Measuring the Costs of International Reserve Accumulation in Brazil, Argentina and Mexico

In a previous piece here, we measured the sterilization costs associated with international reserve accumulation by Brazil, Argentina and Mexico, between 2003 and 2007. In this piece we measure the costs of holding reserves by these three countries. The main difference between the previous piece and this one is that we are not concerned about sterilization policies. The debate is relevant because according to Dani Rodrik the net reserve holdings of developing economies has increased sharply: from 6% of GDP in 1995 to 30% in 2004. 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.

Rodrik does not provide a number for the optimal level of reserves but argues against the massive accumulation of reserves that developing economies have been building since the 1990s. In 2004, developing countries lost 1% of their GDP by holding more reserves than the amount required to cover three months of imports. He argues that current levels of reserve holdings are excessive.

Rodrik emphasizes that government reserve accumulation is often the counterpart of private sector flows, and argues that conceptually, the difference between the rate private lenders charge private sector borrowers for short-term external lending and the rate of return on the government’s reserve assets offers the best measure of the social cost of holding reserves. However, given data difficulties, Rodrik uses the historical average of the EMBI spread as a proxy for the private sector borrowing rate in his calculations. Rodrik defines excess reserves as reserve holdings greater than required to cover three months of imports and – using a 500 basis point spread – argues that the cost of excess reserves in 2004 is almost 1% of emerging economies’ GDP. His back of the envelope calculations also suggest that protection against the sharp output swings associated with sudden stops in capital flows is also worth about 1% of emerging market GDP. However, Rodrik argues that a decrease in the short-term external debt of emerging countries could reduce the risk of a sudden stop at a lower overall social cost than high levels of reserves.

Instead of using the EMBI spread, we used the yearly changes in the short term interest rates for each one of the three countries. In turn, following Rodrik’s methodology we use the Libor (6 months) as a proxy for short term external lending. Clearly, the difference between the short-term domestic interest rates and the Libor is the cost of accumulating reserves.

In table 1 we provide the net international reserves for each country. In table 2 we have the yearly change in net international reserves for each country, the percentage change in the short term interest rates and the 6 month Libor. In table 3, we calculate the interest rates differential defined as short term domestic interest rates minus the short term external interest rates. This difference (that we would rather not coin ‘risk premium’) is one way of measuring the opportunity costs of holding reserves. In table 4 we multiply the yearly change of international reserves by the interest rates differential and obtain the cost of accumulating reserves for each of the three countries on a yearly basis.

In the case of Brazil, the total cost of reserve accumulation between 2003 and 2007, is $13.3 billion. According to Lipschitz, Messmacheer and Mourmouras the estimates of the cost of holding reserves based on the difference between domestic and foreign interest rates tends to overstate the real cost of holding reserves, as most estimates ignore capital gains (and losses) from exchange rate changes. Since the currencies of most emerging markets have tended to depreciate over time, the costs of holding reserves are often overestimated.

Holding reserves is costly, but without reserves, a sudden stop in capital flows leads to sharp falls in consumption and output. According to Garcia and Soto developing countries should hold 10% of their GDP as international reserves to prevent sudden stops. Using this measure, we notice in table 5 that only Mexico did not aim to accumulate more than 10% of GDP as international reserves. In 2007, both Argentina and Brazil have more than 10% of its GDP as reserves. In brief, the idea that Brazil is accumulating ‘too much’ international reserves seems to be true. What remains to be seen is whether the Brazilian government will indeed implement a sovereign wealth fund to deal with excess reserves (international reserves minus short-term debt) or will create a fund to subsidize the domestic industries, as explained by Claudio Haddad.