IMF Executive Board Discusses Assessing Reserve AdequacyPublic Information Notice (PIN) No. 11/47
April 7, 2011
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
Countries’ reserve holdings have risen sharply in recent years. This has been most notable across emerging market economies (EMs), but many low income countries (LICs) and some advanced market economies (AMs) have also experienced increases. While sound macroeconomic and prudential policy frameworks remain critical in reducing vulnerabilities, an adequate level of reserves forms an important element of countries’ defenses against shocks. At the same time, very large reserve holdings can have significant costs both at the national and global level. Assessments of reserves are relevant both to the Fund’s role in bilateral surveillance, as well as its mandate in oversight of the international monetary system.
While acknowledging that reserves may also have been rising for non-precautionary reasons, this paper focuses on the role of reserves as precautionary liquidity buffers—in line with their definition as liquid assets to meet potential balance of payments needs—and discusses different approaches to assessing their adequacy from this perspective. The main focus is on reserve adequacy in EMs and LICs, with a preliminary discussion of issues relevant to AMs reflecting new questions about reserves in these countries arising in the wake of the recent crisis. In addition to reviewing the literature, exploring cross-country demand for reserves empirically, and examining actual country practices, the paper suggests metrics for assessing reserve adequacy—for EMs, based on an empirical analysis of various balance of payments drains experienced during crises; and for LICs, calibrated against country-specific shocks. These measures are proposed to be complemented by alternative metrics and scenarios reflecting relevant country risk profiles. The paper also briefly discusses the role of reserves in the context of alternate forms of country insurance, and the connections between reserve adequacy and reserve management.
Executive Board Assessment
Executive Directors welcomed the discussion on approaches to assessing reserve adequacy, which comes at a time when many countries grapple with ways to reduce external vulnerabilities and global reserve accumulation has resumed its pre-crisis pace. They observed that, as in earlier episodes, along with sound overall policies, adequate reserves had been an important factor in helping defend against shocks in the latest crisis.
Noting that consensus is lacking on what constitutes an adequate level of reserves, Directors considered that a variety of analytical approaches can be informative in assessing reserve adequacy. They generally welcomed the elaboration of the new metrics for emerging market and low income countries proposed in the staff paper , as providing useful starting points for analyzing some of the considerations and trade-offs involved in determining adequacy of reserves for precautionary purposes. Directors stressed that there should be no “one-approach-fits all” to such assessments and supported supplementing the metrics with judgment and country-specific characteristics. This should include due consideration to macroeconomic and prudential frameworks and policies, as well as alternative forms of contingent financing, country insurance, and overall assets and liabilities. They also noted the relevance of reserve management practices in consideration of reserve adequacy.
Directors noted that countries accumulate reserves for both precautionary and
non-precautionary purposes. They encouraged additional work on the drivers of reserve accumulation, particularly the non-precautionary reasons, and the costs and benefits, including further analysis on the spillover effects of countries’ policies.
For emerging markets whose balance of payments is dominated by capital account flows, most Directors agreed that, going beyond traditional metrics, approaches encompassing a broad range of potential drains on reserves, including a sudden stop of new financing, withdrawal of foreign portfolio investments, capital flight, and current account vulnerabilities could be useful. Directors therefore generally welcomed the proposed new risk-weighted metric, as building on the simple and transparent approach of the traditional calculations while encompassing these broader vulnerabilities. Many Directors felt that the suggested range of 100-150 percent of the new metric provided a reasonable basic test of adequacy across countries, while stressing that a full assessment of adequacy at the individual country level would require a more detailed examination of potential vulnerabilities and resources available to meet them. However, many other Directors felt that this range was not adequately justified and suggested that higher or lower levels of reserves might be appropriate.
For low-income countries, whose balance of payments vulnerabilities are mostly based in the current account, Directors agreed that an approach which took into consideration a fuller set of information on country circumstances was warranted. They concurred that the proposed approach for calibrating optimal reserves according to country characteristics provided an effective means of introducing such characteristics into the assessment. Most Directors noted that, just as for emerging markets, while no metric could capture all the factors bearing on individual country reserves decisions, the consistent methodology of the paper provided a useful starting point.
Most Directors agreed that the crisis had raised new issues about the role of reserves in advanced market economies, and welcomed the preliminary discussion of these issues in the paper. Some Directors noted that it was difficult to use empirical methods to identify a common metric for reserve adequacy for these countries. Some Directors suggested grouping countries by structural features rather than by income level, as a distinction between advanced and emerging market economies may be blurred, and some encouraged further work on developing a consistent approach applicable to all members.
Directors looked forward to further analysis on the international monetary system and the role of global financial safety nets, including the Fund’s lending facilities and regional financing frameworks as well as the importance of access to such instruments, in determining reserve accumulation. They also looked forward to further clarification on how the new risk-weighted metric fits into the Fund’s surveillance and policy discussions. In this context, Directors called for the elaboration of an effective communication strategy for policymakers and market participants as regards reserve adequacy.
Directors called for revisiting or relaxing some of the main assumptions to test the robustness of the findings and make them more universally applicable. In general, recognizing that adequate reserves remain an important component of a stable international monetary system, they encouraged further analysis and refinement as part of work in progress in this area to enable a more comprehensive assessment of reserve adequacy.
1 At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.