Public Information Notice No. 10/137

Public Information Notice: IMF Executive Board Discusses the Adequacy of the Fund’s Precautionary Balances

September 30, 2010

On September 13, 2010, the Executive Board of the International Monetary Fund (IMF) reviewed the adequacy of the Fund’s precautionary balances.¹

Background

Precautionary balances are one element of IMF’s multi-layered framework for managing financial risks. These balances, comprising retained earnings held in the Fund’s reserves and the Special Contingent Account (SCA-1), are ultimately available to absorb possible financial losses, thereby helping protect the value of reserve assets that members place with the Fund and underpinning the exchange of international reserve assets through which the Fund provides assistance to members with financing needs. In recent years, the Executive Board has reviewed the adequacy of the Fund’s precautionary balances every two years, with the last such review held in 2008.

The Executive Board discussion took place against the backdrop of a sharp increase in Fund lending and financing commitments during the past two years in response to its members’ needs in the global crisis. In addition to reviewing the adequacy of the Fund’s precautionary balances, the Executive Board discussion of the paper “Review of the Adequacy of the Fund’s Precautionary Balances” covered staff proposals for a more transparent and rules-based framework for adjusting the precautionary balance target over time.

Executive Board Assessment²

Executive Directors welcomed the opportunity to review the adequacy of the Fund’s precautionary balances and to consider the proposed shift to a more transparent, rules-based framework for assessing reserve adequacy and adjusting the precautionary balances target over time. They noted that this review is timely in view of the global financial crisis and the recent changes to the Fund’s lending toolkit and policies.

Directors observed that, since the last review in late 2008, the balance of financial risks facing the Fund has shifted further from income to credit risks as the Fund responded to members’ needs in the crisis. While credit capacity has nearly doubled, credit outstanding has almost tripled, and total commitments have reached new highs. Also, credit concentration remains high and the size of the largest individual exposures has increased sharply and is projected to rise further. Against this backdrop, Directors underscored the importance of the Fund’s multi-layered framework for managing credit risks, including its lending policies and preferred creditor status, and stressed that, within this framework, an adequate level of precautionary balances remains essential in mitigating financial risks and protecting the value of reserve assets that members place with the Fund.

Directors emphasized that determining the appropriate target for precautionary balances is a matter of judgment. The proposed rules-based approach to assessing reserve adequacy would increase the transparency of decisions on the target and provide greater guidance on the need for adjustments over time, while leaving scope for Board discretion in light of a broad assessment of the financial risks facing the Fund. Directors stressed the importance of ensuring that the new framework is adequately adapted to the Fund’s unique mandate, with due regard to the policy framework governing use of its resources.

Most Directors supported maintaining the precautionary balances target broadly within a range of 20 to 30 percent of total credit, subject to a minimum floor. Noting the volatility of Fund credit, which had led to a wide fluctuation of the reserve coverage ratios in the past, a few Directors suggested exploring alternative methodologies, for example by linking the target for precautionary balances more to lending capacity or historical peak levels of credit. While acknowledging that credit risk should remain the primary consideration in assessing reserve adequacy under the new income model, a few Directors saw room for improving the framework to capture other financial risks faced by the Fund more explicitly.

Directors broadly supported the proposed credit measure to be used in calculating the target range, which would take account of the latest actual developments while including a strong forward-looking element. Many Directors also agreed that, until further experience is gained with precautionary facilities, commitments under these arrangements should not be explicitly included in the calculation of the target range, but rather related risks should be taken into consideration, as appropriate, when setting the target. Many other Directors considered that such commitments should be explicitly factored into the calculation, noting that they are already large, and could potentially rise further with the establishment of the Precautionary Credit Line. On balance, Directors agreed to revisit this issue at the time of the next review, or earlier if warranted.

Directors supported setting a minimum floor for precautionary balances to protect against an unexpected rise in credit risks and ensure a sustainable income position. They generally supported the proposed initial floor of SDR 10 billion, and highlighted the need to keep it under review.

Directors agreed that the overall quality of the Fund’s credit portfolio remains high. Nevertheless, most Directors considered it prudent to raise the indicative target for precautionary balances over the medium term, to SDR 15 billion, given the sharp increases in commitments and actual and projected lending, the projected rises in individual exposures, and the current limited capacity of the burden sharing mechanism. A few Directors were not convinced that such an increase in the target is warranted at this time, and preferred to revisit this issue when the existing target of SDR 10 billion has been reached. A few others saw a case for a higher target given the potential for large drawings under existing precautionary arrangements.

Directors underlined that the framework will need to be kept under review, and refined in light of further analysis and experience. They looked forward to a further consideration of these issues at the time of the next review before the floor of SDR 10 billion is reached.

Directors broadly agreed that the current projected pace of reserve accumulation remains adequate. Precautionary balances remain comfortable relative to existing arrears, and the pace of reserve accumulation is already expected to accelerate significantly under existing policies. A few Directors suggested that consideration be given to accelerating the pace of accumulation, including through an increase in the margin for the basic rate of charge, if needed to ensure that the target would be reached as projected.

Directors urged national authorities yet to do so to take the necessary domestic legislative steps to make the Fund’s new income model effective. There were also some calls for further staff work on how to deal with a situation when precautionary reserves exceed the targeted level, including a dividend policy and possible adjustment in the basic rate of charge, on a reform of the burden sharing mechanism, and on a modification of the de-escalation policy to encourage countries in arrears to give priority to paying charges falling due. A suggestion was made that the Board consider the adequacy of progress in achieving the precautionary balance target in the context of an integrated income and expenditure framework.

¹ This PIN summarizes the views of the Executive Board as expressed during the September 13, 2010 Executive Board discussion based on the paper entitled ”Review of the Adequacy of the Fund’s Precautionary Balances”.

² An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.