Shanghai, China. Reserves in emerging markets have grown sixfold during the past decade, and now stand at $5 trillion (photo: Steve Jaffe/IMF)
INTERNATIONAL MONETARY SYSTEM REFORM
But are higher reserves always better? As reserves increase, the benefits of holding additional reserves taper off, and the costs go up.
With the impact of the crisis declining and as central banks in many countries resume the buildup of large reserves, the IMF has reconsidered the tools available for assessing what constitutes an adequate level of reserves. The first step has been to focus on reserves needs of emerging market and low-income countries. Future work will look in more detail also at advanced countries.
First line of defense
Reserve holdings in both emerging market and low-income countries have grown rapidly over the past decade. In emerging markets alone, reserves have grown six-fold during the past decade, and now stand at over $5 trillion.
Reserves played an important role within countries’ overall defenses against shocks during the recent global economic crisis. Countries with adequate reserves generally avoided large drops in output and consumption, and were able to handle outflows of capital without experiencing a crisis. But holding reserves also entails costs, both directly for each individual country, and globally in the form of macroeconomic imbalances.
How to assess needed level of reserves
Traditional “rules of thumb” that have been used to guide reserve adequacy suggest that countries should hold reserves covering 100 percent of short-term debt or the equivalent of 3 months worth of imports.
But despite their appeal in terms of simplicity and transparency, these traditional measures of reserve adequacy appear to have limited relevance today. In 2009, median reserve coverage ratios considerably exceeded these norms in emerging markets, standing at about six months of imports, and 200 percent of short-term debt.
Moreover, the reserves losses that many countries experienced during the crisis did not show any relationship with needs indicated by these two standard metrics.
This reflects the fact that each crisis is unique and that the impact of crises vary greatly from country to country. Some crises result from withdrawal of foreign capital, while others involve the loss of export income, or capital flight by domestic residents.
Taken together, these factors suggest that reserve adequacy should be judged against the potential for outflow pressures from multiple sources.
Two-step approach
Based on this evidence from past crises, the IMF study proposes a two-stage approach for assessing what constitutes an adequate level of reserves for emerging markets:
First, using a new “risk-weighted” metric to assess country-specific vulnerabilities. The metric is akin to the risk-weighted capital stock that is used to assess bank capital needs, and covers potential vulnerabilities from:
• Falling export income
• Sudden stop in short-term debt flows
• Outflows from other debt and equity liabilities
• Resident capital flight
It also takes into account the exchange rate regime of the country.
Second, estimating the level of reserves that might be needed, as measured against this risk-weighted metric.
As with other approaches, the metric suggests that most emerging market countries have at least adequate reserves, while a number have reserves much higher than might be necessary to guard against potential economic shocks.
Assessing reserve adequacy in low-income countries
Low-income countries typically have more limited access to capital markets than do emerging markets. Here, the traditional rule of thumb of 3 months of imports is widely used to assess the adequacy of their reserves, but the question has remained as to whether this is an appropriate benchmark..
For most low-income countries, drains in the balance of payments primarily result from terms of trade shocks, and volatile aid, foreign direct investment, and remittance flows. These factors suggest that reserve coverage in months of imports remains a useful indicator for measuring reserve adequacy in low-income countries.
The empirical analysis in the paper suggests that 3 months of imports remains broadly appropriate for countries with flexible exchange rates, given the estimated benefits provided by reserves in reducing both the probability and impact of shocks.
The analysis also suggests that countries with good institutions and policies need lower levels of reserves.
The limits of holding reserves
Despite the importance of holding adequate foreign currency reserves as protection against unforeseen events, reserve holdings have their limits. Ultimately, the overall quality of macroeconomic policies is critical to protect countries against potential crises.
