Assessing the Need for Foreign Currency Reserves

Foreign currency reserves are key to countries' defenses against shocks but can be costly

Search for better ways to measure adequate level of reserves

New metrics to guide reserves policy in emerging market and low-income countries

But are higher reserves always better? As reserves increase, the benefits of holding additional reserves taper off, and the costs go up.

With the impact of the crisis declining and as central banks in many countries resume the buildup of large reserves, the IMF has reconsidered the tools available for assessing what constitutes an adequate level of reserves. The first step has been to focus on reserves needs of emerging market and low-income countries. Future work will look in more detail also at advanced countries.

First line of defense

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.

Reserves played an important role within countries’ overall defenses against shocks during the recent global economic crisis. Countries with adequate reserves generally avoided large drops in output and consumption, and were able to handle outflows of capital without experiencing a crisis. But 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

Traditional “rules of thumb” that have been used to guide reserve adequacy suggest that countries should hold reserves covering 100 percent of short-term debt or the equivalent of 3 months worth of imports.

But despite their appeal in terms of simplicity and transparency, these traditional measures of reserve adequacy appear to have limited relevance today. In 2009, median reserve coverage ratios considerably exceeded these norms in emerging markets, standing at about six months of imports, and 200 percent of short-term debt.

Moreover, the reserves losses that many countries experienced during the crisis did not show any relationship with needs indicated by these two standard metrics.

This reflects the fact that each crisis is unique and that the impact of crises vary greatly from country to country. Some crises result from withdrawal of foreign capital, while others involve the loss of export income, or capital flight by domestic residents.

Taken together, these factors suggest that...