MANAGEMENT OF FOREIGN CURRENCY RESERVES1

Overview

Although central banks and fund managers appear to be quite similar in regards to their management of foreign currency portfolios there are some important differences. Whereas fund managers are expected to make investment decisions in such a way as to maximise the value of the assets under their management subject to their client's investment mandate, central banks must manage their reserves portfolios subject to a range of policy-related constraints. Most obviously, central banks hold foreign currency reserves to fund foreign exchange market operations that arise as part of their broader monetary policy functions. Under a fixed exchange rate regime, foreign currency reserves are used to maintain a particular exchange rate. However, even under a floating exchange rate regime, foreign currency reserves are often used to provide liquidity in the event of extreme market movements to maintain investor confidence in markets. Foreign currency transactions are also used by many countries to augment their domestic liquidity operations while other countries use foreign currency reserves to manage the impact of government transactions. Reflecting the nature of these policy objectives, central banks understandably place a relatively high premium on ensuring the liquidity of their foreign currency reserves.

This doesn't mean that income generation and capital preservation are not also important to central banks. Indeed, depending on a central bank's circumstances, income generation and capital preservation may be extremely important. For example, in the case of central banks that borrow their reserves (rather than own them outright), the income generated by their reserve assets ideally should exceed their cost of funding. For other countries, where the income generated by these foreign assets constitutes a significant source of public sector revenue, shortfalls can have significant political ramifications.

While it is relatively easy to enunciate the broad objectives of reserves management in respect of their security, liquidity and return characteristics, it is much more difficult to translate those characteristics into a functional investment mandate: a framework that essentially describes the broad parameters of the reserves management process. When defining an investment mandate, the central bank executive needs to articulate the desired level of reserves, the extent to which the reserves are to be managed in separate investment tranches, the instruments that may be invested in and the preferred management style. These aspects of an investment mandate are examined below.

Once an investment mandate has been agreed on, the operational areas of the central bank need to develop systems and processes that define how this mandate is to be efficiently and prudently implemented. Essentially an ‘operational' mandate is a roadmap for how portfolio returns are maximised subject to the prudent management of the risks associated with managing the reserves portfolio. Details of the performance measurement and risk management aspects of the operational mandate are discussed in detail below.  Details of the Reserve Bank of Australia's objectives and mandates are presented separately.

Footnote

1. This paper was prepared by Michael Andersen, Senior Manager (International Reserves) at the Reserve Bank of Australia. (back to text)