Syrian & Modern Banking
in light of
Arab & International Practices
Damascus 2 – 3 July 2005
Foreign Currency Reserve Management
Practices and Guidelines
Jaafar Salim Badwan
National Bank of Abu Dhabi
Table of contents
Purpose of holding foreign currency reserves3 – 4
Objectives of reserve management5 – 6
Scope of the reserve management7
Reserve management strategy and coordination8 – 9
Reserve management strategy10 – 18
Risk management19 – 21
References22
Every country needs to hold reserves. This is as true of countries with large self-sufficient economies as it is of smaller, more open ones. In many cases, the foreign currency reserves are a major national asset. Even in the rich and developed economies, reserves forms several percentage points of GDP. Insome developing countries, the corresponding figure is considerably higher.
The management of reserves is an important task for almost all central banks. Poor management of reserves may put at risk other elements of national policy (for example, an official exchange rate policy), which can cause severe economic damages.
Purposes of holding foreign currency reserves
Reserve assets may serve a variety of purposes, ranging fromexchange rate management to external debt management. In general, central banks hold reserves for a variety of reasons, such as to:
1-Fund foreign exchange market operations that arise as part of Central Banks’ monetary policy function
2-Support monetary policy
3-Guarantee payments of foreign currency debt
4-Control excessive volatility of the national currency against other currencies
5-Other reasons:
- Support trade in an open economy for transaction purposes
- Take precautionary measures, associated with potential balance of payment’s crisis
- Improve a country’s access to international capital markets via maintaining sound foreign exchange liquidity policies
- Help governments in loweringfuture tax rates
- Save surpluses for future generation
- Compensate for any reduction in natural resources
For many countries, especially developing countries, reserves are both a major national asset and a crucial tool of monetary and exchange rate policy. It is vital therefore that this national resource is used and managed wisely and effectively.
Efficient management of reserves is vital for the Central Bank’s credibility.
Successfully managing of foreign reserves will:
1-boost confidence in a country’s:
- monetary policy
- banking and financial system, and
- stability of the national currency
2-enhance the Central Bank’s capability in protecting and promoting a safe
and sound banking and financial system. In a small economy that is going through a transitory period, weakness in the banking system distorts the transmission mechanism of monetary policy. Unsound banks that are not able to control their balance sheet are usually less responsive to changes in reserve money or interest rates. In addition, the central bank may be pressured to create credit for bailing out ailing banks and to loosen monetary conditions, thereby undermining monetary control.
3-grow the size of the reserves and increase profitability. This would enhance GDP growth.
4-improve disclosure, accountability, and transparency in monetary policy.
Objectives of reserve management
Reserve management must ensure the following:
(I)adequacy and availabilityof foreign exchange reserves to meet a defined range of objectives.
(II) prudent control of liquidity, market, and credit risks
(III)generating reasonable returns on the invested funds over the medium and long term horizon within certain liquidity and other risks constraints
Reserve management forms part of official economic policies, and specific circumstances will impact choices concerning both reserve adequacy and reserve management objectives. In order to ensure the availability of reserves, and as part of setting appropriate investment priorities, the reserve senior management needs to assess what constitutes an adequate level of reserves.
There is no single applicable measure for assessing the adequacy of reserves however; relevant factors have traditionally included a country'smonetary and exchange rate arrangements, size, nature, and variability of its balance of payments and external position.
Financial risks associated with a country's external debt position and the volatility of its capital flows hasalso received particular attention, especially for economies which have poor access to international markets. In the process, ensuring the availability of reserves will be influenced by the exchange rate system, and the particular objectives for which they are held.
To ensure that reserves are available at the times when they are needed, liquidityusually receives the highest priority, albeit with a cost that usually involves accepting lower yielding investment instruments. Closely following, is the need for the management and control of risks to ensure that asset values are protected. Market and credit risks, for instance, can lead to sudden losses and impair liquidity.
Finally, returns are an important result of the management of reserve assets. For some countries, thesereturns play a role in offsetting the costs associated with central bank policies and domestic monetary operations, which among other things fund the acquisition of reserves. In other cases, such as where reserves are borrowed in foreign markets, returns play an important role in minimizing the cost of carry. Accordingly, achieving an acceptable level of returns should be a priority within clearly defined liquidity and risk constraints.
Short and Long portfolios
Management of foreign currency reserves must balance the needs of liquidity and capital preservation during difficult market conditions. Dividing foreign currency reserves into a short term portfolio according to liquidity, investment objectives, and policy requirements is recommended. In this respect central banks may consider establishing two types of portfolios:
1-A short term portfolio which reflects transaction and/or intervention needs based on the assessment of potential need for liquidity on demand. Such portfolios are typically invested in the most liquid and risk averse instruments.
2-A long term portfolio which is held to provide an additional cushion, but is less likely to be drawn upon. In this portfolio greater emphasis is placed on return as well as safety and liquidity. Thisllongterm portfolio may take into consideration the maturity of the country external debt by investing in fixed income securities of the same maturity as the external debt. In this respect combining asset/liability management would lead to a better risk management and would be more useful for countries with more debt or too low reserves in terms of import cover.
The relative size of each portfolio may be determined as part of an assessment of reserve adequacy, and each portfolio would have a separate benchmark reflecting the different objectives.
Scope of reserve management
Reserves consist of official public sector foreign assets that are readily available to and controlled by the monetary authorities. Reserve asset portfolios usually have special characteristics that distinguish them from other foreign currency assets.
1-Official reserve assets normally consist of liquid or easily marketable foreign currency assets that are under the effective control of, and readily available to, the reserve management entity. Furthermore, to be liquid and freely useable for settlements of international transactions, they need to be held in the form of convertible foreign currency claims of the authorities of nonresidents.
2-Reserve management activities may also includeliabilities management, other short foreign exchange positions, and the use of derivative financial instruments. Depending upon a country's specific policy objectives and settings, the reserve management entity may also be involved in the borrowing of foreign exchange, or drawing against committed credit lines, as part of its responsibility for maintaining an adequate level of reserves. Managing reserves may also involve liability positions that derive from repurchase agreements, forward exchange and swap agreements, as well as positions arising from operations involving futures and options.
Reserve management strategy and coordination
Reserve management strategy should draw upon the following important factors:
1-Reserve management strategies should be consistent with a country's policiestowards and support of its business environmentand the country’s monetary and exchange arrangements.
Reserve management strategies should be designed with the following factors in mind. Of particular relevance:
1-monetary policy and exchange rate management,
2-The degree to which exchange and capital controls have been liberalized.
Countries that frequently operate in the foreign exchange market (e.g. fixed exchange rate) will need reserves that can be readily converted into foreign exchange. Especially in these cases, reserves are needed to provide confidence in the currency peg, and prevent speculation. For these purposes, reserves tend to be invested in a form that facilitates their ready availability.
Intermediate exchange rate regimes, such as managed float, require the authorities to operate in support of the arrangement. This may call for more or less active operations depending on market evolution and conditions with consequences for the choice of the appropriate level of liquidity that would need to be maintained.
2-Cost/benefit analysis of holding reserves and their respective implications for reserve adequacy facilitates evaluation of alternative reserve management strategies. Such analysis would aim to place values on the costs and benefits of holding more or less reserves, for example, by weighing the costs of rising and holding additional reserves against expected benefits of less volatile capital flows, increased foreign investor confidence, and reduced risk of contagion.
3-Reserve management strategies may also need to take into account strategies for the management of external debt for purposes of reducing external vulnerability. Mutually consistent and supporting policies for debt and reserve management can be important elements of crisis prevention. At the public sector level, this might involve a coordinated approach that considers the assets and liabilities of several official institutions including, where relevant, positions of sub-national authorities. The aim in these circumstances is to determine whether a country's official "whole of government" balance sheet has an adequate level of reserves to provide liquidity as needed, and to allow time to absorb shocks in situations where access to borrowing is curtailed or very costly. In some economies, short-term external private debt may also be an additional factor in determining reserve adequacy.
In countries where reserve management and debt management responsibilities are entrusted to the same authority, consistent strategies can be achieved through a well-coordinated asset/liability risk management approach. Where reserve management and debt management responsibilities are split between authorities, however, the respective policy objectives may differ. In situations where, for example, the reserve management entity has a primary responsibility for monetary policy, care should be taken to ensure that coordination efforts are not seen as compromising the separation between monetary policy and debt management. In such situations, coordination might also seek to ensure that the authorities' respective actions send out clear signals and avoid contradictory messages.
Reserve management Strategy
Reserve management strategy transforms goals and risk return preferences into long term optimal proposals for individual asset classes. In the context of reserve management, reserve strategy can be seen as follows:
1-To create a sound organization structurefor managing reserves efficiently
2-To establishedinvestment philosophy alternativeswhich translate policy requirements into investment principles
3-To implement the process that should address how to derive strategic benchmark, how to define rebalancing rules and how to specify the leeway for active management.
4-To determine the reserve long term risk return profiles which is derived from the previously established investment principles.
1-Organization structure
Central banks must build sound organization structuresto satisfy certain government requirements.Furthermore, given the significance of the foreign reserves assets in the financial statement of the central bank, a transparent and accountable reserve management framework should be established to ensure effective governance and implementation of the reserve strategy. The framework should rely upon a sound organization structure.
Selection of organization structure will depend on the selected style of reserve management, senior reserve management investment principles,and the selected strategies. Active reserve managementwhich is normally preferred by many central banks comprises of three tiersof management:
1-the Senior Reserve Management Committee,
2-the Investment Committee and
3-Portfolio Managers.
Figure 1 illustrates the three tier organization structure with an investment process that allows active reserve management. Starting from the reserve strategy (asset allocation strategy) followed by tactical asset allocation and portfolio management.
First tier-The Senior Reserve Management Committee comprises of Executive Board Members and senior officials from other executive areas of the Bank. The main responsibilities of the Senior Reserve Management Committee are:
1-Settingreserve strategy
2- Setting performance targets for the investment committee
3-Defining risk management approach and parameters
4-Monitoring the investment committee and portfolio management
5-Internal finance
Senior Reserve Management Committee sets reserve strategy for the medium to long term which should be consistent with the country’s general policies and support to monetary policy and exchange arrangement. It should also reflect the central bank’s risk appetite, and views on investment environment. Any structural changes in long term investment opportunities will be reflected by the senior management into the reserve strategy.
Senior Management Reserve conveys its message to the investment committee and senior portfolio managers through:
1-Setting investment principles, which include the long term risk return preferences and objectives for the Senior Reserve Management Committee, and the process of monitoring the implementation of the reserve strategy.
2-Setting objectives for the Investment Committee
3-Establishing the asset mix, in this respect a comprehensive budgeting risk approach is usually employed
4-Establishing currency composition,
5-Establishing the margin of freedom given to the Investment Committee and Portfolio Managers in implementing the reserve strategy. The margin of freedom given to members of the investment committee to manage the foreign reserve assets is defined in terms of forward looking tracking errors, Value at Risk etc.
6-Monitoring the implementation of the asset allocation
Second tier-The Investment Committee comprises of senior portfolio managers, economists, and strategists.The Committee is responsible for:
1-Implementing and monitoring the reserve strategy.
2-Setting the tactical asset allocation to benefit from changes in assets relative values and market outlook in the short to medium term
3- Reviewing the tactical asset allocation
Performance targets for the Investment Committee are set by the Senior Reserve Management Committee either tooutperform a certain benchmark or a certain total return objective.
If the benchmark is a total return objective, then the main task
for the Investment Committee is to deviate from the strategic
asset allocation in order to reduce downside risk. If a
benchmark is selected, then the task of the Committee is to
outperform the benchmark by deviating from the main strategic
assetallocation through tactical asset allocation. Skilled
portfoliomanagers are required for successfully managing
the tacticalallocations.
Third tier-The Portfolio Managers who are responsible for
1-Implementing the tactical asset allocation decisions and
2-Taking positions in the market against their benchmark
The responsibilities of the Portfolio Managers are given by the Investment Committee through a mandate consisting of risk models, benchmarks, reasonably flexible guidelines, and sound portfolio construction.
Portfolio Managers should invest in strategies that will allow for significant out-performance of the guidelines. Level of Portfolio Managers’ experience should be high.
2-Policy objectives and investment philosophy:
In order to establish the reserves’ strategic asset allocation, general policy objectives such as theprovision of liquidity, the reduction of external vulnerability or the storage of national wealth,have to be transformed into more specific, quantifiable, objectives and constraints.
These objectives and constraints are to be laid down in the Statement of Investment Principlesand form the basis for determining the optimal combination between reserves’ expectedreturn, liquidity (risk) and security (market and credit risk). In addition, the investmentprinciples also define the organizational set-up and make specific provisions for the conduct
of tactical asset allocation, portfolio implementation and risk management.
Thethree investment philosophiesthat support the formulation of concrete objectives and constraints are:
1-The individual currency approach
This approach is usually implemented when the minimization of the exchange rate exposure is not a primary objective.The strategic asset allocation for individual currency sub-portfolios is establishedindependently of the reserves currency distribution. This therefore separates the decisionsabout the allocation of the overall reserves to individual currencies and the allocation toindividual asset classes within these currencies. The subordinated treatment of exchange raterisks implied by this approach reflects the notion that these risks are of a special nature forcentral banks.
2-The base currency approach
This approach explores the diversification effect on the level of aggregate reserves as measured in the banks’ base currency. Also this approach establishes the currency distribution and assets composition of the sub-portfolio simultaneously. It requires definition of objectivesat the level of the overall reserves in base currency return.
Compared to the first approach, this approach is likely to result in more extreme allocations within individual sub-portfolios; however it could improve the reserve’s risk return profile measured in base currency
3-Asset and liability approach
This approach seeks to integrate the management of the reserves with the country’s external debt. When the central bank responsibilities encompass reserve management and debt management, asset – liability management may be applied in a way that objectives and constraints for deriving the strategic asset allocation can be determined against the size and characteristics of foreign currency liabilities. For instance, reserve management would try to find the optimal risk return combination in a set-up where risk is measured relative to the composition of external public sector debt.