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IMF POLICY PAPER
REVIEW OF THE ADEQUACY OF THE FUND’S PRECAUTIONARY BALANCES
December 2022
IMF staff regularly produces papers proposing new IMF policies, exploring options for reform, or reviewing existing IMF policies and operations. The following documents have been released and are included in this package:
A Press Release summarizing the views of the Executive Board as expressed during its December 12, 2022 consideration of the staff report.
The Staff Report, prepared by IMF staff and completed on November 16, 2022, for the Executive Board’s consideration on December 12, 2022.
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© 2022 International Monetary Fund
Press Release
IMF Executive Board Discusses the Adequacy of the Fund’s Precautionary Balances
FOR IM MEDlATE RELEASE
WASHINGTON, DC- December 20, 2022 The Executive Board of the International Monetary Fund (IMF) concluded the Review of the Adequacy of the Fund’s Precautionary Balances.1
The Fund’s precautionary balances—which consist of general and special reserves, except for the portion attributed to gold sales profits—are a key element of the IMF’s multi layered framework for managing financial risks. Precautionary balances provide a buffer to protect the Fund against potential losses resulting from credit, income, and other financial risks. For this reason, they help protect the value of reserve assets represented by member countries’ positions in the Fund and underpin the exchange of assets through which the Fund provides financial assistance to countries with balance of payments needs.
This review of the adequacy of the Fund’s precautionary balances took place on the standard two-year cycle, after the December2021 interim review. In conducting the review, the Executive Board applied the rules-based framework agreed in 2010. The framework uses an indicative range for precautionary balances, linked to a forward-looking measure of total IMF credit, to guide decisions on adjusting the target for precautionary balances overtime. The framework also allows for judgement in setting the target, considering a broad range of factors that affect the adequacy of precautionary balances.
The Board also discussed the role of surcharges, which are primarily a component of the Fund’s risk management framework but also contribute to the accumulation of precautionary balances.
Executive Board Assessment2
Executive Directors welcomed the opportunity to review the adequacy of the Fund’s precautionary balances on the standard two-year cycle, after an interim review in December 2021. They emphasized the importance of maintaining an adequate level of precautionary balances to mitigate financial risks, safeguard the strength of the Fund’s balance sheet, and protect the value of members’ reserve positions in the Fund. Directors underscored the importance of adequate precautionary balances for the Fund’s ability to lend to its membership.
Directors agreed that the current rules-based framework adopted in 2010 for assessing the adequacy of precautionary balances remains broadly appropriate. They emphasized that judgment and Board discretion remain an important part of the framework. Against the background of the recently approved Enterprise Risk Management framework, Directors welcomed the discussion of enterprise risks in the staff report and encouraged staff to work with the Office of Risk Management to ensure that all relevant risks are adequately incorporated in the assessment of precautionary balances.
Directors noted that precautionary balances have risen further since the interim review and coverage ratios have strengthened. At the same time, credit and other financial risks have also increased. Credit outstanding is close to historical peaks, driven by lending to some of the Fund’s largest borrowers, and is estimated to remain on a higher trajectory than projected at the time of the 2021 interim review. Credit riskis heightened by a projected peak in repurchases in FY2023–25, mainly from the largest borrower and emergency financing. Near-term income risks have moderated but remain subject to concentration risks, while investment risks are elevated amid heightened volatility in financial markets.
Directors agreed that despite the higher trajectory of credit outstanding than projected at the interim review, the medium-term target for precautionary balances is expected to remain within the indicative range of the forward-looking credit measure and above its mid- point in the most plausible desk-based demand scenario. Moreover, commitments under precautionary arrangements have declined and the burden-sharing capacity has increased significantly since the interim review. Against this backdrop, Directors broadly agreed to retain the current medium-term target of SDR 25 billion. Some Directors argued for a higher target.
Directors agreed that the evolution of precautionary balances in relation to the target will need to be closely monitored amid the weakening global economic and financial outlook and heightened uncertainty, with risks unusually large and to the downside. Most Directors supported maintaining the regular two-year review cycle but would welcome an interim review should lending developments diverge significantly from the paper’s projections, or credit and other financial risks rise materially, including due to changes in Fund lending policies. A few Directors considered that currently elevated risks and uncertainties warranted an interim review in 2023.
Directors broadly supported maintaining the minimum floor for precautionary balances of SDR 15 billion for now. They emphasized that an adequate minimum level of reserves should be maintained to ensure sufficient income and protect against an unexpected rise or deterioration in credit risks. Directors underlined that under the framework, the minimum floor is expected to be changed only occasionally, as it is based on long-term credit and income considerations, and agreed to revisit the adequacy of the minimum floor at the next review. However, some Directors would have preferred raising the floor in the current review.
Directors noted that the pace of reserve accumulation is slightly faster than projected at the time of the interim review and that, overall, it remains ad equate, with the precautionary balance target projected to reach the medium-term target in early FY2025 under the baseline scenario with existing Fund arrangements, and in late FY2024 if new lending under the desk survey scenario is factored in. Directors agreed that no additional steps are needed to reach the precautionary balance target. The pace of accumulation should continue to be monitored closely.
Directors welcomed the opportunity to discuss the role of surcharges and staffs illustrative analysis of the financial implications of potential surcharge relief. Against the backdrop of a weakening global economy and financing pressures, most Directors were open to exploring possible options for providing temporary surcharge relief, with a few of these Directors supporting a change in policy. A number of other Directors, however, did not see merit in exploring such options at this stage. These Directors noted that the average cost of borrowing from the Fund remains significantly below market rates, while also stressing the critical role of surcharges in the Fund’s risk management framework.
Directors agreed that staff should continue to monitor the need for a successor SCA account. A number of Directors stressed the merits of this account to protect the Fund against provisioning for impairment losses and encouraged staff to explore funding options for the account.
Title page
REVIEW OF THE ADEQUACY OF THE FUND’S PRECAUTIONARY BALANCES
November 16, 2022
EXECUTIVE SUMMARY
Precautionary balances are a key element of the Fund’s multilayered framework to mitigate financial risks. They consist of the adjusted balances in the general and special reserves and address residual financial risks of the Fund, notably from non-concessional lending, after applying other elements of the multilayered credit risk management framework.
This paper reviews the adequacy of the Fund’s precautionary balances on the standard two-year cycle, after an interim review in December 2021. It uses the transparent and rules-based framework employed since 2010 to guide the assessment. Under this framework, the Board sets a medium-term target for precautionary balances based on a comprehensive assessment of risks facing the Fund and an indicative range of 20–30 percent for the ratio of precautionary balances to a forward-looking credit measure, as well as a minimum floor. The framework also envisages a role for judgment in setting the target.
Precautionary balances have risen further since the interim review and coverage metrics have strengthened. Precautionary balances amounted to SDR 21.6 billion as of end-September 2022, up from SDR 19.3 billion at end-July 2021. They now cover 3.1 percent of lending capacity, 11.8 percent of lending commitments and 23.7 percent of credit outstanding.
However, credit and other financial risks have also increased. Credit outstanding from the General Resources Account (GRA) is close to historical peaks and is expected to remain on a higher trajectory than earlier estimated. Credit to some of the Fund’s largest borrowers has been the main driver of the increase. Credit concentration risks continue to be heightened by a projected peak in repurchases in FY2023–25. The weakening global economic and financial environment is likely to make the mobilization of balance of payments financing more challenging for Fund borrowers going forward and perceived credit risks as reflected by sovereign credit ratings and spreads of the Fund’s borrowers remain elevated. Near-term income risks remain moderate but are subject to concentration risks. Investment risks are elevated amid heightened volatility in the prices of risky assets.
Staff proposes to retain the current medium-term target of SDR 25 billion and the minimum floor of SDR 15 billion. Despite the higher trajectory of credit outstanding than projected at the time of the interim review, the current target is expected to remain within the indicative range of the forward-looking credit measure and above its mid-point in the most plausible demand scenario. Moreover, commitments under precautionary arrangements have declined and the burden sharing capacity has increased significantly since the interim review. However, with the global economic and financial outlook now substantially weaker and risks unusually large and to the downside, the precautionary balances target will need to be closely monitored. Staff proposes to maintain the normal two-year adequacy review cycle but would proceed with an interim review if lending developments diverge significantly from the paper’s projections or if credit and other financial risks rise materially, including due to changes to Fund lending policies.
The pace of reserve accumulation is expected to remain adequate. Staff projects precautionary balances to reach the medium-term target in early FY2025 under the baseline with existing arrangements and in late FY2024 if new lending under the desk survey scenario is factored in, somewhat faster than estimated previously. Against the backdrop of higher credit risk, staff judges that a slightly faster accumulation of precautionary balances in these scenarios than earlier envisaged is adequate and thus does not propose any additional steps to reach the precautionary balances target.
While primarily a risk management tool, surcharges have significantly contributed to the Fund’s operational income and the accumulation of precautionary balances. Their incidence across the membership and contribution to the Fund’s operational income and accumulation of precautionary balances in the coming years is sensitive to the future demand for GRA resources. The average cost of borrowing from the Fund, including surcharges, remains significantly lower than market rates and the discount has increased recently. However, against the backdrop of a weakening global economy since the last inconclusive discussion on surcharges at the time of the December 2021 interim review, this review provides further technical background on the impact of potential temporary relief and offers another opportunity for Directors to express views on the merit of exploring temporary relief options.
Approved By
Bernard Lauwers (FIN)
Prepared by the Finance Department.
Contents
Glossary
INTRODUCTION
PRECAUTIONARY BALANCES AND THE FRAMEWORK FOR ASSESSING RESERVE ADEQUACY
A. Financial Risks and the Role of Precautionary Balances
B. Precautionary Balances: Composition and Coverage
C. Framework for Assessing Precautionary Balances
DEVELOPMENTS SINCE THE INTERIM REVIEW
A Size and Coverage of Precautionary Balances
B. Credit Risk
C. Income Risks
D. Financial Risks Related to Investments
ASSESSMENT OF THE ADEQUACY OF PRECAUTIONARY BALANCES
A Indicative Precautionary Balances Target
B. Minimum Floor
C. Pace of Accumulation
D. Analysis of Surcharges
ISSUES FOR DISCUSSION
BOXES
1. Typology of Fund Financial Risks and Mitigation
2. The New Approach for the Treatment of Pension-Related Revaluations in Precautionary Balance
3. Main Changes in the Fund’s GRA Lending Policies during the COVID-19 Crisis
4. Credit Concentration Risk-A Regional Perspective
5. Illustrative Example of Temporary Surcharge Relief via a Higher Level-Based Threshold
6. Enterprise Risk Implications of Staff Proposal
FIGURES
1. Framework to Determine the Indicative Target and the Minimum Floor for Precautionary Balances
2. Precautionary Balances: Composition, Accumulation, and Coverage
3. Total Commitments and Credit Outstanding: January 1995-September 2022
4. Credit Concentration Toward Largest Borrowers and Regional Concentration
5 Scheduled Repurchases: FY2023–27
6. Fund Borrowers: Sovereign Ratings and Spreads
7. Medium-Term Projected Operational Income and Expenses: FY2023–27
8. Market Rates and Cost of Fund Borrowing
TABLES
1. Credit Risk Indicators and Precautionary Balances Metrics: Current Versus Interim Review
2. Forward Looking Credit Measure and Calculated Range for Precautionary Balances: FY2020–2024
3. Basic Information on Level and Time-Based Surcharges
4. Medium-term Projections on Surcharges Income and Precautionary Balances Under Various Scenarios
ANNEXES
I. Demand for New Programs
II. Burden Sharing Capacity
III. Credit Concentration Risk – A Regional Perspective
References
Glossary
| BOP | Balance of Payments |
| EA | Endowment Subaccount |
| EFF | Extended Fund Facility |
| Fl | Fixed-Income Subaccount |
| FCL | Flexible Credit Line |
| FTSE | Financial Times Stock Exchange |
| FY | Fiscal Year |
| GSFR | Global Financial Stability Report |
| GRA | General Resources Account |
| IAS | International Accounting Standards |
| IFIs | International Financial Institutions |
| IFRS | International Financial Reporting Standards |
| PBs | Precautionary Balances |
| PFA | Post Financing Assessment |
| PPM | Post Program Monitoring |
| PLL | Precautionary Liquidity Line |
| RFAs | Regional Financial Agreements |
| RFI | Rapid Financing Instrument |
| RSBIA | Retired Staff Benefits Investment Account |
| RTP | Reserve Tranche Positions |
| SBA | Stand-By Arrangement |
| SCA-1 | First Special Contingent Account |
| SDR | Special Drawing Rights |
| SLL | Short Term Liquidity Line |
| SRF | Supplemental Reserve Facility |
| SRP | Staff Retirement Plan |
| TBRE | Time Based Repurchases Expectation Policy |
| UCT | Upper-Credit Tranche |
| WEO | World Economic Outlook |
This press release summarizes the views of the Executive Board as expressed during the December 12, 2022 Executive Board discussion based on the paper entitled “Review of the Adequacy of the Fund’s Precautionary Balances.”
At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summingsupcan be found here: http://www.IMF.orc/external/np/sec/misc/qualifiers.htm.
