S&P Global Ratings rates 44 International Monetary Fund (IMF) member sovereigns at 'B+' or below, with an average per-capita GDP of $4,714--about one-third of the emerging-market average. Last year, these economies' foreign currency earnings fell 4.8% faster than their overall GDP, while net reserves for the group (excluding Argentina, Iraq, and Turkey) declined by 25% or $72.1 billion to $220 billion. While these 44 sovereigns represent one-third of all rated sovereigns, and 4% of global GDP, their reserves account for a little over 2% of global reserves.

Such comparatively low reserve levels are not just an external constraint. They are also a fiscal constraint given that the majority of sovereigns rated 'B+' and below lack the reserve currency status, monetary flexibility, and deep domestic capital markets that permitted their advanced economy peers to fund a comprehensive contracyclical fiscal response to COVID-19. Indeed, unequal reserve endowments explain at least in part why the global economy appears to be taking off in two distinct directions: growth in higher-income economies accelerating on the back of fiscal support and vaccinations, but only flatlining in low- and lower-middle-income economies grappling with persistent localized outbreaks of the virus, without the means to support households and firms.

To ease these constraints, the IMF is planning a $650 billion increase in Special Drawing Rights (SDR) this year, the first such SDR creation since 2009, and one which would mark around a 220% increase in the total stock of existing SDR. As a consequence of the increase, SDR would increase to 7% of total global reserve assets versus 2% at present. While most of these new SDR are expected to end up in developed markets (DM), many emerging markets (EM) still stand to benefit from large relative increases in their international reserve positions. Moreover, discussions are ongoing about proposals for DM to lend or potentially even donate, their new SDR, to low-income countries (LIC; which they define as those with per capita gross national income levels below $1,185) and other similarly vulnerable nations.

While we recognize that the focus country group is low-income countries, in this survey we have included a broader range of low- and lower-middle-income countries, where reserve levels have contracted significantly due to the fallout from the global health emergency. We have examined what the creation of SDR implies for three key metrics of reserve adequacy for the 44 sovereigns in our sample with long-term foreign currency ratings at 'B+' or below. These are:

• At least three months import cover;
• 100% coverage of short-term external debt; and
• 20% reserve coverage of M2 as a buffer against capital flight.

Our conclusion is that the initial allocation of SDRs will restore complete reserve adequacy (defined as satisfying all three benchmarks) in five sovereigns rated 'B+' or lower. An additional two sovereigns would see at least one of three reserve adequacy measures restored but would still fail on at least one of the benchmarks. Moreover, and specifically for the LIC as defined by the IMF, we calculate a reallocation of an estimated 42% of wealthy country SDR allocations to LIC (both rated and unrated) would be what it would take to bring the reserve levels in all rated LIC up to complete reserve adequacy.

What Is An SDR And Why Does It Have Value?

Special Drawing Rights are interest-bearing reserve assets controlled by the IMF. They are pegged to a basket of five reserve currencies that include the U.S. dollar, euro, Japanese yen, British pound, and Chinese yuan. The weighting was last set in 2015, when the Chinese yuan was added. The IMF uses SDR as its unit of account, for example by denominating its lending in SDR (although commentators often quote a U.S. dollar-converted amount).

Countries can sell their SDR holdings to fellow IMF members for the five aforementioned currencies. The U.S., along with 31 other IMF members, have made voluntary agreements to purchase such SDR from countries wishing to sell. In case these voluntary agreements fail, a mechanism also exists whereby the IMF can designate a member with strong external positions to sell reserve currencies for SDR.

In this regard, SDR are a claim on the stronger IMF members' monetary authorities, and hence indirectly on their economies.

What Do Monetary Reserves Have To Do With Sovereigns' Capacity To Operate Contracyclical Fiscal Policy?

One of the principal lessons from the Asian financial crisis of 1997 was the danger of emerging nations depending upon short-term portfolio inflows to finance sizable external deficits. The second-round effects of a sudden stop of capital inflows into Asia in 1997 and 1998 lead to currency devaluations, balance-sheet shocks, as well as pro-cyclical fiscal tightening, which, in turn, triggered steep economic contractions. Since then, Asian sovereigns as a whole have shifted from operating recurrent net external deficit positions on their balance of payments to posting external surpluses. As a consequence, Asian sovereigns at present hold the largest stock of reserves globally and are increasingly a source of investment in lower-income economies. Whether economies operating large external surpluses require such high reserve levels is not the subject of this report; of the 44 lower rated sovereigns included in this survey, only nine are operating current account surpluses. The rest are posting deficits, averaging 6.8% of GDP last year.

Our data confirms that there is a strong negative correlation between reserve levels and governments' cost of debt. In particular, lower import coverage and constrained short-term external debt coverage lead to a higher cost of dollar debt, all else being equal. High stocks of reserves also lower the cost of capital for an economy's private sector, benefiting investment and growth. In addition, reserves act as a backstop for any country running a managed currency regime. If there is any credible intention to maintain a peg at a certain level, reserves will play an active daily role in supporting that level (absent highly restrictive capital controls). Most countries running such arrangements--which are by and large EM--will often target a certain level of adequacy to retain confidence in the peg. The less flexible a country's monetary arrangement, the more binding a restraint there is on fiscal flexibility, absent very substantial reserves. Recent examples of this include Ecuador, where in the two years before the outbreak of a global pandemic, authorities were already forced to tighten the fiscal stance due to an increasingly binding external financing constraint.

Are Emerging Market Reserves Adequate?

A number of factors can be considered when assessing reserve adequacy, and ratios often include variables such as imports, exports, external debt, and the amount of money in circulation. These provide a helpful starting point, after which idiosyncratic factors should also be evaluated, including considerations such as financial development, economic flexibility, and the likelihood of external support, among other characteristics.

For the purpose of this study, we have narrowed down the analysis to consider the three most widely tracked benchmarks, as described in table 1.

Table 1

We've listed the data on reserve adequacy of the 44 EM sovereigns rated 'B+' or lower in table 2. We believe reserve adequacy is most relevant as a concept for sovereigns at the lower end of the rating scale, owing to the heightened external vulnerabilities these sovereigns face, often with fewer offsetting factors.

In 2019, before COVID-19, reserve adequacy was already a challenge for just under half of 'B+' or lower rated EM, with 21 out of the 44 sovereigns failing at least one the benchmark tests. The pandemic has made things worse. By end-2021, we expect the number of EM rated 'B+' or lower failing an adequacy test will rise to 23. Moreover, those sovereigns already with deficient reserve levels have fallen even further from adequacy benchmarks. In aggregate, we estimate a total of $110 billion of additional funds would have been required to bring all 44 EM reserves to adequate levels according to the three benchmarks. In 2021, we estimate this adequacy gap will have risen by about four-fifths to reach $199 billion by year-end.

Table 2

How Would The New SDR Allocation Benefit Emerging Markets' Reserve Adequacy?

By the end of 2021, the IMF is expected to create $650 billion in new reserve assets. We calculate that $42 billion of this will be available to the 44 lowest-rated EM. While the allocation may only make up 7% of total new SDR created, we still judge that for five sovereigns it will be enough to sufficiently bring reserves to a level at which all adequacy benchmarks will be newly satisfied. This group includes Zambia (the gross reserves of which will more than double), Jordan, El Salvador, Benin, and Togo. Furthermore, an additional two sovereigns (DR Congo and Suriname) will see their M2 coverage newly surpass the benchmark, although they will still fail the import coverage test.

More recently, France's President Emmanuel Macron has committed France to redirecting its SDR and is asking other advanced economies to reallocate $100 billion to Africa alone. We estimate that around 61% of the new SDR will accrue to DM, due to rich countries' relatively higher quota shares. We do not anticipate that such SDR, in the hands of DM, would likely have any material impact on DM creditworthiness. However, onward lending of such resources could help to shore up external liquidity for the world's poorest states.

Following the initial SDR allocation, we estimate a total of $189 billion would still be required to bring all remaining 'B+' or lower rated sovereigns up to adequate levels. However, around $95 billion of this aggregate gap will accrue to Turkey and Bahrain--two middle-income EM sovereigns that arguably would not receive DM support. In contrast, we estimate seven countries (Burkina Faso, Mozambique, Kenya, Bolivia, Congo-Brazzaville, Belize, and Suriname) would need less than $1 billion each to shore up reserves to levels deemed adequate by all three benchmarks.

Chart 1

Table 3

How Would A Reallocation Of Rich Countries' Resources Change The Story?

Proposals put forward initially by France to onlend rich countries' new SDR to poorer countries, particularly those in Africa, have the potential to supercharge the gains from the SDR allocation for the world's poorest countries, and to increase their resources to fight a concerning third wave of COVID-19 variants.

We calculate that 18 sovereigns rated 'B+' or lower would still fail at least one of the adequacy tests following the initial allocation. Of these, seven are classified by the IMF as LIC, which we believe would put them in scope for any further reallocation of rich countries' SDR. The details of such plans are still being discussed and therefore remain uncertain. Nonetheless, we have made some assumptions to calculate how much would be needed to bring all seven up to adequate reserve levels.

If rich countries were to redistribute to all LIC (rated and unrated) proportional to existing IMF quotas (as the initial allocation will be), we calculate it would take around a 42% reallocation for all sovereigns we rate to reach complete reserve adequacy.

Our baseline expectation is that any potential reallocation of SDR would take the form of onlending, most likely through the IMF's interest-free Poverty Reduction and Growth Trust (PRGT) balance-of-payments facilities, including the Extended Credit Facility (conditional lending at 0% rates at maturities of up to 10 years), the Standby Credit Facility (streamlined conditionality at maturities not exceeding three years and 0% rates), and the Rapid Credit Facility. It would therefore increase already high debt levels in LIC, albeit at 0% rates. The alternative--wealthy countries donating their surplus SDR--would come at relatively low cost for advanced economies (0.05% on an annual basis) and represent a major fiscal boost for countries where vaccination rates currently average around 2% of the total population.

For the purpose of this analysis, it would not matter whether these resources arrived on LIC shores in the form of grants or debt, since liquidity is a concept in gross terms. Nevertheless, unlike the initial SDR allocation, longer-term debt sustainability could be damaged if these resources were onlent in the form of debt, for instance as part of the IMF's PGRT facility. Absent separate debt relief measures, that would put authorities in LIC in uncomfortable positions.

How Will The New SDR Creation Benefit The Credit Quality Of The 44 EM Rated 'B+' Or Lower?

We calculate that after the SDR allocation, reserve adequacy would be newly met on all three metrics in five sovereigns--Zambia, Jordan, El Salvador, Benin, and Togo. This, alongside an improving trend in commodity prices could lead to upward pressure on these sovereigns' external assessments, and hence, over the medium term, their ratings. However, the key rating constraints in lower-rated sovereigns is likely to continue to be our assessment of weak institutions and low economic resilience.

With copper price levels currently up nearly 70% on an annual basis, and Zambia's reserve levels set to double as a consequence of the SDR allocation, the country's reserve adequacy, and broader external metrics, are certain to improve over the next 12 months. However, Zambia's ability to emerge from default depends primarily upon ongoing negotiations with the IMF on a New Extended Credit Facility, a prerequisite for Zambia to advance in its talks with its official and commercial creditors. We expect that progress on this front is likely to be delayed until after this August's general election. Indeed, the recent improvement in Zambia's key export prices may encourage its creditors to play for time. Overall, without greater visibility on the direction of future policy, upward rating pressure would seem to be limited, despite a considerable improvement in external dynamics, including those afforded by the SDR allocation. Since early June, there has been a rapid increase--from low levels--in COVID-19 infection rates in Zambia. An estimated 0.4% of the population has been vaccinated.

In Jordan, the near half a billion dollars-worth of SDR allocation will go some way to plugging the external financing gap left by the sudden stop in tourist arrivals since 2020. Up to this point, the country has tapped external bond markets to top-up reserves through the pandemic, and the allocation will lighten this burden. The country has also received considerable IMF support over the years, although is too rich to be eligible for the PRGT facility, which we expect will be a conduit for the onlending of rich countries' SDR. Jordan must maintain a higher level of reserves due to its fixed-currency arrangement. Nonetheless, we consider the key constraint on the rating on Jordan to be the structurally weak growth outcomes, which have contributed to shrinking per capita GDP levels for most of the past decade. A turnaround in this dynamic, particularly one that led to a sustainable increase in export earnings, would therefore be most critical for Jordan returning to the 'BB' category. Since early May, there has been a steady decline--in reported COVID-19 infection rates in Jordan. An estimated 14% of the population has been vaccinated.

Fully dollarized economies like that of El Salvador do not require reserves to defend a non-existent local currency. Yet, adequate reserve levels for dollarized economies still function as a buffer against balance-of-payments volatility, which can quickly feed into fiscal tightening in inflexible monetary regimes. El Salvador failed both import and M2 coverage ratios in our projections for 2021. The country only needed $352 million to secure adequacy on both--helpful given the country will receive $392 million in the initial allocation. More broadly, El Salvador is currently in negotiations with the IMF for an expected package, which we see as key to shoring up external liquidity and supporting the current rating. Failure of these talks could see downward pressure emerge on the rating, which the SDR allocation may only partially mitigate. We note that there are no significant external debt repayments due until 2023. Since early June, there has been a gradual increase in COVID-19 infection rates in El Salvador. An estimated 19% of the population has been vaccinated (El Salvador received its first delivery of vaccines from the COVAX Facility on March 11).

Benin and Togo are both members of the West African Economic and Monetary Union and are likely only to benefit indirectly from a top-up in foreign currency reserves, which are pooled between all eight members. Their creditworthiness will more likely reflect progress on fiscal reforms, including raising tax pressure, and growth outcomes, rather than external dynamics. Since April, reported new cases of COVID-19 in Benin and Togo have been on the decline. An estimated 0.1% of the population has been vaccinated in Benin, and 2.1% in Togo.

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