Academic journal article Journal of Economic Cooperation & Development

Optimal Levels of Reserves and Hedging Sudden Stops Recessions for Egypt: A Stochastic Control Approach

Academic journal article Journal of Economic Cooperation & Development

Optimal Levels of Reserves and Hedging Sudden Stops Recessions for Egypt: A Stochastic Control Approach

Article excerpt

This paper discusses the issue of optimal international reserves in Egypt during the period 1977-2007. We derive, using stochastic control, the optimal level of reserves to maximize the welfare of the society as measured by the utility of the consumption. The paper also presents a new approach to manage international reserves. It is proposed that part of the reserves will be held as risky assets. The risky assets are sensitive to the volatility index (VIX) of the Chicago Board Options Exchange (CBOE). The analysis reveals that the actual normalized level of reserves is in excess of the optimal one. Hence, the study recommends reducing the international reserves to the optimal level. This is almost 25% of the current levels of reserves. We also present a scenario whereby the reserves are reduced by almost half of its existing levels in year 2007. We then invest a small portion, through a sovereign wealth fund, in VIX based options. In case of crisis (sudden stop) the payoff of the options will yield an amount that is almost the same as the kept value of reserves. Following this strategy allows for an opportunity gain in the range of (1-2) % of GDP. Moreover, the study proposes the activation of other institutions role in the society to attract long term investments, maintaining a certain limit of coordination among fiscal and monetary policies and consolidating the norms of ethical standards in the financial system.

(ProQuest: ... denotes formulae omitted.)

"International reserves are both observable and have a market value... "

Gray, Merton and Bodie 2007

1. Introduction

Recently, along with the dramatic increase in international reserves in emerging market countries, estimated by more than 60 percent since the Asian financial crisis in 1997 as mentioned by Mendoza (2004), debates about the fitting/optimal amount of reserves for an open economy have gained a new life (Jeanne and Rancière 2009). Being characterized by weak access to international capital markets, recurrent credit crunches and financial underdevelopment; emerging countries run persistent current account deficits and are vulnerable to foreign investors' insights about the underlying economic and institutional circumstances. Jeasakul (2005) put forward that, since investment decisions are based upon profitability criteria,3 any alterations in these conditions due to financial crisis or turmoil, foreign creditors can suddenly cause capital inflows to come to an end, leading to what Dornbusch, Goldfajn and Valdes (1995) firstly marked as a "sudden stop", a term that was further developed analytically in Calvo (1998).

1.1 Sudden Stops: Some Stylized Facts

Many Asian countries during the late nineties of the last century were hit by currency crises and sudden stops.4 Since then, hoarding international reserves has been the preferential policy of most developing economies (Cheung and Qian 2007; Wijnholds and Sndergaard 2007). Sighted in this light, the sharp augmenting in the amount of reserves held by many emerging markets can be relevant to the rise in the "globalization hazard" that confronts emerging markets as suggested by Calvo (2002). A moderate probability of globalization hazard "sudden stop" can induce emerging markets to self-insure fully by hoarding international reserves, rather than relying on non-reserve options of taking preventative measures. A sudden stop,5 in this context, is a distinctive phenomenon of the crisis wracked in emerging countries during the post of the nineties. Lee (2008) put forward that sudden stops in its essence is a situation under which there is a reversal capital inflows to the country, lack of access to external insurance and hence a sharp current account adjustment on recipient countries. Caballero and Panageas (2005) demonstrate that international financial markets cause the sudden stop and not the emerging economies themselves.

On the main features of sudden stops, Mendoza (2008) mentioned three stylized facts that are: (1) Changing direction of international capital flows in a reverse order, (2) reductions in domestic production and absorption, (3) Alterations in asset prices. …

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