## IMF Survey: Assessing the Need for Foreign Currency Reserves

_IMF News, April 7, 2011_

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## Bibliographic details
- Published: April 7, 2011

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### Overview
- 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.

### First line of defense — evidence and key statistics
- 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.

### How to assess needed level of reserves — limitations of traditional metrics
- 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.

### Two-step approach proposed for emerging markets
- 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.

### Assessing reserve adequacy in low-income countries
- 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.

### Limits of holding reserves and policy implications
- 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.

### Key statistics (as reported)
- 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).*

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## References

- [https://www.imf.org/en/News/country-focus](https://www.imf.org/en/News/country-focus)
- [PRESS CENTER](http://presscenter.imf.org/)
- [Policy](https://www.imf.org/en/news/search)
- [Blog: Discussions in Nanjing](http://blog-imfdirect.imf.org/2011/03/31/new-international-monetary-system/)
- [Debate on crisis lessons](https://www.imf.org/external/pubs/ft/survey/so/2011/RES030811A.htm)
- [Right kind of recovery](https://www.imf.org/external/pubs/ft/survey/so/2011/NEW021911A.htm)
- [Reforms to tackle imbalances](https://www.imf.org/external/pubs/ft/survey/so/2011/NEW021111A.htm)
- [Global cooperation is key](https://www.imf.org/external/pubs/ft/survey/so/2010/POL101510B.htm)
- [Ideas to strengthen the system](https://www.imf.org/external/pubs/ft/fandd/2011/03/camdessus.htm)
- [https://www.imf.org/en/home](https://www.imf.org/en/home)

_Source: https://www.imf.org/en/news/articles/2015/09/28/04/53/sopol040711b_