Appendix 3 

The Adequacy of Foreign Exchange Reserves 

While many economies struggle to maintain adequate reserve levels, a growing number of 

countries have accumulated vast stocks of reserves; in some cases the reserve stocks are so large 

as to bring into question their 

necessity.1

The most common motivation for 

holding large reserves is to insure 

against currency crises by enabling 

authorities to support their own 

currency. Figure 1 shows that seven of 

the top ten reserve holders are countries 

typically considered emerging 

economies. 

Other reasons to hold reserves will not 

likely require similarly large amounts. 

The act of acquiring reserves may serve 

an immediate purpose, such as fighting deflation. Once acquired, however, large reserve 

stockpiles serve little purpose other than to serve as a precautionary fund. Indeed, in advanced 

economies, flexible exchange rates and strong macroeconomic policies have diminished even the 

precautionary value of reserve holdings. 

The emerging market crises of the 1990s resulted in a growing literature on the level of reserves 

necessary to adequately insure against shocks.2 In that literature, several basic benchmarks for 

emerging economies were suggested: 

• Reserves equal to short-term external debt: Countries that may be vulnerable to a 

capital account crisis can benefit from holding reserves sufficient to cover all debt 

obligations falling due within the coming year. This benchmark, known as the 

Greenspan-Guidotti rule, is the most widely preferred benchmark for measuring 

vulnerability to capital account crisis, and its relevance to currency crisis prevention has 

the strongest empirical support.3

 

1

 This topic has been analyzed extensively in Green, Russell and Tom Torgerson, 2006, “Are High Foreign 

Exchange Reserves in Emerging Markets a Blessing or a Burden?” Forthcoming Treasury Department Occasional 

Paper. 

2

 See Wijnholds, J. Onno De Beaufort and Arend Kapteyn, 2001, “Reserve Adequacy In Emerging Market 

Economies,” IMF Working Paper No. 01/143. 

3

 See Bussière, Matthieu and Christian Mulder, 1999, “External Vulnerability in Emerging Market Economies: How 

High Liquidity Can Offset Weak Fundamentals and the Effects of Contagion,” IMF Working Paper No. WP/99/88; 

García, Pablo and Claudio Soto, 2004, “Large Hoardings of International Reserves: Are They Worth It?” Central 

Bank of Chile Working Papers No. 299; and Jeanne, Olivier and Romain Rancière, 2005 “The Optimal Level of 

International Reserves for Emerging Market Economies: Formulas and Applications,” IMF Working Paper No. 

WP/06/229. 

Figure 1: Top 10 Holders, Total Reserves Minus Gold

Level Percent Increase

USD bn as of 

June 2006

from

June 2005

from

June 2002

China 943.6 32% 283%

Japan 849.8 2% 94%

Taiwan 262.0 3% 77%

Russia 243.2 64% 510%

Korea 225.6 10% 101%

India 156.8 17% 183%

Singapore 127.3 10% 59%

Hong Kong SAR 126.6 4% 13%

Mexico 84.9 29% 86%

Malaysia 78.4 5% 143%

Source: IMF
2

• Reserves equal to roughly 5-20 percent of M2: Economies that need to shore up 

confidence in the value of local currency and reduce the risk of capital flight may find 

this benchmark useful. Less flexible exchange rates necessitate higher reserves relative 

to M2. 

• Reserves equal to three or four months of imports: This benchmark is especially 

relevant to low-income countries exposed to current account shocks and without 

significant access to capital markets. 

The emerging economies among the top ten reserve holders maintain reserves far in excess of 

nearly all of the benchmarks, as 

shown in Figure 2. Some have 

attempted more sophisticated 

calculations to empirically 

estimate optimal reserve demand 

by taking into account the fact that 

different economies have different 

degrees of exposure to different 

risks.4

 All of the top reserve 

holders studied were found to have 

actual holdings in significant 

excess of predicted levels. 

Holding reserves beyond the recommended benchmarks will, other things equal, probably reduce 

an economy’s vulnerability to financial crisis. But it will do so with diminishing marginal 

benefit and rising marginal costs. Though difficult to quantify, the costs associated with holding 

reserves include: 

• Sterilization costs: Sterilization neutralizes the inflationary monetary impact of reserve 

accumulation, typically by domestic debt issuance to offset the associated increase in 

money supply. If the interest rate for domestic borrowing exceeds the interest rate on 

reserves, the direct fiscal costs may be significant. In addition, the economy may incur 

indirect systemic costs because sterilization allows a central bank to influence the real 

exchange rate and hence disrupt appropriate current account adjustment. 

• Opportunity costs: Alternative uses for foreign exchange reserves may yield greater 

returns – examples include prepaying external debt and undertaking public investment 

projects.5

 If reserves exceeding the level or ratio indicated by adequacy benchmarks 

 

4

 See Aizenman, Joshua and Nancy Marion, 2003, “The High Demand for International Reserves in the Far East: 

What Is Going On?” Journal of the Japanese and International Economies, 17(3):370-400; Edison, Hali, 2003, “Are 

Foreign Reserves Too High?” World Economic Outlook, IMF, September; and Gosselin, Marc-André and Nicolas 

Parent, 2005, “An Empirical Analysis of Foreign Exchange Reserves in Emerging Asia,” Bank of Canada Working 

Papers No. 05-38. 

5

 This idea has been recently discussed by Genberg, Hans, Robert McCauley, Yung Chul Park and Avinash Persaud, 

2005, “Official Reserves and Currency Management in Asia: Myth, Reality and the Future,” Geneva Reports on the 

World Economy 7, Centre for Economic Policy Research; 

Figure 2: Emerging Market Adequacy Reserve Ratios, 2005

reserves/short-term 

debt reserves/M2

reserves/months of 

imports

China 11.58 0.22 15.72

Taiwan 5.95 0.35 15.65

South Korea 2.63 0.21 7.93

Russia 4.43 0.93 16.40

India 4.29 0.80 13.17

Mexico 2.71 0.18 3.78

Malaysia 3.09 0.43 7.49

benchmark 1.00 0.05 - 0.20 3.00

Source: IMF, BIS, and national sources.
3

were put to alternative uses with returns only three percent higher than current risk-free 

reserve assets, benefits could be as much as one percent of GDP each year. 

• Balance sheet risks: If the local currency appreciates, the local value of international 

reserves decreases. Although some monetary authorities may average these losses out 

over time, other central banks may realize significant balance sheet losses. Even if the 

central bank is able to recapitalize from retained profits and is not directly affected by 

losses, those retained profits represent revenue forgone by the treasury. Reserves in most 

of these countries are several times central bank capital and more than ten percent of 

GDP, so the magnitudes of potential losses are significant. 

• Other costs: If reserves create a false sense of security, the incentive to tackle difficult 

reforms may be reduced. Rapid reserve accumulation may also complicate the 

formulation of monetary policy under flexible exchange rates. 

In light of the potential cost of holding reserves, in situations where reserves far exceed 

commonly accepted adequacy levels, questions can arise about the necessity and wisdom of 

adding further reserves to existing stocks. 

 Summers, Lawrence H., 2006, “Reflections on Global Account Imbalances and Emerging Markets Reserve 

Accumulation,” L.K. Jha Memorial Lecture, Reserve Bank of India, Mumbai, India; and 

Rodrik, Dani, 2006, “The Social Cost of Foreign Exchange Reserves,” International Economic Journal, forthcoming.