IMF Survey: Assessing the Need for Foreign Currency Reserves

IMF News, April 7, 2011

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The recent crisis demonstrated that foreign currency reserves play a critical role as a first line of defense against external turbulence.
As reserves increase, the benefits of holding additional reserves taper off, and the costs go up.
The IMF has reconsidered tools for assessing adequate levels of reserves, focusing first on emerging market and low-income countries; future work will examine advanced countries.

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.
Countries with adequate reserves generally avoided large drops in output and consumption, and were able to handle outflows of capital without experiencing a crisis.
Holding reserves also entails costs, both directly for each individual country, and globally in the form of macroeconomic imbalances.

Traditional “rules of thumb”:
- Hold reserves covering 100 percent of short-term debt.
- Hold reserves equal to 3 months worth of imports.
In 2009, median reserve coverage ratios in emerging markets stood at about six months of imports, and 200 percent of short-term debt — considerably exceeding these traditional norms.
Reserve losses during the crisis did not show any relationship with needs indicated by these two standard metrics.
Each crisis is unique; sources of pressure vary (withdrawal of foreign capital, loss of export income, capital flight by domestic residents).
Conclusion: reserve adequacy should be judged against the potential for outflow pressures from multiple sources.

Step 1: Use a new “risk-weighted” metric to assess country-specific vulnerabilities. The metric is akin to the risk-weighted capital stock used to assess bank capital needs.
- The metric 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.
Step 2: Estimate the level of reserves that might be needed, measured against this risk-weighted metric.
Finding: the metric suggests 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.

Low-income countries typically have more limited access to capital markets than emerging markets.
The traditional rule of thumb of 3 months of imports is widely used for low-income countries, but its appropriateness has been questioned.
For most low-income countries, balance of payments drains 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.
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.

Reserve holdings have limits; ultimately, the overall quality of macroeconomic policies is critical to protect countries against potential crises.
Policy implications:
- Use country-specific, risk-weighted assessment rather than sole reliance on simple rule-of-thumb metrics.
- For low-income countries with flexible exchange rates, 3 months of imports remains a broadly appropriate benchmark, adjusted for institutional quality.
- Recognize costs of excessive reserves, and weigh benefits against macroeconomic and global imbalance costs.

Reserves in emerging markets: grown six-fold during the past decade.
Total emerging market reserves: over $5 trillion.
Traditional metrics: 100 percent of short-term debt; 3 months of imports.
2009 median emerging market ratios: about six months of imports; 200 percent of short-term debt.
Benchmark for low-income countries: 3 months of imports.

Source: IMF Survey: Assessing the Need for Foreign Currency Reserves (April 7, 2011).