What’s all the Fuss About International Reserves?

If you’ve watched a Central Bank of Barbados quarterly review or listened to any discussion about the state of Barbados’ economy, you’re undoubtedly aware that the level of international (or foreign) reserves is something that is closely monitored. But what are they? Why do they matter? And what is an adequate level? Read on to find out. And after you do, you’ll understand just how critical they are to our way of life.

What are International Reserves?

International reserves refer to foreign currency that is under the control of the Central Bank of Barbados. It’s important to note the second part of this definition so as not to think of them as the total value of the foreign currency in the country, because the foreign currency that businesses and individuals have in accounts or use to import goods and otherwise do business do not count as and are not generally taken from Barbados’ international reserves.

In fact, it’s useful to think of international reserves as akin to a rainy-day fund that is only dipped into when there is a shortage of the usual supply.

Why are they so Important to Barbados’ Economy?

The reason there’s so much emphasis placed on international reserves is because having an adequate stock of them allows the country to maintain our fixed exchange rate of two United States dollars to one Barbados dollar.

Dr. Justin Robinson, Professor of Finance and Dean of the Faculty of Social Sciences at the University of the West Indies, Cave Hill Campus explains what a fixed exchange rate regime is as well as what the alternative to one is.

“The Central Bank of Barbados dictates by law… it tells the commercial banks that ‘when you are exchanging US dollars, this is the price you do it for’. In a floating exchange rate system, it doesn’t work that way. Foreign exchange is traded like any other commodity.

He goes on to explain how Barbados, because of our fixed exchange rate, addresses shortages of foreign currency in the financial system:

“Let’s say Barbadians in total want to buy US$10 million and the banking system only has US$5 million. In a floating system, what would happen is that the price of a US dollar would go up and some of us would get priced out of the market because we couldn’t afford it. Our system says ‘No. Everybody must be able to buy at two to one. But for that to work, if Barbadians want to buy US$10 million and there’s only US$5 million, the Central Bank has to inject US$5 million in the system.”

Having an adequate level of international reserves is what makes it possible for the Central Bank to do that.

How Much Reserves is Enough? And How Do We Get Them?

Given the importance of international reserves, it’s important for there to always be enough. Conventional wisdom used to be that $1 billion was the minimum, but Professor Robinson says that the thinking has evolved away from an absolute dollar value to how many weeks of imports the reserves can pay for, also known as import cover. Using that metric, the baseline benchmark is 12 weeks.

Where Do International Reserves Come From?

Barbados builds up its reserves in two ways. The first is through earnings from the export of goods and services that are deposited into the banking system and then purchased by the Central Bank. The second, which Professor Robinson admits can be controversial, is through borrowing from entities. “When our reserves are extremely high, they are largely due to some element of foreign borrowing.”

Is there Such a Thing as Too Many Reserves?

While it’s clear that Barbados needs a good stock of reserves, is it possible to have too many? Professor Robinson says yes. That’s because of something he calls “negative carry”, which occurs when the cost associated with having an asset exceeds the value you can get from it. “Let’s say you borrow this money at 4 percent. You have it as reserves and the Central Bank is managing it, and they’re investing it in US bonds that are earning 2 percent, you have a cost there. That’s a loss.”

Nevertheless, he sees the cost as worth it given the potential consequences of the alternative. “I don’t think many people would disagree that the stability that comes from the fixed exchange rate makes that a cost well worth carrying.”

How Does this All Affect Me?

The fact that international reserves underpin a central tenet of our economy should be enough to warrant all Barbadians’ closely monitoring this key macroeconomic indicator, but lest there be any question as to why you should pay attention, Professor Robinson sums it up:

“Barbados is what we call a small open economy. Our quality of life depends on imported goods and services. To get those medicines, those trips overseas, those fancy clothes… everything you need, you have to bring them in from overseas. And they have to be paid for with foreign currency. Foreign exchange is the lifeblood of our economy.”