1. Foreign exchange reserves have a central place in the policy tool kit of most economies. They are held for many different reasons, including to engender 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. Reserves can bring considerable benefits to the country that holds them but also entail costs as they generally yield lower returns than alternative uses. In addition, sizable and persistent one-sided intervention can move an exchange rate far from its equilibrium, aggravating a country’s external imbalances with potential spillovers on other countries. Partly because of the multiple roles played by reserves, but also because of the complexity of quantifying external risks across different countries, assessing the appropriate level of a country’s reserves remains very challenging. Nonetheless, whether a country has sufficient reserves is a central part of any external sector assessment and hence a critical part of the Fund’s surveillance mandate.
2. The 2012 evaluation by the Fund’s Independent Evaluation Office (IEO) found that the discussion in Fund surveillance of issues related to the holding and accumulation of reserves should be deeper.1 The IEO argued that while the Fund had been at the forefront of research on reserve issues, there had not been sufficient discussion in individual country Article IV reports.2 In particular, there had been too little emphasis on reserve adequacy issues and on country specificity in reserve discussions, including for advanced economies.
3. Responding to the recommendations made by the IEO, this paper seeks to advance recent work on reserve adequacy, making specific proposals on how these issues could be covered in bilateral surveillance reports. It builds on past Board papers on assessing reserve adequacy (ARA), in particular the IMF (2011a) and IMF (2013b), which henceforth will be referred to as ARA (2011) and ARA (2013), as well as an informal Board discussion in July. While the global financial crisis has heightened recognition of the importance of holding adequate reserves, there has been little consensus about the assessment of an adequate level for precautionary purposes: in particular, little consideration has been given in the literature to the possible needs for advanced economies, and, for emerging and low-income economies, traditional metrics have been narrowly-based and have not guided behavior. This work stream aims to outline the broad parameters of possible guidance to country teams on the coverage of reserve issues in staff reports, which is a key part of the external stability assessment and facilitate informed discussions at the Board. At the same time, it aims to respond to the IEO recommendations. While the emphasis in this paper is on bilateral surveillance, the analysis could also be relevant outside surveillance work.
4. Within this broader context, and in line with the previous ARA papers, the paper focuses particularly on reserve adequacy for precautionary purposes—that is, on the role of reserves in providing adequate space to country authorities to respond to shocks and prevent disorderly market conditions and undue economic dislocation.3 While traditionally the focus has been on the reserve needs of low-income and emerging market countries the 2013 ARA paper argued that advanced countries may also need reserves for precautionary purposes. However, the role played by reserves, and hence a country’s reserve needs, differ depending on the type and structure of the economy, suggesting that different tools are appropriate to assess reserve adequacy in different types of economies. In general, although not exclusively, more mature (advanced) economies’ reserve needs for precautionary purposes center on limiting the risk of market dysfunction from shortages in foreign currency. Countries with market access (emerging market and frontier) have needs to mitigate the risk of crises from potential current and capital account shortfalls, and countries with limited market access need to protect domestic absorption against current account shocks.
5. While this paper is part of the Fund’s broader work on monetary and foreign exchange policies, its scope is limited to reserve adequacy issues. The paper does not discuss issues that are tackled in other parts of the Fund’s work, including on policy responses to market pressure which is the subject of the upcoming presentation on The Role of Exchange Rate Intervention: Issues and Experiences, the appropriateness of foreign exchange intervention in periods of inflows or outflows which is covered by the Fund’s institutional view on capital flows, and reserve accumulation in a multilateral context, which is covered by multilateral surveillance products including the Spillovers and External Sector Reports.
6. The paper is structured as follows. First, it outlines the scope of reserve adequacy discussions in Fund surveillance (Section II), retraces the role of reserves in the different types of economies and proposes considerations for classifying economies for reserve adequacy purposes (Section III). It then considers specific proposals for adequacy assessments in different types of economies (Section IV), and discusses considerations for assessing the cost of reserves (Section V). Section VI concludes with issues for discussion.