Monday, 24 June 2013

Reserves adequacy in Tunisia

The IMF loan will be used to increase Tunisia’s international reserves to adequate levels. But what is adequate?

On 7 June, Tunisia entered a two-year programme with the International Monetary Fund (IMF) worth $1.7 billion, making it the fourth country in the region to get the IMF’s help since 2011 after Yemen, Jordan and Morocco. One of the aims of the programme is to strengthen Tunisia’s external position by increasing foreign exchange reserves to adequate levels. How large should reserves be before they are considered adequate?

One standard measure of reserves adequacy is a rule of thumb stating they should cover three months worth of imports. Underlying this rule is the question of whether import purchases can be sustained when a country’s income from abroad (through exports and financial assets) falls to zero. On this metric, Tunisian reserves are adequate as they are expected to cover more than three months of imports.

This measure, however, suffers from at least two drawbacks. First, it does not consider important drains on reserves such as capital flight. Even with unchanged export revenue, imbalances could occur if investors sold their domestic assets and transferred capital abroad. This risk is not captured by the import coverage rule. The second drawback is that it is too pessimistic on the income side when it assumes that export revenue would be completely annihilated.

Aware of these drawbacks, the IMF seems to be adopting an alternative analytical method for assessing reserve adequacy. The new measure considers a scenario where four events occur simultaneously:

1.    Export earnings drop by 10%;
2.   Short-term debt falls by 30%;
3.   Portfolio investments into the local stock and bond markets fall by 15%; and
4.   Investments into other liquid domestic assets decline by 5%.

Note that different types investments (events 2 to 4) are assumed to fall by different amounts depending on their riskiness and liquidity, with the more risky and liquid investments experiencing larger drops. Let us call the sum of assumed losses under this four-risk scenario the emergency stock. (The IMF gives it the more awkward name: risk weighted liability stock). IMF research suggests that, for a typical country, international reserves need to cover between 100 and 150% of emergency stock to be regarded as adequate.

So how does Tunisia fare on this new measure?

My calculations displayed in the table below show that Tunisian reserves are currently below the recommended range at around 82%. Furthermore, in the absence of the IMF’s intervention, they would remain below the 100% threshold even as late as 2015. With the IMF loan, however, reserves are expected to be at the low end of the adequacy range by the end of this year and to increase further into the safety zone reaching 115% by the end of 2015.

It remains to be seen whether Tunisian reserves will actually build up to the planned levels or whether they will prove sufficient if economic shocks hit. But the IMF’s adoption of a new framework for assessing reserve adequacy might have consequences beyond Tunisia.