Front Matter Page

November 13, 2013

IMF Policy paper

IMF POLICY PAPER

ASSESSING RESERVE ADEQUACY – FURTHER CONSIDERATIONS

November 13, 2013

IMF staff regularly produces papers proposing new IMF policies, exploring options for reform, or reviewing existing IMF policies and operations. The following document(s) have been released and are included in this package:

• The Staff Report on Assessing Reserve Adequacy – Further Considerations, prepared by IMF staff and completed on November 13, 2013 for the Executive Board's consideration on December 4, 2013.

• Staff Supplement on Assessing Reserve Adequacy – Further Considerations.

• A Press Release summarizing the views of the Executive Board as expressed during its December 4, 2013 consideration of the staff report.

The policy of publication of staff reports and other documents allows for the deletion of market-sensitive information.

Electronic copies of IMF Policy Papers are available to the public from:

International Monetary Fund ‧ Publication Services P.O. Box 92780 ‧ Washington, D.C. 20090 Telephone: (202) 623-7430 ‧ Fax: (202) 623-7201 Email: mailto:publications@imf.org Internet:http://www.imf.org

International Monetary Fund

Washington, D.C.

© International Monetary Fund

Front Matter Page

ASSESSING RESERVE ADEQUACY—FURTHER CONSIDERATIONS

November 13, 2013

Executive Summary

Reserves remain a critical liquidity buffer for most countries. They are generally associated with lower crisis risks (crisis prevention) as well as space for authorities to respond to shocks (crisis mitigation). While other instruments, such as official credit lines and bilateral swap lines, are also external buffers, for most countries they principally act as a complement to their official reserves. For countries with sound fundamentals and a good policy framework, reserves provide policy makers with considerable space to respond to transitory shocks. However, this space diminishes as fundamentals deteriorate and the existence of adequate reserves does not, by itself, eliminate the risk of market pressures.

This paper reviews and builds on the guidance developed in the 2011 Assessing Reserve Adequacy (ARA) policy paper. It has two aims: (i) to explore the role reserves play in preventing and mitigating crises; and (ii) to consider in what ways current guidance on adequacy may need to be augmented, in particular to account for country-specific factors. In doing this, the paper responds to outstanding issues identified by the IMF Board following the 2012 IEO evaluation International Reserves—IMF Concerns and Country Perspectives, and will be followed by a guidance note distilling the operational implications of the work contained in this paper.

The paper seeks to approach the question of reserve needs of a country by the maturity, depth and underlying liquidity of its markets as well as its economic flexibility, rather than by standard classifications (AM, EM, and LIC). Along these lines it finds that (i) despite having more liquid markets and a higher tolerance for foreign exchange volatility, many mature market economies may need to hold precautionary reserves to stem instances of severe market dysfunction and ease short-term foreign currency funding pressures; (ii) for emerging and less-mature market economies, the general guidance provided in ARA metric seems to have worked relatively well, although important refinements are suggested to better capture the risks faced by some specific types of economies; and (iii) for LICs with limited market access, there is a need for more specific guidance on the marginal cost of reserves.

Despite the significant benefits they provide, reserves can be costly. For countries with market access the paper supplements the net financial cost approach developed in ARA with evidence on the opportunity cost associated with sterilization. This measure is applicable to countries with relatively little foreign currency debt, and suggests that large sterilization needs can impose a significant quasi-fiscal cost. For LICs the paper provides more granular guidance on establishing a benchmark for the cost of reserves. For instance, frontier markets with minimal credit constraints face a different opportunity cost of reserves compared with resource-rich LICs, which face the choice between investing windfalls at home or abroad, and a LIC with net capital inflows, where sterilization costs matter the most.

Approved By

Siddharth Tiwari

Contents

• INTRODUCTION

• PART I: RESERVES AND BUFFERS: THEIR ROLE AND USE

• I. What Role Do Reserves Play?

• II. Intervention: Effectiveness and Modalities

• PART II. ASSESSING THE ADEQUACY AND THE COST OF RESERVES

• I. Do Mature Markets and Flexible Economies Need Reserves?

• II. Refining Advice for Economies with Less-Mature Markets

• III. Cost of Reserves—Considerations for Market Access Countries

• IV. Revisiting Reserve Adequacy for Credit Constrained and Low Income Economies

• V. Dollarized Economies and Currency Unions

• CONCLUSIONS

• ISSUES FOR DISCUSSION

• BOXES

• 1. Episodes of FX Swap Market Dysfunction

• 2. Reserve Use During the Global Financial Crisis: Sweden and Australia

• 3. Market Dysfunction and Systemic Banking Crises

• 4. The EM ARA Metric

• 5. Modeling the opportunity cost of holding reserves: Marginal Productivity of Capital

• 6. Dollarized LICs

• FIGURES

• 1. Exchange Market Liquidity in Selected Markets

• 2. Reserves, Vulnerabilities, and Policies and Crisis Probabilities

• 3. Allocation and Access in U.S. Dollar Swap Lines

• 4. Implications from the Estimated Policy Rules

• 5a. Decomposition of Exchange Market Pressure (EM Average)

• 5b. Decomposition of Exchange Market Pressure

• 6. Implied U.S. Dollar FX Swap Rate and Risk Premium in the Market

• 7. Periods of Market Dysfunction

• 8. Determining Reserve Needs

• 9. Reserves in Percent of the ARA Metric, 2007 and 2012

• 10. Estimated Coefficients of ARA Metrics

• 11. Reserve Loss and Risk Factors

• 12. A Decomposition of Other Liabilities

• 13. Equity and Debt Liabilities Changes during EMP Events

• 14. Volatility of Capital Flows and Reserve Adequacy Metric

• 15. Opportunity Cost of Holding Reserves pre-, during, and post-GFC

• 16. LICs: Illustrative Calibration of Adequate Level of Reserves for LICs

• 17. Potential External Drains in Dollarized Economies

• 18. Reserves Adequacy and Dollarization

• TABLES

• 1. Reserves Movements During Currency Appreciation / Depreciation

• 2. Countries Above Relevant Adequacy Threshold

• 3. 10th Percentile of Loss in ARA Metric Component, by Exchange Rate Regime

• 4. Regression of Real Oil Imports on Macro Variables, 1980–2013

• 5. Results from Reserve Demand Regressions

• References