Something for a Rainy Day

While the ramifications of the financial crisis were global, countries whose economies were weak at its onset have been hit especially hard. Thoughts may now be turning to recovery, but scholars at the International Monetary Fund (IMF) are still closely monitoring these low-income nations.

In a January 2012 IMF Working Paper, “International Reserves in Low Income Countries: Have They Served as Buffers?”, Valerio Crispolti and George Tsibouris take a longitudinal look at the behavior of low-income countries after financial crises. They analyze the historical effects of a low-income nation’s economic structure and level of financial reserves on its reaction to and recovery from a financial shock. The authors then extend these trends to the current financial crisis.

Tsibouris and Crispolti survey 71 low-income countries from 1980 through 2007. They find that the average low-income country experienced a severe financial shock once every decade during this period, either in the form of a natural disaster, a sudden reduction in trade or foreign aid, or some other crisis. They also find that low-income countries remained depressed, with decelerated growth, for an average of two years following a shock. However, low-income countries with a large financial reserve fared dramatically better than non-reserve countries.

While reserves appear to make a dramatic difference in a low-income country’s ability to withstand a financial crisis, Tsibouris and Crispolti  stress that the role played by the low-income country’s economic structure is equally important:

[H]igher reserve coverage was not panacea …[T]he appropriate level of reserve holdings may vary with the structural characteristics of the economy.

Large debt, a non-flexible exchange rate, and weakly diversified exports are all associated with slower recovery. In contrast, the authors find that participation in an IMF program seems to be correlated with faster recovery.

Tsibouris and Crispolti see these trends continuing in the current recession: low-income countries with reserves have so far fared much better than their counterparts.