Introduction
The purpose of this panel is, of course, to discuss the management of liquidity risk. But before getting into the intricacies of the subject allow me to emphasize that the multitude of vulnerabilities common to transition economies necessitates maintaining several lines of defense. This conference concentrates on one of them - the third. The first line of defense would include all the elements of prudent macro policies: a proper fiscal policy and an appropriate monetary policy, combined with an exchange rate regime as flexible as possible. The second line of defense consists of a sound financial system, and especially a strong banking system.
The third line of defense is the proper management of the country's international debt and liquidity. Since the first signs of weakness of a national economy always emerge in the foreign exchange market, maintaining a strong foreign liquidity position is important in assuring the economy's good health. This line of defense, to which increasing attention has been paid in the aftermath of the recent
financial crises in emerging markets, will be the subject of the rest of my comments.
Alan Greenspan introduced the concept of “liquidity at risk” in the World Bank Conference on
Reserves Management a year ago. According to his definition, liquidity at risk can be calculated by considering the “country’s liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.)” and the probabilities of th seoutcomes. A country can manage its liquidity at risk position by different combinations of reserves, debt and their maturity. “For example, an acceptable debt structure can have an average maturity in excess of a certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex-ante probability, such as 95 percent of the time.”
Mr. Greenspan mentioned setting international standards for the level of liquidity at risk, which can be handled in different ways. One possibility is to increase the level of reserves through mobilizing long-term debt. Another option would be “a wide range of innovative financial instruments – contingent credit lines with collateral such as the one maintained by Argentina, options on commodity prices, opposite options on bonds, etc.”.
The concept of liquidity at risk deserves careful consideration, and I would like to address five issues: Is it possible to calculate liquidity at risk? How can the desired level of liquidity at risk be attained? What can be achieved by maintaining the desired level of liquidity, and what cannot? Is this concept at all applicable to countries with flexible exchange rate regimes? What can be said about the Israeli experience?
Calculating liquidity at risk
Liquidity at risk can be calculated by estimating the country’s liquidity position for a range of possible values of relevant financial variables and the probabilities of these scenarios. Doing this is not a simple exercise and the necessary database is not always available. But keeping in mind that he concept of “Value at Risk” is already quite familiar, it might be possible to develop and to implment the approach of “liquidity at risk”. Moreover, in recent years we have seen a substantial development of early warning models. The database needed to calculate liquidity at risk includes the same variables as those used in these models. Perhaps the IMF would find it beneficial to do the needed calcu ations and provide them to member countries (one of the early warning models was developed in the IMF Research Department). An obvious advantage of the IMF calculations is that the same methodology would be used for all countries. Such results could be helpful for the IMF as well in analyzing the liquidity position of different countries.
Adjusting to the desired level of liquidity at risk Let us assume that the authorities wish to improve their liquidity position. How can this be achieved?
In the long run, policy will have to be aimed at improving the underlying performance of the economy, by reducing the current account deficit, encouraging balanced growth, especially in exports, promoting adequate domestic savings, and so on. In the medium term, it might be feasible to improve liquidity by long- erm government borrowing aimed at building up foreign reserves, by changing the structure of the government external debt - increasing the weight of long-term debt or a combination of both. But changing the maturity structure of external debt takes time and entails costs, es ecially if a country finds it difficult to raise long-erm debt. Therefore, any application of such a rule has to be gradual. It is not advisable to improve the liquidity position of the economy by bolstering reseves through market intervention, since this would necessitate overly restrictive fiscal and monetary policies, aimed at attracting capital inflows and creating a surplus in the current account.
Establishing contingent credit lines can also help achieve the liquidity at risk target. At first si ht it looks like a perfect solution for countries that need to strengthen their foreign position. Howe er, on further thought, lines of credit look just a little too perfect: can such lines be big enough to be of consequence when a real crisis hits? Will the international banking system refrain from defending itself through cutting other credit lines to a country (to the private sector for example), when the contingent credit lines are used? Will such contingent arrangements not be too big of a temptation for governments not to pose the familiar moral hazard problem? Moreover, it is not clear that the cost of maintaining contingent credit is lower than borrowing long-term and maintaining short-term reserves. Such reservations are by no means an indication that this idea is a bad one. It is, after all, aninsurancearrangement, and it is believed that in general insurance does work. But only time and further experience will tell how effective and efficient contingent credit lines really are.
What can be achieved by maintaining a liquidity at risk target and what cannot?
Adopting a target for liquidity at risk can provide a cushion through increasing the financial stability of the economy. A stronger financial structure of assets and liabilities increases the credibility of the economy, enhances its access to international capital markets and can substantially reduce the odds of a crisis taking place.
Nevertheless, achieving some target level of liquidity at risk cannot always provide sufficient
protection against shocks. In the case of a breakdown of confidence in the government’s policy, demand for foreign exchange might be much larger than the amount of reserves and credit lines, which were determined according to the above mentioned criteria. Since globalization is increasing, a strong financial situation according to historical standards may not be adequate for present flows. Demand for foreign currency might come from different directions and in amounts much larger than in the past.
Is the concept of liquidity at risk relevant for countries with flexible exchange rate regimes?
The concept of liquidity at risk was developed against the background of a managed exchange rate regime of one type or another, since such regimes make liquidity essential. However, an economy with a floating exchange regime, which has not yet achieved proven long-term stability, will also need huge liquidity. Otherwise, a floating exchange rate regime can bring about extreme nominal instability.
Therefore, when the exchange rate is floating, the level of reserves should be set at a level that will prevent extreme fluctuations in the exchange rate – and in the price level - anot according to the liquidity needed for intervention in different scenarios. This can be achieved by estimating the minimum level of reserves that ensures access to international capital markets for the economy and thereby contributes to achieving some limit for “value at risk”. “Value at risk”, in this case, refers to the exchange rate and the price level fluctuations.
It should be noted that adopting a rule for the optimal level of reserves - when the Central Bank does not intend to use them - might appear to be a very costly strategy. It is clear that borrowing will generally be more expensive than investing, all the more so as the maturity of the debt is significantly longer than the maturity of the assets. Moreover, does holding liquid assets make sense at all, while it is possible to borrow in the deep international financial markets, should the need arise? I think that the exchange rate regime perse is not of crucial importance for setting the optimal level of reserves. It seems that the main factor is the extent of proven long-term stability. Access to the capital markets cannot be taken for granted, and capital might not be available precisely when it is most urgently needed. Moreover, holding high levels of reserves can lower the cost of borrowing for the economy as a whole, making the strategy optimal for the country.
The Israeli experience
The concept of the optimal level of reserves in general, and in particular for Israel, has evolved over time. Fifteen years ago “three months of imports” was considered the optimal level of reserves for Israel. Research conducted in the BoI at the end of the eighties introduced some sophistication. It took into account the volatility of capital flows, “window dressing” effects and other factors2, to find the optimal level of reserves.
Currently the exchange rate is floating within a very wide band. Nevertheless, it is much more
difficult nowadays to predict the volatility of capital flows. Moreover, given the financial turmoil of recent years, it seems that the optimal level of reserves today is much higher than it was at the beginning of the nineties.
The current level of reserves is close to 21b$. As can be seen in Table 1, the level of foreign reserves has grown in comparison to all major financial variables. For example, their average level in 1999 was larger than the level of short-term liabilities of the country and exceeded the level of BoI domestic liabilities to the private sector.
How did the improvement in the liquidity position take place and what were the forces behind it? In the case of Israel, debt had already been of a long maturity for many years; but reserves increased dramatically during 1995 to 1997 as a result of heavy intervention, aimed at avoiding the exchange rate impact of huge private sector capital inflows. Therefore, this improvement of the liquidity position was a by-product of a tough monetary policy coupled with the constraints of the prevailing exchange rate regime.
As mentioned before, the exchange rate is currently floating within a very wide band (its width is 37% - relative to the average of its boundaries - and it is increasing by 4% a year). The Bank of Israel has committed itself not to intervene in the foreign exchange market as long as the exchange rate remains within the boundaries set by the band. Some commentators fault what they perceive to be the central bank's failure to use the stock of foreign reserves in order to stabilize the exchange rate. But more to the point, questions are raised concerning the need for such a high level of reserves if they are not 'used' by the central bank.
Table 1
Israel’s Foreign Currency Reserves relative to various aggregates (%)
(Averages)
|
|
Months |
Gross |
Short |
Foreign |
M1 |
Unlinked |
The |
|
1991 |
3.2 |
21 |
59 |
76 |
223 |
64 |
328 |
|
1992 |
2.7 |
18 |
55 |
67 |
177 |
50 |
283 |
|
1993 |
2.1 |
15 |
44 |
62 |
145 |
37 |
219 |
|
1994 |
2.1 |
15 |
43 |
66 |
142 |
33 |
208 |
|
1995 |
2.5 |
19 |
50 |
62 |
183 |
34 |
295 |
|
1996 |
2.6 |
21 |
49 |
55 |
190 |
32 |
288 |
|
1997 |
4.6 |
33 |
84 |
75 |
316 |
48 |
466 |
|
1998 |
5.9 |
39 |
108 |
82 |
392 |
55 |
520 |
|
1999 |
5.8 |
39 |
103 |
77 |
392 |
50 |
506 |
* Includes the monetary base, time deposits of commercial banks and government deposits connected to outstanding balances of short term loans (Makam).
The answer to this legitimate concern is that high reserves are doing their job by just being there. Precisely this very level of liquidity was one of the factors that protected Israel from the financial turmoil in 1997 and 1998. It helped to maintain a relatively low risk premium on its foreigndebt and to maintain relative exchange rate stability without any intervention by the Bank of Israel.
A few concluding remarks
Maintaining an appropriate level of liquidity is an important line of defense for countries in transition. It cannot completely prevent currency crises but it can decrease the probability of its occurrence by enhancing the economy’s access to the international financial markets.
The concept of liquidity at risk can help establish the appropriate level of liquidity. However, the right level is not easy to calculate and some work by the IMF, which collects all the relevant data, can be of great help. Converging to the desired level of liquidity at risk has to be done gradually. Contingentcredit lines might be of value but more experience is needed to assess their robustness.
The concept of liquidity risk was developed for countries with managed exchange rate regimes. However, countries in transition maintaining floating exchange rate regimes also need substantial liquidity, if they aspire to avoid extreme nominal instability. One way to establish the optimal level of reserves in this case can be through setting some target for “value at risk” and attaining the liquidity position that is necessary to achieve this target.
Israel is an example of a country with an almost totally floating exchange rate regime that maintains large reserves. My impression is that the strong liquidity position of the country has helped to protect Israel from the financial turmoil of 1997 and 1998.
-------------------------------------------
1Prepared for the Conference of the World Bank Treasury on “Current Issues in Reserve Management for Central Banks in Europe, Middle East and North Africa”, Istanbul, Turkey, May 4-5, 2000
2See Ben-Bassat, A. and Gottlieb, D., “Optimal International Reserves and Sovereign Risk”, Journal of
International Economics 33, 345-362, 1992 and Ben-Bassat. and Gottlieb, D., “The Effect of Opportunity Cost on International Reserve Holdings”,Review of Economics and Statistics 74, 329-332, 1992