Reserves—in foreign currency, plus gold, held by central bank—have important place in policy toolkit of most economies (photo: Kamran Jebreili/AP/Corbis)
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Reserves—the assets denominated in foreign currency, plus gold, held by a central bank—occupy an important place in the policy toolkit of most economies. Together with sound policies, they can help reduce the likelihood of balance of payment crises and preserve economic and financial stability. In addition to these important benefits, reserves also have costs.
Although the global financial crisis highlighted the importance of adequate reserves, there is little consensus on how to determine the desired level of reserve holdings for a given country. A new IMF report aims to fill this gap by outlining a framework for discussing reserve adequacy issues in the context of the IMF’s regular “health checks” of its members’ economies, also known as Article IV consultations.
“The framework provides some tools for quantifying the risks facing a country,” said Nathan Porter of the IMF’s Strategy, Policy, and Review Department, one of the report’s authors. “Based on the risks a country needs to cover, the framework helps country authorities decide how much reserves might be needed.”
Role of reserves
Countries hold reserves for a variety of reasons: to build confidence in the national currency, counter disorderly market conditions, support the conduct of monetary policy, build assets for intergenerational purposes, or influence the exchange rate, the report notes.
Countries may want reserves on hand for precautionary purposes—that is, to provide space to country authorities to respond to potential shocks, prevent chaotic market conditions, and avert economic dislocation. They may also hold them for nonprecautionary purposes—for example, an oil-exporting country may set aside as reserves a portion of its revenue to preserve wealth for future generations.
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 across countries, the IMF report notes.
Greater country specificity
Because the role played by reserves—and hence a country’s reserve needs—differs depending on the type and structure of the economy, different tools are needed to assess reserves in different types of economies. The new framework classifies countries based on the strength of market access, depth and liquidity of their markets and the flexibility of their economies.
In general, the report says, the reserve needs of more mature (advanced) countries center on limiting market dysfunction including that associated with shortages of foreign currency liquidity in financial institutions. Emerging markets and low-income economies gaining market access (frontier economies) tend to focus on mitigating the risk of crises from potential current and capital account shortfalls. Countries with limited market access often need reserves to smooth domestic absorption of current account shocks.
For each country group, the paper proposes frameworks to help assess the appropriate level of reserves based on its circumstances. To achieve this, the report also provides further reserve assessment guidance for specific country types within these categories—for example, countries with capital controls, commodity-intensive countries, and dollarized economies.
This framework—which builds on work published in 2011 and 2013—offers a considerably greater level of country specificity than previous methods of assessing reserve adequacy, Porter says. It also devotes more attention to advanced economies, a group whose reserve needs were not given much consideration prior to the global financial crisis.
Too much, too little, just right
If holding too little reserves can be problematic, so too can holding too much, the report observes. For all categories of countries, there is an opportunity cost associated with holding reserves—reserves may be earning a lower rate of return than they would if put to different use. For low-income countries, in particular, public capital not held in reserves could instead be spent on much-needed infrastructure, which would likely yield far greater long-term dividends.
“There is a point at which the benefit of any additional reserves doesn’t really justify the cost of holding them,” Porter says. For all countries, he stresses, there is a desirable range of reserve holdings, which is what the new framework attempts to pinpoint.
Because there are both costs and benefits to reserves, the report proposes that Article IV consultations include a fuller discussion of the authorities’ stated objectives for holding reserves, an assessment of the reserve needs for precautionary purposes, and a discussion of the cost of reserves.
The availability of external buffers beyond reserves—for example, central bank swap lines and credit lines from international financial institutions—should also be taken into account when discussing the adequacy of a country’s reserves, as should an assessment of risks over the medium term.
A country’s reserve accumulation can also have important outward spillovers on other countries. Analysis of this aspect of reserve accumulation is discussed in the IMF’s Spillovers Report and the External Sector Report.
