Finance: The Importance of Foreign Exchange Reserves
An important lesson of the 2008–2009 financial crisis was that the emerging market economies with high levels of international reserves were better able to withstand the ripple effects of the global meltdown. In Latin America, the cases of Brazil and Mexico provide a clear illustration.
When Lehman Brothers went under in September 2008, Brazil had foreign exchange (FX) reserves of $205.5 billion—equivalent to 12.9 percent of GDP—while Mexico had $83.6 billion, or 7 percent of GDP. While the FX reserve levels easily covered a year of short-term debt maturities, Mexico’s were below the other precautionary threshold of six months of import coverage.
Brazil’s much higher level allowed its central bank (BCB) to more effectively respond. It intervened in the FX market to help stabilize the Brazilian real, provide FX swap lines to Brazilian corporations that faced difficulties rolling over U.S. dollar-
denominated maturities and assist exporters hit by the global dry-out of trade financing lines.
In contrast, Mexico’s central bank (Banxico) did not have the flexibility to support the Mexican peso and meet the surge in U.S. dollar demand from Mexican corporations. Overall, the strong FX reserves position was a key factor that allowed Brazil to adopt more aggressive countercyclical measures and emerge from a short-lived recession by the second quarter of 2009. Mexico had to endure a deeper downturn that lasted several quarters.
The explanation for the divergent tales of Brazil and Mexico is in their different balance-of-payment structures. On the current account front, 55 percent of Brazil’s exports are composed of commodities, which had surged in the years prior to the Lehman collapse and helped sustain a current account surplus. On the capital account front, Brazil’s high interest rates and booming economy had attracted hefty portfolio and foreign direct investment (FDI) inflows. All this allowed the BCB to more than triple its FX reserves between 2004 and 2008 amid heavy U.S. dollar buying to prevent excessive Brazilian real appreciation.
Commodities account for less than 20 percent of Mexican exports. In the years that preceded Lehman, Mexico—following China’s entry into the World Trade Organization—faced stiffer competition from China in selling manufactured goods to the United States. As a result, the nation’s current account always stayed in deficit and its FX reserves increased only 40 percent between 2004 and 2008.
The rest of Latin America fell somewhere between Brazil and Mexico. However, the region registered a current account surplus from 2004–2007 and FX reserves had more than doubled to around $437 billion when Lehman hit.
Since the end of 2008, Latin American central banks have accumulated FX reserves of more than $225 billion, of which over $100 billion alone correspond to 2011. This leaves the region in a very solid position to withstand the external shocks that may come from the sovereign debt and banking crises in Europe, a slowdown in the U.S. and China, lower commodity prices, and a moderation in capital flows.
Interestingly, the cases of Brazil and Mexico no longer bracket the extremes. Brazil’s FX reserves remain the highest in the region at $352.9 billion, or 14.9 percent of GDP. But Mexico has managed to build a stronger reserves position—of $144 billion—since the crisis. Taking into account the additional $72 billion available in the Flexible Credit Line granted by the International Monetary Fund to Mexico, for all practical purposes, its reserve position is now equivalent to 18 percent of GDP—more than double the ratio seen in September 2008.
That said, the pace of accumulation of FX reserves in Latin America will moderate substantially in 2012, following the current trend of deterioration in current account balances [see table]. The region’s aggregate current account deficit is expected to widen from $38 billion in 2011 to $90 billion in 2012 amid lower commodity prices, while the relative resilience of domestic consumption and investment should prevent a comparable decline in imports. As a result, the region’s FX reserves are expected to increase by only $20 billion this year, with Argentina, Ecuador and Venezuela seeing reserve losses as they deal with conflicting policy objectives.
In terms of financing, FDI inflows are still projected to fully cover current account gaps in Chile, Mexico and Peru. Visibly slower growth will curb the gap in Argentina, which otherwise will need to be covered by FX reserve losses or by a policy change that prioritizes accessing capital markets instead of paying down debt on a net basis. In turn, portfolio and debt flows should provide the financing for Brazil and Colombia. These balance-of-payments dynamics suggest that Latin currencies will not face the same pressures on appreciation seen over the past two years.
In general, though, while higher FX reserves will not insulate Latin America from the global economy this year, at least they will give policymakers room to maneuver and help contain the pressure on external accounts and currencies.