#ActiveAllocator Research: Ideas about the right level of international reserves have changed with the evolution of markets and crises. Paul Krugman in a recent interview suggested that the attitude at the moment should be “don’t worry about government deficits so much and start spending”. The U.S. Federal Reserve and other counterparts have moved aggressively with sweeping emergency rate cuts, and offers of cheap dollars, to help combat the coronavirus pandemic. Emergency policy easing by central banks in UK, Europe, Japan provide stabilization. But can countries pump indefinite liquidity into markets to support monetary and fiscal stimulus? The coronavirus pandemic will test how much debt countries can bear.
For much of the post-war period, the rule of thumb was that international reserves should cover three-to-four months of imports. The Guidotti rule that reserves should exceed short term debt is now generally accepted as benchmark for assessing the adequacy of reserves – governments should be able to stay out of market for new financing for up to a year if needed. With the growth of capital markets, views of reserve adequacy have changed. Countries are now expected to have more reserves to protect against potentially large and disruptive capital flows, even if the exchange rate regime is floating
Factors include the exchange rate regime, the size and currency composition of the debt, trade flows, monetary aggregates and an assessment of risks and structural aspects of the market. Taking all these into account often raises the estimate of required reserves