the impact on the exchange rate, inflation, and public and private investment. While the level of reserves remains adequate on average, some countries have accumulated excessive reserves especially in recent years. The empirical analysis in this paper shows that the recent reserve accumulation cannot be justified by portfolio choice motives (in terms of returns to assets) or stabilization objectives. At the same time it has resulted in exchange rate appreciation while it has yielded little benefits in terms of public and private investment. The evidence suggests that African countries, especially those endowed with natural resources, need to adopt a more pro-growth approach to reserve management.

Literature Review

The buildup of reserves in Africa and emerging economies has accelerated over the last decade with the bulk of the increase occurring in oil-exporting countries. The accumulation of reserves has occurred at a time of generally stable or slightly appreciating exchange rates, particularly against the US dollar. Countries generally maintain reserves in order to effectively manage their exchange rate and to reduce adjustment costs associated with fluctuations in international payments. Accordingly, demand for international reserves increases with global trade. Empirical research shows that both the variance and level of trade (current account and openness to trade or the propensity to import) are important determinants of demand for reserves (see Mendoza 2004). In practice, however, most countries follow the “rules of thumb” in determining the optimal level of reserves, including maintaining reserves equivalent to at least three months of imports (Mendoza 2004). The recent accumulation of reserves in developing countries has been largely interpreted as a form of self-insurance precipitated by the high level of global economic and financial instability and the absence of an adequate international system for crisis management. The 1997 East Asian financial crisis is a good example in this regard ...