FX Reserves in China decreased by USD 94 b to USD 3,557 b in August, the highest monthly fall on record, the biggest fall in percentage terms since May 2012. While falling commodity prices, several other emerging market and low income countries have experienced drains in their international reserves too.
Sensational headlines aside, what matters is assessing
how adequate FX reserves are as a country insurance against external shocks.
Rules of thumb for measuring FX reserves levels adequacy
have been in use for years. Best known among them are:
- the 3-month import minimum as a cushion against foreign trade collapse;
- the short term one year residual debt, known as the Greenspan-Guidotti rule for mitigating the market access risk;
- the combination of both above plus the projected current account deficit, intended to reflect the full potential 12-month financing need;
- the, also arbitrary, 20% of broad money (M2) as a proxy for protection against the risk of capital flight.
Some newer approaches include the cost of holding
reserves into the picture, therefore changing the question from what is an adequate
level to what is an optimal level for a country´s FX reserves. Unfortunately
they are very dependent on stylized modeling assumptions and calibrations which
jeopardize possibilities for their practical use.
The IMF developed a new methodology (2011, 2013) to assess
reserves adequacy which suits the need of practioners very well. It built upon older measures by offering a metric which
weights the different sources of FX reserve drains.
As if it were a risk weighted capital ratio for assessing
a bank´s solvency, the IMF established a minimum, adequate level of precautionary
FX reserves for a given country. Weights are suggested for Short term debt (STD), Portfolio Liabilities
(OPL), Broad money (M2) and exports (X).
Since the exchange rate framework matters during an
event of FX market pressure, weights are lower for countries under flexible exchange
rate regimes.
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IMF international reserves adequacy
metric
Minimum expected outflows during exchange market
pressure events
Fixed ER: 30% of STD + 15% of OPL + 10% of M2 +
10% of X
Floating ER: 30%
of STD + 10% of OPL + 5% of M2 + 5% of X
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The IMF suggests that the adequacy requirement is
met as long a country’s reserves lie between 100-150% of the metric defined
above
When applying the IMF benchmark to China, those now diminished current levels are still 32% above the estimated cushion to cope with exchange market pressure. Minimum adequate FX
reserves would be USD 2,702 b.
The same metric applied to a China-exposed emerging
country like Chile results in a similar 30% comfort margin: IMF-metric, USD 29.3b as compared to USD 38.1b of current international reserves.
Indeed, both China and Chile have access to IMF contingent credit facilities. They both also hold Sovereign Wealth
Funds which are in part kept as precautionary reserves for macroeconomic stabilization
purposes, so they could eventually provide extra liquidity should that be
needed from outside their own central banks.