Foreign exchange reserve management practices: trends and challenges

1
Foreign exchange reserve management practices
trends and challenges

• by
• Claudio Borio, Gabriele Galati, and Alexandra
  Heath
• Bank for International Settlements, Basel
• Closing lecture at the third conference on
  Foreign exchange reserves and the international
  monetary system Genoa and beyond
• Genoa, 27-28 March 2008

The views expressed are those of the authors
and not necessarily those of the BIS.
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Questions and methodology

• How has RM evolved?
• What have been the main drivers?
• What are the key challenges?
• focus on market functioning
• Ad hoc survey for a central bank (CB) meeting at
  the BIS
• end-06 (mid-07)
• 80 of world reserves

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3
Backdrop

• Unprecedented accumulation of FX reserves in
  recent years
• alongside major changes in reserve management
  (RM) practices
• Some changes are well-known others less
• Definition of RM
• Allocation of FX reserves across currencies and
  asset classes for a given net FX position

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4
Key points trends and drivers

• Trend towards convergence to asset management
  processes in the private sector
• greater attention to return alongside more
  structured decision-making (upgrading of internal
  external governance)
• Drivers
• country-specific
• accumulation of reserves
• more general
• changes in the financial landscape
• changes in the institutional landscape

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5
Key points challenges and market functioning

• Key challenges owing to central bank specificity
• defining the appropriate risk-return trade-off
• choice of numeraire
• how much disclosure
• can have a significant impact on market
  functioning
• tension between return-seeking and public-good
  responsibilities
• future of the dollar as reserve currency
• market volatility/arbitrage opportunities

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6
Trend 1 increased focus on returns

• Broader universe of investable assets (Table 1)
• longer duration, spread products (Graph 1)
• corporate credits and equities
• less gold (G. 2)
• Increased use of derivatives
• Increased use of external managers (T. 2)
• Tranching of portfolio
• liquidity and investment tranches
• Establishment of separate SWFs (T. 3)
• but not net wealth!

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Trend 2 more structured decision-making

• Shift towards a top-down approach
• importance of executive level
• defines Strategic Asset Allocation, SAA (T. 4)
• defines management style
• Greater vertical tiering (T. 4)
• creation of Tactical Asset Allocation (TAA) layer
• Greater horizontal separation of activities (T.
  5)
• to limit conflicts of interest

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Trend 3 strengthened risk management

• Market risk (T. 6)
• largest part is unavoidable (FX risk)
• but tighter management ex ante ex post
• greater sophistication of tools
• Credit risk (T. 7)
• primarily because of reputational risk (avoid a
  credit event)
• ratings key own analysis balance-sheet
  constraints
• Operational risk (T. 8)
• greater centralisation and formalisation

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9
Trend 4 increased public disclosure

• About institutional structure/processes (T. 9)
• common across CBs
• About eligible asset classes (T. 9)
• for a majority of CBs
• About currency allocation (T. 9)
• for only a few

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Driver 1 unprecedented accumulation of reserves

• Sense that reserves exceed adequacy measures
  (T. 10)
• has influenced the various trends
• need for liquidity pressure from body politic
  ? return
• return ? internal discipline risk management
• demands for accountability ? internal
  external governance (including disclosure)

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Driver 2 developments of financial markets and
technology

• financial know-how ? availability of tools
• enabled transition to more structured
  decision-making
• Developments of markets ? improve trade-offs
• liquidity for given return
• derivatives ? flexibility

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Driver 3 the external governance environment

• Trend towards greater CB operational independence
• demands for accountability and transparency ?
  internal governance disclosure
• Keener recognition of importance of credibility
  and reputation for effective policy-making
• risk management sensitivity to reputational
  risk
• more favourably disposed towards disclosure

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Challenge 1 what risk-return balance?

• No obvious criteria for choosing
• CBs are multifunctional public sector
  institutions
• RM not to interfere/ to support macro and
  financial stability objectives
• special lens for gains losses is the source of
  an apparent conservative bias

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Challenge 1 (ctd) implications

• Losses
• mainly concerned with reputation independence
• importance of accounting, income distribution/
  recapitalisation rules, relationship to body
  politic
• Gains
• matters how gains are achieved ? reputation
• inhibit investments in certain asset classes
• inhibit active trading strategies that could
  destabilise markets
• Defining the economic (? pecuniary) opportunity
  cost of the reserves
• need for a general equilibrium analysis
• typical misconceptions
• casts the need to raise yield in a different
  light

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Challenge 1 (ctd) future prospects

• Other things equal, trend toward higher risk
  tolerance may well continue
• Implication 1
• support relocation of reserves out of CB balance
  sheets
• Implication 2
• for CBs, tensions between competing objectives
  
• but may actually potential tensions between
  sovereign states

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Challenge 2 which numeraire?

• Key decision highlighted by formalisation of the
  process
• It defines the unit of account for returns and
  risks for RM purposes
• can and often does differ from unit for
  accountingreports
• Ultimately to be derived from objective function
• what are the reserves for?
• how do they impact on the other CB functions?
• Some examples
• intervention ? most liquid currency
• import hedging ? import baskets
• liability hedging ? composition liabilities
• wealth maximisation ? domestic currency
  (imperfect)
• accounting-loss minimisation ? domestic currency

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Challenge 2 implications

• Numeraire has first-order impact on currency
  allocation
• tilts it heavily towards the currency (basket)
  that replicates the numeraire
• minimisation of volatility for given return
• If the domestic currency is the numeraire ?
  importance of the exchange rate regime
• against which currency (basket) is the domestic
  currency more stable?

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Challenge 2 (ctd) implications

• Apparent greater use of domestic currency as
  numeraire could continue
• (imperfect) proxy for wealth maximisation
• CB independence public scrutiny
• sensitivity to accounting losses
• IFRS?
• Resistance to switch away from dollar as
  reserve currency
• intervention role, exchange rate regime
• especially if currencies asked to flexibility
  vis-à-vis dollar

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Challenge 3 how much public disclosure?

• Nature of external governance arrangements
• highly country-specific
• institutional, legal, cultural
• Assessment of the impact of disclosure on
  effectiveness of RM and other CB functions
• depends on trade-off between
• efficiency-enhancing effects of more information
  to the market
• loss of tactical room for manoeuvre
• is more amenable to purely economic
  considerations
• exchange rate regime
• size of the reserves

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Challenge 3 prospects

• Not obvious how disclosure will develop
• external pressures to disclose vs.
• or continued reluctance given the size of the
  reserves
• role of FX regime evolution

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Conclusion

• Major evolution of RM practices
• return-oriented, structured decision-making,
  disclosure
• convergence but considerable differences remain
• Several drivers
• accumulation of reserves
• development of markets and financial know-how
• independence accountability of CBs

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Conclusion (Ctd)

• Unresolved challenges remain
• choice of risk-return balance
• choice of numeraire
• choice of disclosure
• and their resolution can have a significant
  impact on market functioning
• tension between individually profitable actions
  market stability
• future of dollar as reserve currency