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Foreign exchange reserve management practices: trends and challenges

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Closing lecture at the third conference on 'Foreign exchange reserves and the ... Defining the economic ( pecuniary) opportunity cost of the reserves ... – PowerPoint PPT presentation

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Title: 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.
2
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

1
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

2
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

3
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

4
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!

7
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

6
8
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

7
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

8
10
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)

9
11
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

10
12
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

11
13
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

12
14
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

13
15
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

14
16
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

17
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?

18
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

19
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

20
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

21
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

22
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
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