Reserve Adequacy in Emerging Market Economies

The Capstone workshop team's final report provides an overview and assessment of current methodologies for measuring reserve adequacy, and discusses alternative policy options that may supplement reserves in defending against external shocks. It concludes by proposing refinements to the existing approaches to reserve adequacy.

The unprecedented accumulation of foreign reserves over the past two decades has been broad-based across emerging markets. This has been driven by precautionary motivations but also influenced by financial globalization, commodity prices, and other drivers. Traditional metrics for measuring reserve adequacy, narrowly designed to account for trade shocks or capital flight risk, have changed over time along with the evolving nature of risks in the global economy. In 2011, the International Monetary Fund (IMF) developed a broad measure of reserve adequacy by combining several traditional benchmarks into a single composite risk-weighted metric to account for potential foreign exchange pressure involving short-term debt, other portfolio liabilities, broad money, and exports. This IMF Metric has become a common standard for the assessment of reserve adequacy.

To the extent that reserve accumulation is motivated by self-insurance against international illiquidity, alternative policies are available. The Capstone team evaluated liquidity assurance in the form of bilateral or multilateral lending, such as access to central bank swap lines and financing from the IMF, and crisis prevention and management policies such as capital controls and macroprudential policies. While helpful in some cases as supplements, these options are limited to serving as imperfect substitutes for foreign reserve accumulation.

In the final part of the paper, the Capstone team proposed refinements to the IMF Metric to take into account evidence of recent increases in the volatility of portfolio capital flows, countries whose exports are reliant on volatile commodities, and countries with weak fundamentals. The team assessed the revised metric in terms of predicted consumption losses and find that our Adjusted Metric is a better predictive measure of consumption losses during crisis episodes compared to the IMF Metric.