Information about Sub-Saharan Africa África subsahariana

Chapter 2. Macroeconomic Vulnerability: Reserves Adequacy and Fiscal Policy

Lamin Leigh, and Ali Mansoor
Published Date:
January 2016
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Ara Stepanyan

The turbulence in global markets in the past few years underscores the importance of reassessing the adequacy of international reserves, including for small middle-income countries (SMICs) in sub-Saharan Africa. Many of these countries tend to be much more susceptible to global shocks and outward spillovers given their less diversified economies, open capital accounts, and lower fiscal policy buffers (see Box 2.1 and Figure 2.1). Reflecting the fixed costs of operating an independent monetary policy or their lower levels of financial intermediation, they have mostly opted for intermediate regimes, such as soft or hard pegs, and therefore do not have domestic policy levers beyond fiscal policy to react counter-cyclically to shocks.1 Without the buffer of nominal exchange rate flexibility, and given their higher exposure to macroeconomic volatility, maintaining adequate reserves is of particular importance in SMICs. At the same time, some of the SMICs are also working on closing their infrastructure gaps and are grappling with devising best practice macroeconomic and fiscal policy frameworks to help address this challenge while preserving macroeconomic stability. How to address this issue with a less-than-adequate level of reserves coverage in a pegged exchange rate regime amid the current fragile global environment is a key policy challenge.

Figure 2.1Selected Middle-Income Countries in Sub-Saharan Africa: Reserves Adequacy, 2012

(Percent of GDP)

Sources: Country authorities; and IMF staff calculations.

Since 2000, reserves of SMICs in sub-Saharan Africa increased five times in dollar terms. The desire to hold more reserves is driven by the important role reserves play in both preventing crises and mitigating their impact. However, holding reserves is costly and the utility of reserves has diminishing returns. It is important to strike a balance between reserves’ crisis prevention and mitigation features and their cost.

This chapter applies a framework, developed by the IMF, to determine the adequacy of reserves for select SMICs in sub-Saharan Africa.2 Using self-insurance models, the analysis finds that international reserves held by some of the SMICs are broadly adequate to smooth large shocks. However, in Cabo Verde and Namibia, both of which have pegged exchange rate regimes, reserves remain either too close to or below adequate levels, which suggests the need for more medium-term fiscal consolidation, as emphasized in their bilateral consultation reports. In addition, structural reforms to improve the foreign investment environment and boost private sector savings would enhance each country’s external balance, supporting reserves accumulation.

Box 2.1Seychelles’ Experience and Perspective on Reserves Accumulation1

As a small, open, island economy, Seychelles is heavily dependent on imports. Its main source of foreign exchange earnings is the tourism sector, the volatile performance of which is inherently susceptible to external developments. For these reasons, an appropriate buffer of international reserves can be viewed as critical for Seychelles. This became apparent when the country’s reserves levels were almost depleted in 2008 as a result of unsustainable macroeconomic policies; this situation not only led to balance of payments difficulties but also a collapse of confidence in the domestic currency as well as the economy in general.

Toward the end of 2008, at the peak of Seychelles’ own economic crisis, gross official reserves amounted to a mere US$51 million, equivalent to only a few weeks of import coverage. At that level, reserves could also not defend or support the existing pegged exchange rate system. Following the crisis, a strategy to build up reserves as a buffer became a key component of a macroeconomic reform program that was launched in late 2008 with the support of the IMF; net international reserves levels were set as program targets.

In the initial stage of the reserves accumulation process, funds from international partners in support of the country’s reform agenda played an important role. However, as the country’s economy has strengthened, with a marked improvement in fundamentals, reserves accumulation from opportunistic purchases of foreign exchange in the local market have become more important. By the end of 2013, the stock of reserves had increased to US$425 million (up from US$195 million at end-2009).

But a strategy based on the accumulation of reserves carries its own challenges. Starting out with limited expertise, the Central Bank of Seychelles (CBS) had to leverage its capacity, design reserves management policies and guidelines, and set up a reserves management team to execute the decisions of an investment committee and to ensure that the country’s foreign assets yield appropriate returns.

However, with the overall very loose monetary policies currently being implemented worldwide, interest rates have plummeted. The CBS reacted by diversifying its reserves holdings into higher-yielding currencies, such as the Australian dollar and Canadian dollar. Still, income on reserves, which had peaked at about US$3.5 million in 2011, fell to less than US$1.0 million in 2013 despite the recorded increase in gross reserves over the same period. To address capacity issues, the CBS has engaged with Crown Agent Investment Management and the Reserves Advisory and Management Program of the World Bank, from which staff are benefiting through relevant training.

From a monetary policy perspective, reserves accumulation through purchases of foreign exchange from the market injects new domestic liquidity, which, under the current monetary targeting framework needs to be sterilized at a cost. In view of the low interest rate environment, the sterilization costs outweigh the income earned on reserves assets.

Given that holding reserves carries an opportunity cost, it is of paramount importance for the CBS to know the optimum amount that it needs to hold. (The opportunity cost is ultimately fiscal and therefore crowds out other spending needs, such as much needed infrastructure investment.) Theoretically, this optimum amount is influenced by factors such as the exchange rate regime, how effectively the economy adjusts to external payments imbalances, and the level of external exposure of the economy, among others. This amount is set as a multiple of months of import coverage, which, according to the CBS’s five-year strategic plan starting 2014, should not be lower than 4.5 months of imports at the end of each year. Based on an IMF analysis of various shock scenarios, Seychelles’ reserves level at about US$450 million, or 4 months of imports at the end of 2014, meets the different measures of reserves adequacy and compares favorably with similar economies.

According to the IMF, “Seychelles has unusual vulnerabilities as a remote, highly open, and tourism-dependent micro-state; as a result, standard reserves adequacy metrics underestimate country-specific needs” (IMF 2014, 37). However, based on studies carried out in early 2014, “the analysis of the impact of potential shocks and peer comparisons on pertinent metrics indicates that coverage has now reached a desirable range” (IMF 2014, 37). This conclusion is based on the country’s ability at the current level of reserves to weather significant shocks, such as a 40 percent decline in tourism earnings or terms-of-trade shocks resulting in a 20 percent increase in food and other non-oil imports. The IMF study also shows that on widely used traditional metrics, “Seychelles fares average in peer comparison of pertinent traditional reserves coverage metric” (IMF 2014, 38). Seychelles compares favorably on coverage in relation to GDP and broad money although the study notes that these are less pertinent sources of risk for the country. With regard to import coverage, which can be viewed as a more relevant measure of reserves adequacy, the study finds that Seychelles lies around the mean compared with other tourism-dependent peers but in the second-lowest quartile among emerging markets, which have achieved import coverage of about six months.

The IMF also indicated that while the new reserves adequacy metric (IMF 2011) would suggest Seychelles has reached an adequate level of reserves since 2011, it further indicates that the metric “does not sufficiently take into account Seychelles’ unusual country characteristics,” namely the “small island’s increased sensitivity to external shocks, extreme openness and tourism dependency” (IMF 2014, 38). Consequently, to uphold confidence in the economy and further strengthen the country’s capacity to deal with external shocks, the Seychelles authorities are maintaining their policy of reserves accumulation through opportunistic purchases of foreign exchange from the market.

1 Prepared by the Seychelles authorities.

Empirical Analysis

The first methodology uses a metrics-based approach that focuses on potential balance of payments pressures. The newer metric is based on the weighted average index of export earnings, two separate external liability shocks, and capital flight risk (Box 2.2). In general, this new approach suggests that reserves coverage in the neighborhood of about 100–150 percent of the metric is broadly adequate to address potential balance of payments pressures. Table 2.1 shows that Botswana, Lesotho, and Mauritius have comfortable amounts of reserves, whereas the level of reserves of Cabo Verde, Namibia, and Swaziland were somewhat too close to the 100 percent suggested by the metric in 2007–13.3,4

Table 2.1Middle-Income Countries in Sub-Saharan Africa: Adequacy of International Reserves
(Actual reserves versus metrics suggestion, in percent)
Cabo Verde81.098.692.397.787.882.968.568.5
Sources: Country authorities; IMF, World Economic Outlook database; and IMF staff estimates.

Data for 2013 are estimates.

Sources: Country authorities; IMF, World Economic Outlook database; and IMF staff estimates.

Data for 2013 are estimates.

Box 2.2Standard and Modern Approaches for Estimating Reserves Adequacy1

Standard measures of reserves adequacy are usually based on a simple ratio of gross official reserves. Four measures are typically identified:

  • For a country with a fixed exchange rate, the level of reserves should be at least three months of prospective imports of goods and services.
  • Another metric is to ensure full coverage of short-term debt service by remaining maturity. Specifically, reserves should be sufficient to cover the payment of debt-service outflows over the next 12 months in full.
  • The ratio of gross official reserves to base or reserves money (typically M0) gives a measure of the backing of currency in circulation. This measure is most relevant in countries with currency boards, where the law requires the central bank to maintain a high percentage of reserves (60–100 percent) to be freely available to be exchanged for domestic currency in circulation.
  • The reserves coverage of broad money (typically M2) is another popular measure. The metric is intended to capture the risk of capital flight, and a ratio of 20 percent is commonly used as the minimum threshold for countries with a fixed exchange rate regime.

Model-based approaches derive the adequate level from a cost-benefit analysis. The benefits of holding reserves (that is, reducing the probability of a crisis and smoothing consumption) are assessed against the cost of holding reserves, as measured by forgone investment in the economy. The benefits are typically defined in two broad categories:

Along these lines, Dabla-Norris, Kim, and Shirono (2011) propose a methodology to assess reserves adequacy for low-income countries and small island developing states.

Dabla-Norris and coworkers’ model takes into account both the costs and the benefits of holding reserves. In this framework, a crisis is defined as a sharp drop in absorption, and the optimal level of reserves is determined when the crisis prevention and mitigation benefits of reserves are balanced against the net financial cost of reserves, defined as forgone investment opportunities measured by the marginal product of capital.

An alternative approach to assessing the optimal level of reserves is developed by Ben-Bassat and Gottlieb (1992). They focus on the demand for optimal precautionary reserves for a borrowing country and augment the standard approach to optimal reserves by relating default risk to macroeconomic variables such as the ratio of reserves to imports and the external-debt-to-exports ratio and per capita gross national product.

A model-based approach has also been developed by the IMF (2011) to derive optimal reserves holdings. Since 2002, emerging market and low-income countries have outpaced the traditional reserves adequacy metrics. Subsequently, during shocks these reserves have provided a useful cushion against economic crises, including during the 2008–09 global financial crisis.

This model-based approach provides a framework for optimal reserves. For emerging market economies, a two-stage methodology is employed.

  • The first stage estimates different potential losses of foreign reserves. The potential outflows during periods of exchange market pressure are estimated, when the specific sources of loss identified are (1) a potential loss of export earnings from a drop in external demand or a terms-of-trade shock, (2) an external liability shock to short-term debt and medium- and long-term debt and equity liabilities, and (3) a capital flight risk.
  • In the second stage, the level of reserves a country should hold is estimated based on the metric obtained from the first stage. For countries with fixed exchange rate regimes, the approach proposes to use the following risk weights, based on tail event outflows during exchange market pressure: 10 percent of export income, 30 percent of short-term debt, 15 percent of other portfolio liabilities, and 10 percent of broad money, which in this case is a proxy for liquid domestic assets.
1 Drawn from IMF (2011).

The chapter also presents other estimates of the optimal level of reserves for SMICs based on standard methodologies.5 The chapter shows estimates of the level of reserves that would be required to satisfy simple rules of thumb that have been widely used for measuring reserves adequacy. The comparison of the results from traditional rules of thumb and the new metrics against the actual holdings of reserves for SMICs in sub-Saharan Africa is presented in Figure 2.1.

Considerable developments have occurred in the theoretical literature on the determinants of reserves. The literature identifies two main motives for holding reserves—the precautionary and the mercantile—and it uses different types of variables to measure the size of these motives. This chapter focuses mainly on the precautionary motive.

The determinants of international reserves are grouped into two broad categories: (1) those that describe countries’ external positions, and (2) those that describe countries’ macroeconomic policies. This chapter focuses on exploring macroeconomic policy options that could be exercised to increase reserves accumulation in a given external position. Structural reforms to boost a country’s competitiveness would be another measure in support of reserves accumulation. However, identifying the types of structural reforms that are important for reserves accumulation is outside the scope of this chapter and could be a relevant area for further research. The analysis will look at the impact of fiscal policy on reserves accumulation, given that many of the SMICs do not have an independent monetary policy. In a formal treatment of government solvency, Buiter and Patel (1997) use the concept of net total liabilities, which deducts foreign exchange reserves from total government liabilities in assessing the fiscal stance. This approach suggests that the fiscal authorities can use international reserves directly to finance fiscal spending. If the private capital account were closed, fiscal policy action would translate one-for-one into reserves changes in the medium term. However, there is an indirect channel of interaction between fiscal policy and foreign reserves. Hausmann and others (1996) argue that a larger stock of international reserves may increase a government’s financial room to maneuver in the event of shocks.

A long-term relationship between reserves and their macroeconomic determinants is identified for SMICs in sub-Saharan Africa. The analysis uses annual data from 1990 through 2011 and employs panel cointegration techniques (Pedroni 2004; Pedroni and Canning 2008). Seven statistics are used to identify the cointegrating relationship between gross reserves and its determinants. As mentioned above, most SMICs choose an intermediate exchange rate regime. Therefore, the analysis focuses more on fiscal policy instruments, given the lack of an independent monetary policy. The statistics below present the results of the cointegration analysis among reserves, exports plus current transfers, and government spending adjusted for external budgetary grants. Three statistics out of seven reject the hypothesis of no cointegration with a 95 percent confidence level (Table 2.2), and one statistic rejects the null hypotheses with a 90 percent confidence level. It is worth noting that the group-mean augmented Dickey-Fuller tests, which tend to have better performance in short panels, rejects no cointegration hypothesis with a 95 percent confidence level.6 A fully modified ordinary least squares regression method is used to estimate the coefficients of the cointegration vector. This method deals with both serial correlation and endogeneity. The results show that while countries’ reserves holdings increase with exports and current transfers, they decrease in response to an increase in government spending—supporting what one would have assumed to be the case from the outset. These results could be used by policymakers in SMICs in sub-Saharan Africa to guide their macroeconomic policies to ensure the adequacy of reserves and the sustainability of those policies.

Table 2.2Cointegration Analysis Results
panel v-stat= 1.38591
panel rho-stat= −1.06914
panel pp-stat= −2.22092**
panel adf-stat= −1.74045*
group rho-stat= 0.39500
group pp-stat= −2.47184**
group adf-stat= −2.16855**
Source: IMF staff estimates.* Rejection with 90 percent confidence interval** Rejection with 95 percent confidence interval Panel stats are weighted by long-term variances.
Source: IMF staff estimates.* Rejection with 90 percent confidence interval** Rejection with 95 percent confidence interval Panel stats are weighted by long-term variances.

This analysis of reserves adequacy uses a multidimensional approach. It uses a variety of methods for measuring the optimal level of reserves based on the results obtained using the new metric. In particular, it uses the Dabla-Norris, Kim, and Shirono (2011) and Ben-Bassat and Gottlieb (1992) methods that are based on cost-benefit models and provide a comprehensive framework to determine the optimal level of reserves. However, these models are sensitive to the assumptions about economic structure and the costs and benefits of holding reserves. Thus, the analysis also uses Frenkel and Jovanovic’s (1981) buffer stock of assessing reserves adequacy.

Measuring the cost of holding reserves is challenging not only for SMICs but also for larger economies. The cost of holding reserves can be analyzed either as the actual financial costs incurred by the monetary authorities in acquiring reserves or from a broader economy-wide view. The following approaches could be used for determining the cost of holding reserves:

  • The external funding cost net of the estimated return earned on foreign assets held as foreign reserves. The yield on sovereign borrowing is a useful proxy for this approach.
  • The sterilization cost that the central bank incurs when it purchases foreign exchange from the market (with some adjustment to account for exchange rate risk), netted against the return earned on foreign reserves assets.
  • Longer-term government bonds adjusted for exchange rate risk provides a good proxy for the sterilization cost.
  • The marginal productivity of capital provides an estimate of the potential returns on forgone physical investment less the returns earned on liquid foreign assets.

The analysis first applies the methods described above to assess the optimal level of reserves for Namibia. The calculations are extended based on the metrics for reserves adequacy for Namibia through 2015 using the framework developed by Dabla-Norris, Kim, and Shirono (2011). The results suggest that, on average, in 2012–15 the projected gross reserves will be about 73 percent of the average level of reserves generated by the new metric. The results based on Dabla-Norris and coworkers’ methodology suggests that, on average, for 2007–11 the optimal level of reserves for Namibia was 4.8 months of imports, whereas the actual level for that period was 3.6 months (Figure 2.2). The analysis also uses the current projections until 2015 to assess whether, in the medium term, the level of reserves is expected to approach the optimal level. The results confirm the outcome obtained using the new metrics for assessing reserves adequacy and suggest that the gap between the optimal and projected reserves levels based on plans at the time of preparation of this chapter will likely widen in the medium term, which is a potential source of vulnerability for Namibia.7

Figure 2.2Optimal Reserves Level for Namibia

Sources: Dabla-Norris, Kim, and Shirono (2011); and IMF staff estimates.

Similar analysis of reserves adequacy for Cabo Verde suggests that current reserves levels are below what is considered adequate. The estimates for the optimal level of reserves for 2009–11 are between 2.7 and 4 months of imports, which is in line with the actual outcome of 3.9 for the same period, suggesting that the central bank’s reserves holdings were adequate. However, for 2012–15, estimates for reserves adequacy are between 3.7 and 5 months of imports compared with 3.4 months, on average, in the macroeconomic framework at the time this chapter was prepared. Given the increased public-debt-to-GDP ratio, the minimally adequate level of reserves, and uncertainties regarding external inflows, a strengthening of the international reserves position in Cabo Verde would be appropriate.

Swaziland’s level of gross official reserves is broadly adequate to protect the country against external shocks. By reflecting the relevant level of risk of the different possible sources of balance of payment pressures, it is estimated that the minimum level of reserves needed to cover the risk of potential balance of payments outflows in Swaziland is 17 percent of GDP (about 5.1 billion Swazi lilangeni for 2012).8 Swaziland is exposed to terms-of-trade shocks because it is an oil importer and a sugar exporter. It is also vulnerable to fluctuations in Southern African Customs Union transfers. In addition, it has a fully open capital account with South Africa, and is thus exposed to capital outflows, while it does not have much access to international capital markets. Consequently, the central bank would be well advised to aim for a level of reserves that is considered minimally adequate. Specifically, the central bank needs a larger base of reserves coverage to address potential liquidity pressures faced by commercial banks while protecting parity with the rand. Should portfolio outflows occur, the level of reserves may not be sufficient for the central bank to be in a position to provide liquidity to commercial banks.

More generally, macroeconomic policies in these SMICs should aim to rebuild policy buffers to help provide a cushion against large external shocks. Given the pegged exchange rate regime in Cabo Verde, Namibia, and Swaziland, the role that monetary policy can play is constrained. The only active policy tool left, therefore, for countercyclical purposes is fiscal policy. Our analysis suggests that further fiscal policy consolidation could possibly help reserves to be accumulated more quickly.

Specifically, our results suggest that for Namibia, a more ambitious fiscal effort beyond the authorities’ stance at the time this chapter was prepared would be advisable to rebuild reserves to adequate levels. To achieve the adequate level of reserves for Namibia, the annual growth rate of reserves should increase by 6 percentage points, on average, until 2015 compared with current projections. Given the estimated elasticity of −1.22 percent between government expenditure and gross reserves, to accelerate reserves accumulation, the average annual growth rate of government expenditure should be reduced by about 5 percentage points, which implies a 6 percentage point reduction in the expenditure-to-GDP ratio by 2015 compared with current projections.9 Given the possible impact of further fiscal consolidation on growth, Namibia needs to increase government savings by undertaking a fiscal consolidation process and reprioritizing the composition of public expenditure in favor of development spending to enhance productivity. Thus, reining in spending would have to focus on reducing the government sector wage bill as well as transfers and subsidies to loss-making state-owned enterprises. Beyond fiscal consolidation, structural reforms to strengthen export competitiveness should also help build up the needed reserves.

For Cabo Verde, similar analysis suggests that rebuilding reserves above minimally adequate levels would involve significant fiscal consolidation in the medium term. To ensure a higher than minimally adequate level of reserves by 2015, Cabo Verde’s reserves holdings should grow by 14 percent annually, while currently they are projected to grow by 3.4 percent. Applying our estimated elasticity between government expenditure and gross reserves on the difference between needed and projected reserves accumulation suggests that the expenditure-to-GDP ratio for Cabo Verde should decrease by 2.5 percentage points by 2015. Thus, Cabo Verde’s efforts to ease the significant infrastructure bottlenecks in the economy would need to continue to follow good practice macroeconomic and fiscal policy frameworks so that these challenges can be addressed in a growth-promoting manner and thus avoid nonproductive spending. This will help preserve fiscal and external stability in the medium term. In recent years, Cabo Verde’s tax reform agenda has aimed for a more neutral tax system that is less reliant on incentives, that will boost export competitiveness, and that will rebuild the fiscal buffers following efforts to close the infrastructure gap, which entailed an increase in capital spending.10,11


The analysis of reserves adequacy for selected SMICs in sub-Saharan Africa shows a mixed picture. Although international reserves held by some of the SMICs are broadly adequate to smooth large shocks, in Cabo Verde and Namibia, both of which have pegged exchange rate regimes, reserves remain either too close to or below adequate levels, suggesting the need for further fiscal consolidation in the medium term. The results of this analysis are, however, sensitive to the assumptions of the medium-term external outlook, which is based on the IMF’s World Economic Outlook projections when this chapter was prepared, as well as to the model’s assumptions concerning the opportunity costs of holding reserves. Moreover, the macroeconomic vulnerability related to reserves adequacy also partly reflects the underlying structure of the economy, including high levels of economic concentration, thus calling for policies that lead to greater economic diversification. Finally, the debt levels in some of these SMICs, a detailed analysis of which is beyond the scope of this chapter, also remain relatively low.12,13


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Note that both Namibia and Swaziland are members of the Common Monetary Area along with South Africa and Lesotho.


For a more detailed discussion of the approach, see IMF (2011).


Given the role of the current account in most SMICs in sub-Saharan Africa, we reduced the weight on short-term debt relative to exports by 10 percentage points for all countries except Mauritius and Cabo Verde. At the time the analysis on reserves was done, the data were based on preliminary estimates; final data that would be available at the time of publication of the book would most likely not substantially alter the broad conclusions reached here.


Note that other more traditional methodologies of assessing reserves adequacy suggest that both Cabo Verde and Swaziland were broadly in the range of what would be considered adequate. Data limitations preclude conducting the reserves adequacy exercise for Seychelles.


Box 2.2 describes the various methodologies used to assess reserves adequacy in this chapter. The data used are based on the IMF’s World Economic Outlook and Government Finance Statistics databases.


The analysis used different combinations of variables describing the external position and fiscal instruments but the results were not significant. We added current transfers to exports because the series for current transfers has negative numbers, which do not allow the use of a log specification for the series. We adjusted the expenditure variable for external budgetary grants to eliminate the impact of grants on both expenditures and reserves.


The IMF staff’s additional simulation experiments show that in the event of a further worsening in the global economic environment compared with the World Economic Outlook projections at the time this chapter was prepared, which may lead to a decline in Namibia’s export prices and therefore a deterioration in its terms of trade, the gap between the optimal and projected levels of reserves would widen further, in the absence of offsetting policy actions.


For an analysis of wage bills within the Southern African Customs Union, see Basdevant (2013).


The mode of fiscal adjustment is beyond the scope of this book. For a more in-depth analysis of those issues, refer to the various IMF Article IV consultation reports for these SMICs.


Similar analysis could be done for other SMICs subject to availability of the detailed data that are needed to run the regressions.


For example, despite the recent increase in the debt level due to the temporary fiscal expansion under the Targeted Intervention Program for Employment and Economic Growth program in Namibia, the debt ratio is expected to decline in the medium term. Namibia has always been a low-debt upper-middle-income country, and IMF staff do not envisage the debt path to be explosive given the potential of the economy and its diversified nature compared with other predominantly mineral-based MIC economies. Namibia’s sovereign credit rating also continues to be investment-grade quality.


Mongardini (2013) provides a detailed report of the workings of the Common Monetary Area for the SMICs that belong to that region. That book also highlights other macroeconomic vulnerabilities, such as the volatility of Southern African Customs Union customs revenues for those SMICs, which are beyond the scope of this current book.

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