A key to economic stability

“CBSL Governor Predicts USD 7 Billion Foreign Reserves by Year-End” was the headline featured on the front page of this newspaper last Wednesday, January 8, 2025. During a discussion on Derana TV, Governor Dr. Nandalal Weerasinghe highlighted that the country’s foreign reserves remained robust, noting, “If Sri Lanka could maintain USD 8 billion in reserves, it would create a strong buffer to meet foreign debt obligations effectively.”

Foreign reserves, comprising foreign currencies, gold, and other international assets held by a country’s central bank or monetary authority, play a critical role in ensuring macroeconomic stability. They serve as a buffer against external economic shocks, underpin currency stability, and instill confidence in a country’s financial system. However, the question of what constitutes the “ideal” level of foreign reserves is complex, involving trade-offs between economic efficiency, opportunity costs, and risk management.

The Importance of Foreign Reserves

Foreign reserves are used to stabilize the national currency by intervening in the foreign exchange market. By buying or selling foreign currencies, central banks can mitigate volatility and maintain exchange rate stability, which is crucial for trade and investment. Countries rely on reserves to meet external debt obligations and finance imports of essential goods, such as food, energy, and medicine. Inadequate reserves can lead to default or economic crises, as seen in countries like Sri Lanka during recent years. Reserves act as a financial safety net during periods of capital outflows or sudden economic shocks, such as a global financial crisis or geopolitical instability. A robust reserve position signals economic resilience, attracting foreign direct investment (FDI) and maintaining credit ratings.

Determining the Ideal Level of Foreign Reserves

The ideal level of foreign reserves depends on a country’s unique economic and financial context, but several frameworks and guidelines have been developed to assess adequacy:

Traditional Metrics:

A widely accepted benchmark suggests reserves should cover at least three months of imports. This ensures the country can sustain essential imports during periods of economic uncertainty. Also, reserves should be sufficient to cover short-term external debt obligations, as a precaution against liquidity crises.

Modern Approaches:

The IMF recommends a more nuanced approach, considering factors like export income, external liabilities, and capital flow volatility. This metric is especially relevant for emerging economies prone to speculative capital movements. In countries with floating exchange rates, reserves should cover potential outflows from speculative attacks on the currency.

Both approaches involve opportunity Cost:

Holding foreign reserves incurs costs, as these funds could be invested in higher-yielding domestic projects. Excessive reserves may lead to inefficiencies, suggesting a balance is necessary between precautionary savings and productive investment.

Case Studies: Successes and Failures

China:

China maintains one of the world’s largest foreign reserve portfolios, over $3 trillion. This ensures exchange rate stability, supports trade policies, and positions China as a global economic powerhouse.

Singapore:

Singapore, despite its limited natural resources, maintains high reserve levels through disciplined fiscal policies and an export-driven economy. Its sovereign wealth fund, Temasek, ensures effective reserve utilization.

Sri Lanka:

A stark contrast is Sri Lanka, which experienced a severe reserve depletion, leading to defaults on foreign debt and import shortages. This crisis underscores the importance of adequate reserves for import and debt coverage.

India:

India has gradually built its reserves, maintaining a position above $500 billion. These reserves have proven instrumental in shielding the economy from global shocks, such as the COVID-19 pandemic and rising oil prices.

Lessons for Sri Lanka

Sri Lanka’s economic challenges in recent years, particularly its foreign exchange crisis in 2022, have highlighted the critical role of foreign reserves in ensuring economic stability. Once considered a growing economy with promising tourism, remittances, and agricultural exports, Sri Lanka faced a severe financial and social crisis due to inadequate reserve management and structural vulnerabilities. Understanding the principles of ideal foreign reserve levels through the lens of Sri Lanka’s experiences reveals crucial lessons for both the country and other developing nations.

Sri Lanka’s Foreign Reserve Crisis: Context and Causes

Debt-Fueled Growth:

Sri Lanka borrowed extensively for infrastructure projects without adequately assessing their economic viability or long-term returns. These projects, including the Hambantota Port and Magam Ruhunupura International Convention Centre, Mattala International Airport, Mahinda Rajapaksa International Cricket Stadium (aka Sooriyawewa International Cricket Stadium), and Colombo Lotus Tower, have failed to generate sufficient revenue to service the associated debt.

Tax Cuts and Governance Issues:

Significant tax cuts in 2019 eroded government revenues, forcing reliance on foreign borrowing. Additionally, political instability and mismanagement eroded investor confidence.

Overvalued Exchange Rate:

The Central Bank of Sri Lanka intervened heavily to maintain an artificially strong Sri Lankan rupee, depleting reserves.

Global Shocks:

The COVID-19 pandemic decimated tourism revenue, which historically contributed around 12% of GDP. A subsequent decline in remittances and rising global fuel prices further strained reserves.

Theoretical Insights Applied to Sri Lanka:

The traditional three-month import cover benchmark is critical. At its crisis peak, Sri Lanka’s reserves were below this level, leading to acute shortages of fuel, medicine, and food. Sri Lanka’s foreign debt-to-reserve ratio reached alarming levels, far exceeding manageable thresholds. Reserves must be sufficient to cover short-term debt obligations to prevent default and maintain investor confidence. The IMF’s Reserve Adequacy Metric (RAM), which considers external liabilities and potential capital flight, offers a more tailored framework for Sri Lanka. While accumulating reserves incurs opportunity costs, Sri Lanka’s experience shows the higher cost of reserve inadequacy. Future policies should strike a balance by maintaining adequate reserves while channeling surplus funds into high-return investments, such as export-oriented industries or renewable energy.

Challenges in Managing Foreign Reserves

Exchange Rate Dilemma:

Excessive intervention to stabilize currency can deplete reserves or create artificial currency valuations.

Inflation and Sterilization Costs:

High reserves may necessitate sterilization measures to control inflation, leading to additional costs for central banks.

Global Economic Trends:

Rising interest rates in advanced economies can cause capital outflows from emerging markets, straining reserves.

Sri Lanka’s recent economic struggles underscore the critical importance of maintaining adequate foreign reserves as a foundation for economic stability. The ideal level of reserves for Sri Lanka—or any nation—is not a fixed number but a dynamic balance tailored to the country’s unique economic structure, external vulnerabilities, and policy priorities. For Sri Lanka, this balance must address its structural challenges, including import dependency, high external debt, and exposure to global shocks.

The ideal level of foreign reserves should be sufficient to cover essential external obligations, cushion the economy against unexpected shocks, and foster long-term stability. At the same time, maintaining reserves must not impose excessive opportunity costs, such as diverting resources from productive domestic investments. Balancing these needs requires a forward-looking, flexible approach to reserve management that integrates both traditional metrics, such as import coverage and debt servicing, and modern considerations like capital flow volatility and geopolitical risks.

For Sri Lanka, the path to achieving an optimal reserve level lies in addressing its structural vulnerabilities and adopting globally proven strategies. This involves building reserves sustainably through export diversification, prudent fiscal policies, and multilateral cooperation. Export-oriented industries, remittance flows, and foreign direct investment (FDI) must be strengthened to ensure stable foreign exchange inflows. Additionally, restructuring external debt, ensuring fiscal discipline, and enhancing transparency in reserve management will bolster confidence among international stakeholders.

By learning from its past mistakes and integrating traditional economic frameworks with modern realities, Sri Lanka can rebuild its reserves and lay the groundwork for economic recovery, as suggested by the Central Bank Governor. A robust reserve position will not only stabilize the economy but also create a foundation for sustainable growth and resilience in the face of future challenges.

(The writer, a senior Chartered Accountant and professional banker, is Professor at SLIIT University, Malabe. He is also the author of the “Doing Social Research and Publishing Results”, a Springer publication (Singapore), and “Samaja Gaveshakaya (in Sinhala). The views and opinions expressed in this article are solely those of the author and do not necessarily reflect the official policy or position of the institution he works for. He can be contacted at saliya.a@slit.lk and www.researcher.com)