Working Paper 178 - Holding Excess Foreign Reserves Versus Infrastructure Finance: What should Africa do?
|Authors||Cédric Achille Mbeng Mezui, Uche Duru|
Financing infrastructure needs in Africa necessitates new thinking on financing mechanisms. Currently, there is a lively debate on the funding and use of foreign exchange (forex) reserves as one of the funding sources for financing infrastructure. The paper provides insight into the objectives of foreign exchange reserves management, their adequacy, the innovative mechanisms to enhance their management, and the optimal required investment for financing infrastructure in Africa. In practice, a realistic foreign exchange reserves level should meet the following requirements: (i) the ratio of import cover; (ii) the ratio of reserves to short-term foreign debt balance (iii) the ratio of foreign exchange reserves to the total foreign debt balance and (iv) the ratio of foreign exchange reserves to Money & Quasi-money (M2).
However more and more studies are showing that the liquidity, followed by security and returns motives remain the main objectives for building excess reserves. The paper argues that the two goals, liquidity and return, can be reconciled by dividing the reserves portfolio into a ‘liquidity portfolio’ and an ‘investment portfolio’, and using different investment guidelines for each portfolio. The rational of this proposal is that the liquidity portfolio which would be targeted at regular disbursements and unanticipated liquidity demand and for intervention objectives would be invested mostly in highly liquid and safe assets such as the money markets of the OECD countries. However, the investment portfolio would comprise a wider set of economic investment products and maturities, and would use investment criteria akin to those of big institutions and pension funds managers.
The present study shows that dividing the reserves portfolio into a liquidity portfolio and an investment portfolio is applicable to the aggregate forex reserves of African countries and further highlights the social cost of the status quo for reserve management in these countries. The study extracts data on the foreign exchange reserve, debt and infrastructure needs of African countries from different IMF, World Bank and AfDB databases and estimates the adequacy level of foreign reserves for these countries based on two commonly used methodologies – the traditional metric method of import cover and the Wijnholds and Kapteyn (WK) method.
The paper estimates the excess foreign reserve and the social cost of holding this excess based on comparison to other alternative investment opportunities such as investments in African infrastructure. Based on these estimations, the study shows that: first, African countries have held excess reserves in the range of $ 165.5 and $ 193.6 billion on average per year between 2000 and 2011. This is more than the infrastructure financing gap identified at $ 93 billion per year. Second, holding these excess reserves when compared to alternative investments in domestic infrastructure in the continent also implies a social cost of up to 1.65% of GDP, on average.
The findings show the total social cost of holding excess reserves is around $300 billion per year in developing countries, which is approximately equal to the amount of resources needed by developing countries to fund basic investments to meet the MDG.
Now, central banks can collateralize their resources or use repurchase agreements (Repo’s) to fund liquidity at short notification, without having to pay huge amounts of securities; and central banks may also include currency forwards and options to their list of financial instruments to defend their currency. Additionally, a range of bilateral and multilateral agreements have been put in place such as credit lines or swap lines among central banks to reinforce foreign exchange reserves. As experienced during the recent financial crisis, highly liquid foreign reserves are no longer the core or sole tool for navigating a currency crisis. Thus, holding a high percentage of highly liquid assets is no longer always the most appropriate approach.
The study has also shown that social cost of holding excess reserves is considerably high in many African countries between 2000 and 2011 and more so for commodity export dependent economies.
The study also shows that based on the two methods of reserve adequacy applied, that African foreign exchanges excess can be managed to meet the infrastructure financing gap of the continent. Therefore, there is room for the use of these excess reserves through novel investment vehicles to complement existing development partners while focusing on the following: i) economic infrastructure projects with a regional impact; ii) innovative mechanisms for cross-border infrastructure investments; iii) encouraging quick handling interventions (more flexible rules, systems and procedures); iv) deal with political risk, credit risk, and refinancing risk. Such envisaged investment vehicles should be driven by performance accountability criteria to manage parts of these excess reserves through investments in less liquid, higher-yielding wealth as compared to the status quo.