International reserves remain an essential external liquidity buffer for most countries. They generally lower crisis risks and provide space for countries to respond to shocks. Indeed, the benefits derived from such buffers were demonstrated during the global financial crisis, where a number of mature and emerging market countries used reserves to prevent market dysfunction, lean against depreciation pressures, or smooth excessive exchange rate volatility. Other instruments, such as official credit lines and bilateral swap lines, are also external buffers, acting as a complement to reserves. The existence of adequate reserves, however, does not, by itself, eliminate the risk of market pressures. As recent events have demonstrated, fundamentals and policy consistency are critically important to reduce vulnerabilities and lower crisis risks. Also, despite their considerable benefits, excessive reserve accumulation can be costly, both for individual countries and may impose externalities on others.
The paper reviews and builds on the analysis developed in the Fund’s 2011 Assessing Reserve Adequacy (ARA) policy paper. It is focused on the precautionary motive for holding reserves, and has two aims: (i) to explore the role reserves play in preventing and mitigating crises; and (ii) to consider in what ways analysis on reserve adequacy may need to be augmented to account for country-specific factors. The adequacy considerations presented in the paper move beyond traditional metrics for less-mature and low-income economies, and consider the reserve needs for mature market economies as well. In presenting these new considerations and analytical work, the paper responds to outstanding issues identified by the IMF Board following the 2012 IEO evaluation on International Reserves—IMF Concerns and Country Perspectives.
Executive Board Assessment
Executive Directors welcomed a new round of discussions on reserve adequacy. They agreed that international reserve buffers complement sound policies and institutions in underpinning the external stability of a country and can play an important role in preventing or mitigating crises. Directors observed that reserve adequacy assessments should capture country-specific characteristics, and noted that the staff paper moved in this direction, broadly in line with recommendations by the Independent Evaluation Office.
Directors broadly concurred that the staff paper has added insights to the Fund’s analytical framework in the 2011 Assessing Reserve Adequacy paper. Nevertheless, Directors emphasized the importance of judgment in gauging reserve adequacy and cautioned against a mechanical application of any metric. Noting that the staff paper focused on the precautionary role of international reserves, many Directors encouraged additional work to assess the drivers of reserve accumulation in excess of precautionary levels.
Directors welcomed the staff’s approach of moving away from assessing reserve adequacy for countries grouped by standard income-based classifications. They generally endorsed a classification that takes into account different degrees of market maturity and economic flexibility.
Directors agreed that, in countries with more mature markets, financial regulation and other macro- and micro-prudential tools should be deployed first to reduce potential external liquidity needs. They considered, nonetheless, that there is also a role for reserves in countries that do not issue a reserve currency in the event of market dysfunction. In this regard, indicators of short-term bank foreign exchange funding, trading liquidity, and the pricing behavior of market participants could be useful to assess reserve needs. Accordingly,
Directors called for further efforts to address data gaps that still impede construction of these indicators.
Directors agreed that the revised metric for reserve adequacy in members with less mature markets and in low-income countries has improved the analysis on reserves relative to traditional benchmarks. Recognizing that the metric is not an overall vulnerability indicator, a few Directors noted that some countries with apparently adequate reserves still came under market pressure during recent market turbulence. Most Directors endorsed the staff’s suggestions to alter the computation of the reserve adequacy metric for countries highly dependent on commodity trade. Some Directors noted that the weight applied to broad money in the metric should be reduced for countries with capital controls, as recognized in the staff paper.
Directors generally supported the staff’s proposals to better reflect the volatility of capital flows in assessing the adequacy of official reserves. In this regard, a few Directors argued that reserve needs for emerging markets could be higher than implied by the suggested range for the risk-weighted adequacy metric.
Directors welcomed the proposed methods to better measure the cost of reserves in countries with market access and in low-income countries. More broadly, a number of Directors also suggested that the cost of reserves should also take account of the spillovers of reserve accumulation on other countries.
Directors saw scope for tapping reserves as part of the policy response to stem capital outflows but reiterated the importance of maintaining appropriate macroeconomic policies and of addressing preemptively emerging vulnerabilities. In this regard, Directors called for further work to strengthen the Fund’s policy advice on foreign exchange market interventions, and a fuller discussion of alternatives to reserves accumulation such as central bank swap lines, Fund arrangements, and regional financing arrangements, including in the broader context of reforms to the international monetary system.
Directors looked forward to further discussions of reserve adequacy, which would build on the work so far. In particular, many Directors called for additional engagement before operational issues are finalized. A guidance note for staff will be prepared.