Hedging “Sudden Stops” and Emergent Recessions through International Reserves in Egypt—An Application of the Martingale Optimality Principle Approach

Abstract

This paper addresses the role of international reserves in mitigating the adverse effects of potential “sudden stops” on economic growth. As holding of reserves implies a cost in terms of domestic consumption, we calculate the optimal level of reserves that helps hedge against such eventuality. Treating it as an optimization problem, we employ the Martingale Optimality Principle to estimate the optimal values of reserves and consumption. For Egypt, we find that optimal consumption is trending upward when the optimal level of reserves is trending downward. Using stochastic control, we obtain another approximate or suboptimal set of values for both variables. These values closely mimic Egypt’s observed reserve and consumption measurements. Our findings indicate that Egypt’s actual reserves during 1985-2017 exceed estimated optimal levels of reserves, even under a highly risk averse scenario, and point out to the implied consumption costs.