For almost all economies, whether developed, emerging, or developing, holding prudent reserves, in conjunction with sound policies and fundamentals, can bring significant benefits. They reduce the likelihood of balance-of-payments crises, help preserve economic and financial stability against pressures on exchange rates and disorderly market conditions, and create space for policy autonomy. While reserves have these important benefits, they also carry an opportunity cost—from reserves earning a lower rate of return than could be achieved if the resources were used differently. These costs are an important consideration as countries decide on their “appropriate” level of reserves for precautionary purposes.
Assessing the appropriate level of reserves to hold is challenging—not just because of the multiple roles played by reserves, but also because of the complexity of quantifying external risks and vulnerabilities, and the opportunity cost each country faces. As such, the assessment should be based on the specific characteristics (including economic flexibility and financial integration and maturity) and vulnerabilities. A number of traditional approaches—including import and short-term debt coverage—have been used and remain relevant for particular sets of countries, typically capturing individual risks.
IMF policy papers
A series of IMF policy papers (2011, 2013 and 2015) have proposed new analytical frameworks to assess reserve adequacy, supplementing traditional guidance. They outline the motivations for holding reserves in developed, emerging, and developing and credit constrained economies. In addition, the papers develop new tools for emerging and developing and credit constrained economies to assess adequacy, and suggest approaches for characterizing the reserve needs for developed economies. These tools generally take a broader view of potential risks, sources of shocks, and vulnerabilities underlying reserve needs than transitional metrics. Measures of the opportunity cost of reserve holdings were also presented throughout these papers. Finally, in the 2015 paper, the importance of non-precautionary motivations for some countries was noted, and the issue of reserve adequacy assessments was placed squarely in the context of Fund surveillance. The bottom line of this work, and its application by the Fund, is summarized in the 2016 Guidance Note to Staff on Assessing Reserve Adequacy and Related Issues.
This paper brings together recent Fund work on reserve adequacy issues aiming to strengthen their discussion in bilateral surveillance. Despite the ongoing debate on reserve issues, there is little consensus about how to assess reserve holdings in different economies, even though this is an important aspect of a member’s external stability assessment. The work stream of which this paper is part aims to fill this gap by outlining a framework for discussing reserve adequacy issues in different economies.
Reserves remain a critical liquidity buffer for most countries. They are generally associated with lower crisis risks (crisis prevention) as well as space for authorities to respond to shocks (crisis mitigation). While other instruments, such as official credit lines and bilateral swap lines, are also external buffers, for most countries they principally act as a complement to their official reserves. For countries with sound fundamentals and a good policy framework, reserves provide policy makers with considerable space to respond to transitory shocks. However, this space diminishes as fundamentals deteriorate and the existence of adequate reserves does not, by itself, eliminate the risk of market pressures.
This paper investigates the impact of international reserves on (i) the likelihood of currency and banking crisis; and (ii) the frequency of liquidity dry-up episodes in FX markets.
The dramatic increase in reserves holdings over the past decade has resumed since the global financial crisis, even at an accelerated pace. While the crisis has heightened perceptions of the importance of holding adequate reserves, there is little consensus on what constitutes an adequate level from a precautionary perspective: traditional metrics are narrowly-based and often provide conflicting signals; while newer approaches tend to be hostage to stylized modeling assumptions and calibrations. As a result, assessments tend to rely on comparisons with peers, probably amplifying the upward trend as perceived needs rise in line with actual holdings.
The metric proposed in the main paper (2011) is based on outflows—principally in relation the relevant stock of underlying foreign liabilities or domestic assets—during periods of exchange market pressure (EMP). Especially as it remains the primary reason countries accumulate reserves for insurance purposes, the metric is based on balance of payments drains experienced during EMP episodes —i.e., a measure of sufficient reserves during periods of pressure and ahead of a full-blown crisis.
This note provides operational guidance to IMF staff undertaking reserve adequacy discussions in IMF country surveillance. It discusses various tools and consideration to be taken into account when assessing each country's reserve needs, including ways to Taylor the assessment to country circumstances. The note addresses also answering the following questions:
- What is the expected coverage of reserve issues at different stages of the bilateral surveillance process (Policy Note, mission, and Staff Report)?
- Which reserve adequacy tools best fit different economies based on their financial maturity, economic flexibility, and market access?
- What do possible reserve needs in mature markets relate to, and how can their adequacy be assessed?
- How can reserve adequacy discussions for emerging and deepening financial markets be tailored and applied to better evaluate reserve levels in: (i) commodity-intensive economies; (ii) countries with capital flow management measures (CFMs); and (iii) partially and fully dollarized economies?
- What reserve adequacy considerations hold for countries with limited access to capital markets? How can metrics for these economies be tailored to evaluate their reserve needs?
- How should potential drains on reserves be covered?
- What are the various measures of the cost of reserves for countries with and without market access?
Examples of Reserve Adequacy Assessments
A description of examples of reserve adequacy assessments from Fund surveillance are provided below:
Mature or Advanced Market Economies
Staff discussed the Riksbank’s preemptive move to increase foreign exchange reserves by borrowing internationally, following large foreign currency liquidity support provided to banks after the Lehman shock. To estimate reserve needs, Staff calculated the size and probability of the banking system potential foreign liquidity needs under a tail risk scenario in European financial markets. While improvements in the macroprudential framework can help reduce FX reserve needs, Staff argued that the size and wholesale dependence of the Swedish banking system called for such costly self-insurance. In that context, Staff weighted the option of readily available preemptive self-insurance, which is less costly in benign borrowing periods, against more uncertain official FX swap lines. To align incentives, Staff suggested banks share the cost of the Riksbank liquidity insurance through fees linked to banks’ own FX funding exposures.
Deepening Financial or Emerging Market Economies
Staff assessed the adequacy of India’s reserves using the reserve optimizing model of Jeanne and Ranciere (2011) and compared the findings with those of the IMF (2013) reserve adequacy metric. The analysis qualifies the risks against which India ought to hold reserves, namely its susceptibility to financial market volatility and to commodity price shocks, and emphasizes the importance of sound macroeconomic and prudential policy frameworks as additional lines of defense. While both methods suggest India’s reserves are within adequate/optimal levels, Staff cautions that uncertainties in global financial markets at the time may warrant holding reserves higher than what is suggested by IMF reserve adequacy metric.
Colombia 2015 Flexible Credit Line (FCL) review staff report, IMF country report No. 15/206, Box 1, page 7
Staff assessed Colombia’s reserve needs as a commodity exporter facing difficulty to adjust to volatile terms of trade. Staff presented reserves against the ARA metric as well as against the ARA metric augmented with the additional buffer using a forward looking measure of price risk. Staff calculations show while reserves stand above the upper 150% range of the ARA metric, they fall within the 100-150 percent range of the augmented metric.
Staff compared actual and projected reserve levels against several metrics including the IMF (2011) ARA metric. As reserves fell short of the lower 100% bound of the metric, Staff called for further reserve accumulation for precautionary purposes over the medium term, while cautioning about the significant fiscal sterilization cost of reserve accumulation in South Africa.
Mozambique Fourth Review Under the Policy Support Instrument (PSI), IMF country report No. 15/223, Annex I
Staff undertook a cost-benefit analysis of the optimal level of reserves using the ARA-CC framework for credit constrained economies, together with a comparison of Mozambique’s reserve coverage with that of regional peers using standard metrics. There is an explicit discussion of Mozambique’s high cost of maintaining reserves. The team included an interesting discussion of actual reserve accumulation against what was possible (based on (i) donor disbursements; (ii) capital gains taxes from natural resource companies (which are paid in US$); (iii) fuel imports; and (iv) valuation changes), with an explanation for differences between actual and potential accumulation. Ultimately the level of reserves was assessed to be adequate for the moment, although staff noted the importance of further gradual reserve buildup.