What Exactly Are Foreign Exchange Reserves, and Why Do Countries Keep Them?

A country needs foreign exchange reserves for a variety of reasons, including to meet its international financial obligations, to keep its domestic currency’s value fixed, to keep it less valuable than the US dollar, to maintain liquidity in the event of an economic crisis, to pay for internal projects, and to reassure foreign investors. The primary issue, though, is “How much of the foreign exchange reserves are regarded as safe?” The conventional “rules of thumb” that have been applied to establish reserve adequacy imply that governments should maintain reserves covering 100% of short-term debt or the equivalent of three months’ worth of imports. This is supported by several empirical studies.

Two-step approach

Based on the evidence from past crises, the IMF study proposes a two-stage approach for assessing what constitutes an adequate level of reserves for emerging markets:

First, use a new “risk-weighted” metric to assess country-specific vulnerabilities. The metric is akin to the risk-weighted assets used to assess bank capital needs and covers potential vulnerabilities from falling export income, a sudden stop in short-term debt flows, outflows from other debt and equity liabilities, and resident capital flight. It also takes into account the exchange rate regime of the country.

Second, estimating the level of reserves that might be needed as measured against this risk-weighted metric The approach is similar to that used for bank capital requirements, where needs are assessed as a percentage of a risk-weighted asset stock.

Assessing reserve adequacy in low-income countries

Access to capital markets is often more constrained in low-income nations than it is in developing economies. The question of whether this is a suitable benchmark has persisted even though the customary rule of thumb of three months of imports is frequently employed to evaluate the sufficiency of their reserves.

For the majority of low-income nations, shocks to the terms of trade, unstable assistance, foreign direct investment, and remittance flows are the main causes of drains in the balance of payments. These elements imply that reserve coverage in months of imports is still a valid metric for assessing the sufficiency of reserves in low-income nations.

Given the projected benefits afforded by reserves in lowering both the probability and effect of shocks, empirical research reveals that three months of imports remains generally suitable for nations with flexible exchange rates. However, the data implies that nations with sound institutions and policies require less in the way of reserves.

Pakistan’s foreign exchange reserves

The entire reserves of Pakistan demonstrate that they have traditionally remained at 3 months’ worth of imports. Even if from a normal vantage point, it appears to be at a comfortable level. Yet, Pakistan’s foreign exchange reserves have recently fallen drastically to worrying levels. As of January 2023, Pakistan’s foreign exchange reserves scarcely have enough money to fund a month’s worth of imports.

The impact of Pakistan’s foreign exchange rates

Pakistan’s foreign exchange rates have dropped to their lowest since 2014, and this development has created a ripple effect in the economy, impacting the lives of the people and the country’s financial system. This article delves into the root causes of the drop and analyzes the impacts of this event on the Pakistani economy.

What led to the drop-in foreign exchange rates?

Several factors have contributed to the drop-in foreign exchange rates. Firstly, Pakistan’s current account deficit has been on the rise, leading to a decline in foreign currency reserves. Additionally, a decrease in exports and a rise in imports have also hurt the economy. The COVID-19 pandemic has also played a part in exacerbating the situation, leading to a significant decrease in remittances and a decrease in tourism revenue.

The impact on the Pakistani economy

The drop in foreign exchange rates has had a profound impact on the Pakistani economy. The depreciation of the Pakistani rupee has led to an increase in inflation, making it difficult for the common man to meet his daily expenses. The cost of imported goods has risen, leading to an increase in the cost of living. This development has put a strain on the average Pakistani’s purchasing power, resulting in a decrease in their standard of living.

Additionally, the drop in foreign exchange rates has also had a significant impact on businesses in Pakistan. It has become more expensive to import raw materials and machinery, making it difficult for businesses to operate. Moreover, foreign investors have become hesitant to invest in the Pakistani economy due to the uncertainty surrounding the foreign exchange rates.

Countries in a similar situation

It is important to note that, according to World Bank statistics, Pakistan and the following nations are in a similar position in terms of their foreign exchange reserves. The nations that are closest to Pakistan in this regard are listed below.

Myanmar

Ghana

Sri Lanka

Zambia

To determine the relative parallels with Pakistan, it would be worthwhile to investigate the overall political and economic conditions in these nations. Here, we’ll examine each nation’s political and economic climate individually.

Originally published at https://www.ssaazs.com.