Management of foreign exchange reserves

Ministry of education, science, sports and youth of Ukraine 
Donetsk National Technical University 
Highest school of economic and management

 

      Department  
of international  
Business activity

 

 

 

 

 

Course work 
On discipline “International finance” 
On theme: “Management of foreign exchange reserves”

 

 

 

 

 

Prepared by    _______________________                          ______________________ 
 
Checked by    ________________________                        _______________________

 

 

 

 

 

 

 

Donetsk 2012

Content

 

 

Introduction...............................................................................................................3

1.Theoretical aspects of foreign exchange reserves.................................................4

1.1. Objectives and  reasons for holding reserves...........................................4

1.2. The optimum size and ownership of the reserves....................................9

2. Delegation,control and reporting of foreign exchange reserves..........................12

2.1. Delegation and control...........................................................................12

2.2. The importance of reporting...................................................................17

 

3. Management of China's foreign exchange reserves............................................21

3.1. China's foreign exchange reserves and SAFE........................................21

3.2. Recommendations..................................................................................30

Conclusion...............................................................................................................36

 

 

 

 

 

 

 

 

 

 

 

Introduction

For many countries, especially in the emerging markets, the official foreign exchange 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.

Management of reserves is a complex and time-consuming business.  It requires clear objectives, extensive delegation, strong control systems, open and transparent reporting and a realistic appreciation of the constraints faced.  If conducted properly, openly and successfully it will greatly strengthen the public’s respect for and confidence in official policy, and can make a material contribution to successful macro-economic management.

Countries differ in a very great number of ways;  for example size of population, types of government system, state of development, wealth, openness to international trade, even between those who borrow exclusively in their domestic currency and those who also borrow in foreign currency.  But despite this, in nearly every case they see a need for holding foreign exchange reserves. Moreover, this is as true of countries with large self-sufficient economies (eg the USA) as it is of smaller, more open ones. In many cases, the official reserves are a major national asset.  Even in the rich and developed economies, reserves can measure several percentage points of GDP.  In some emerging countries, the corresponding figure is considerably higher.  Merely from the standpoint of preserving this national asset, therefore, the management of official reserves is an important one for almost all central banks.  But beyond this, poor management of the reserves may put at risk other elements of national policy (for example, an official exchange rate policy), and this can cause severe economic damage out of all proportion to the financial loss suffered on the assets themselves. This means that the management of official reserves assumes a doubly important role for the authorities:  in many cases not only is a large amount of money at stake, but also significant elements of national economic policy.

 

1.Theoretical aspects of foreign exchange reserves

1.1. Objectives and  reasons for holding reserves

The floating exchange rate is a distinctive component of the policy package adopted by the Central Bank to fulfill its mission of ensuring the stability of the currency and the normal functioning of internal andexternal payments. This exchange rate regime with an inflation targeting scheme, a prudent financial regulation and supervision, and full financial integration with the outside world, provide, along with the fiscal policy, a coherent framework that allows to maintain the essential macroeconomic equilibrium and to meet the different shocks that the economy faces, mitigating their effects.A key element in meeting these objectives is that the country, through the Central Bank, maintains a level of reserves that would support efficient economic policy decisions. In this sense, the main tenanceof FER can be justified for two reasons.

On one hand, reserves act as an insurance against situations where external funding sources are not widely available or are partially available, either due to endogenous or exogenous factors. This is called the precautionary motive. In this sense, the maintenance of liquidity in foreign currency allows using it in emergencies and helps to moderate the adverse effects of a balance of payments crisis. On the other hand, an appropriate level of reserves could help to reduce premiums for country risk.[1,7]

Foreign-exchange reserves (also called forex reserves or FX reserves) in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, special drawing rights (SDRs) and International Monetary Fund (IMF) reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, mostly the United States dollar, and to a lesser extent the euro, the pound sterling, and the Japanese yen, and used to back its liabilities, e.g., the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.[2]

Looking into the origin of foreign exchange reserves, we came to know that official international reserves in earlier times was just the means of official international payments, which formally consists only of gold and occasionally silver. But with the passage of time, there were changes in this international reserve. Under the Bretton Woods System, the US dollar started functioning as a reserve currency, so it soon became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System. But certain changes arise in the year 1968. After this year, only central banks could convert dollars into gold from official gold reserves.

Foreign exchange reserves history also reveals that after 1973 no individual or institution was allowed to convert US dollars into gold from official gold reserves. Another major turning point in the history of foreign exchange reserves is in the 1973, where no major currencies have been convertible into gold from official gold reserves. Like other commodities, individuals and institutions now buy gold in private markets. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves. With the passage of time of different changes were made in foreign exchange reserves, the quantity of foreign exchange reserves can change as a central bank implements monetary policy today[3].

Although almost all countries hold foreign exchange reserves, their reasons for doing so differ widely.  Before setting a strategic policy for the reserves, the authorities need to establish precisely why they are holding the reserves that they have.  Only then can a sensible debate be held on such issues as the optimum size of the reserves, their funding and their investment. The following are some of the main reasons for holding reserves[4, 6-9]:

   Reserves are sometimes held as formal backing for the domestic currency.  This is a very traditional use of reserves, especially gold reserves.  This use of reserves was at its height under the gold standard, and survived after the Second World War under the Bretton Woods system.  After the breakdown of the Bretton Woods system it became less common, though the use of gold especially to back a currency has never completely disappeared, and the idea of using foreign exchange reserves (rather than gold specifically) to back and provide confidence in a domestic currency has recently been revived with the rediscovery of currency boards.  For most countries this is not, these days, the prime use of the reserves.

More common is the use of reserves as a tool of exchange rate or monetary policy.  This is most obviously the case for those countries who are pursuing a fixed exchange rate policy, and who wish to be able to influence the market in their domestic currency so as to maintain a fixed rate.  In addition, countries may choose to use the FX markets to affect domestic monetary policy, by supplying domestic currency to the market or buying it in the market against foreign currencies.  This will affect the domestic money market balance and so domestic interest rates, and is a useful tool for those countries whose domestic markets are not yet fully developed

A third use of reserves is to provide funds for servicing foreign currency liabilities and debt obligations.  Clearly foreign currency is needed at the point in time when debt servicing payments fall due, to avoid a default.  While it would be possible to meet this need for foreign currency by buying it in the market as and when the need arises, this is not a course that many countries pursue, for several reasons[4, 8]:

−  the FX markets might be unfavourable at the time that foreign currency is needed;

−  the transactions might be disruptive to the markets;

−  the strategy entails large open currency risks on the liability portfolio;

−  this approach reduces credit rating agencies’ confidence in the country as an issuer, and as a result both reduces the attractiveness of the country to lenders and increases the cost of foreign currency borrowing.

Reserves can also be held as a source of funds to pay for government expenditure overseas.  For many countries, especially those with known import bills for the authorities to meet, it can be sensible to plan their financing using the reserves.  This is particularly the case when either foreign exchange receipts or outflows are “bumpy” or show a marked seasonal pattern.  In these cases the reserves can be used to smooth out the payment schedules.

Reserves can provide a defence against emergencies or disaster, by acting as a fund to finance recovery and rebuilding.  This is most likely to be appropriate for small countries that are not large enough to provide self-insurance; larger countries are more likely to fund recovery from a crisis in one part of their domestic economy from elsewhere in the economy.  But a small country may possibly be completely overwhelmed by a disaster;  for example, a natural disaster that wipes out the only export, or a collapse in their terms of trade, or even military disaster.  For such events reserves can provide a diversification of assets, a pool of readily usable funds and security and comfort for potential lenders. Finally, reserves may be held as an investment fund, primarily for financial gain.  This will not be a sensible reason for holding reserves for the majority of countries;  few countries will find that the monetary income on their reserves represents the best use of those assets in the wider context of their whole economy.

For any country, the reason it holds reserves will play a very important part in planning how those reserves should be managed and in what way they should be invested.  Policymakers who are planning their country’s reserves management, therefore, should start by running through the checklist above to identify the reasons for holding reserves.  Reserves held for no identifiable reason are seldom optimally used;  indeed, in many cases, the optimum treatment for reserves for which no other use has been identified may even be to return them to the taxpayer. 

Funding the reserves, and the cost of holding reserves

Many people see the reserves as an asset portfolio only;  that is, with no corresponding liability.  This leads to much debate on the correct investment of the reserves, but rather less on how the assets have been acquired.  This is a partial picture only, and a better approach includes a consideration of the funding of the reserves.  Only in this way can the true cost to the authorities of holding reserves be ascertained. There are broadly speaking three ways to fund the reserves.  They have in common the starting point that the authorities do not naturally hold assets in any currency other than their own, and that to acquire and hold foreign currency assets is therefore a conscious decision involving foregoing domestic assets.  In essence, holding foreign exchange assets means that the authorities have decided not to hold domestic assets, and it is in this light that the issue of funding the reserves should be addressed[5, 10].

The three methods of acquiring foreign exchange assets are to borrow foreign currency formally, to borrow foreign currency against domestic currency through the FX swap market, or to buy it outright against the domestic currency.

The three methods of funding the reserves have differing effects on the market:

−  Borrowing, whether via a foreign currency bond issue or some other means (eg an international loan) does not affect the FX market (ie exchange rate) directly at all.  There has been no transaction in the domestic currency and so there should be no direct effect on the exchange rate.

−  FX swapping has timing effects only on the FX market.  This is because although there is a transaction in the spot market to sell domestic currency and acquire foreign currency, there is an equal and opposite deal done for settlement in the future.  So the overall level of the exchange rate should not be unduly affected.

−  Outright purchases of foreign exchange against sales of domestic currency can affect the exchange rate however, as the overall supply of the domestic currency to the market has been permanently increased.

The value of this analysis of the funding of the reserves is that it enables the authorities to ascertain the true cost of holding reserves.  If the reserves are treated simply as an asset portfolio with no funding or corresponding liabilities, the income on the reserves looks like a net gain for the authorities.  An approach which takes into account the true method of funding the reserves will show that in many cases the net financial outcome from holding reserves may even be a loss, especially in those cases where comparatively low-yielding foreign assets are financed with higher-yielding domestic borrowings.  And even a positive return may not be optimal;  the key question is whether higher returns, after allowance for risk, could be made elsewhere. The choice of which of the three methods to use to fund the reserves depends on many things, from the authorities’ ability to borrow, to the state of the FX market, to the perception of the exchange rate.  Cost will also play a significant role for those countries with the ability to choose between the three methods.  Many countries will make use of all three methods at different times, depending on the relative costs of each method, the state of the market and the interaction with other policies.

1.2. The optimum size and ownership of the reserves 

The optimum size of the reserves. This is an important area that is often given insufficient attention, particularly in emerging countries where the background has traditionally been one of concern over having too few reserves rather than analysis of whether the authorities have too much.  Equally, there are often strong political pressures not to declare that “we have enough reserves now”.  Not only may there be a public perception that “reserves are good and the more reserves the better”, but also, the decision to stop accumulating reserves has only downside risk:  the authorities can never be shown to have too large a stockpile of reserves, but the market can dramatically expose countries that have too few reserves. Reserves are a tool of the authorities and an asset to be used wisely. The debate over the optimum size should not just be ignored or put in the “too difficult” box.  This is especially true for emerging economies, for whom reserves are an expensive asset which must therefore be used sparingly.

Any debate over the optimum size of the reserves has two main elements.  The first is the correct identification of the uses of the reserves and therefore of the minimum required to meet the identified needs.  No sensible discussion of the optimum size of the reserves can take place before this has been done.  The second element is a correct analysis of the cost of funding the reserves.  The debate over limiting the growth of the reserves will be easier to conduct if the true cost of reserves accumulation is known.

These two elements together provide a lower bound to the reserves and a pressure not to increase the reserves without limit above that.  It is not possible to identify the precise level that corresponds to the lower bound, as the process is not an exact science.  And most countries will wish to hold a “comfort margin” above the minimum they identify.  But it is important to realise that, except in rare cases, the authorities are unlikely to do best by accumulating reserves without limit.

Ownership of the reserves:  Government or Central Bank

The question of whether the government or the central bank should own the national foreign currency reserves is one to which there is no single right answer. In most countries, the reserves are owned by the central bank;  that is, they are on the central bank’s balance sheet and the ultimate decisions on reserves management are taken within the central bank’s management structure.  But there are several counter-examples to this (the United States, the UK and Japan, to name three) where the reserves are formally owned by the government, and the ultimate decisions on their management are thus taken by the government (usually the Treasury or Finance Ministry).

For any country, the decision between the two approaches will be determined by a number of factors.  Perhaps the most important one is precedent[6,112]:  - if a structure is already in place and if it works, there is often little reason to change.  But beyond that the following factors will have a bearing on the decision:

−  do the reserves play any part in backing the domestic currency or the note issue?

−  are the reserves used primarily for domestic monetary policy management? 

−  are the reserves primarily used to hedge foreign currency liabilities of the government? 

−  how is the central bank funded? 

What is however more widely true is that, whoever formally owns the reserves, they are nearly always managed by the central bank – either as principal or, in the case where the assets are owned by the government, as agent. Equally, whoever formally owns the reserves, they are treated identically by the international authorities as “national FX reserves”.

Finally, however independent a central bank is, the ultimate decisions on a country’s currency (exchange rate policy, significant intervention, union with another currency, or even “dollarisation”) are usually taken by the government, and these decisions will of course have consequences for the management of the reserves.  In such cases the precise legal ownership of the reserves is of lesser importance than the need for co-ordinated policy-making between government and central bank.

2. Delegation,control and reporting of foreign exchange reserves

2.1. Delegation and control

The correct use of delegation, while maintaining overall responsibility and control, is one of the fundamental elements of effective management.  This is particularly true in reserves management, where the trading and analysis involved in active portfolio management is too time-consuming, complex and detailed for senior management to undertake it themselves, but the sums of money and the risks of loss are too large to be left entirely to junior staff.

Instead senior management must delegate the day-to-day trading decisions, while retaining control over the overall strategy and large scale positions.  This necessitates a formal structure of decision-making, in which each level of management knows what they are responsible for and within which parameters or limits they are free to move;  and a formal monitoring system, through which senior management can ensure that more junior levels are not exceeding the authority that they have been delegated.  Given a system of controls to ensure that delegated power is not abused, there is no reason why junior staff should not be given relatively wide power, certainly in comparison with their peers elsewhere in the typical central bank.

In most reserves management operations, there will be three basic levels of management.  The top level consists of those who are ultimately responsible for the reserves.  This level will usually set the overall objectives and strategy of the reserves management operation.  Typical issues that this senior level of management will be concerned with are the size and broad currency split of the reserves, the overall interest rate exposure position, the credit risks and credit limits policy, whether or not to borrow and if so in which markets, legal questions such as whether the central bank has the vires to undertake certain operations, etc. The second level of management is the direct line management of the reserves management team.  This level is responsible for interpreting and implementing the strategy agreed at the higher level and reporting back to the higher level on results.  Typically this will involve decisions on which markets and which instruments to use, on the major positions to be taken, on the allocation of funds between the portfolios, on how much latitude to allow portfolio managers in implementing management positions, and on the form of the control and reporting procedures used.  The line management will also typically be responsible for the general staffing and operation of the reserves management team within the agreed budget[4, 17].