MANAGEMENT OF FOREIGN CURRENCY RESERVES

Investment Mandate

While it is relatively easy to enunciate the broad objectives of reserves management in respect of security, liquidity and return characteristics, it is much more difficult to translate those characteristics into a workable investment mandate; a framework that ensures that the desired characteristics of the foreign currency reserve portfolio are achieved. When defining an investment mandate, the central bank executive needs to consider the desired level of reserves, whether and to what extent the reserves are to be managed in separate investment tranches, the instruments that may be invested in and the preferred management style. These elements are considered in more detail below.

Level of Reserves

One important consideration for all central banks is the need to identify a desired range for the level of reserves within which they feel that they can achieve their nominated objectives. To a large extent, the decision may simply be a function of the policy environment that prevails at the time. However, when determining the optimal size of a reserves portfolio consideration should be given to a number of factors including the size of the central bank's balance sheet, the opportunity costs of maintaining an unhedged portfolio of foreign assets, the relative depth of the domestic and foreign exchange markets, the size and openness of the domestic economy and the extent to which an economy is reliant on external sources of short-term funding.

Investment Tranches

One consequence of a central bank managing its foreign currency portfolio to meet a number of policy objectives is that these objectives often have conflicting liquidity and return characteristics. For example, a central bank that uses its foreign currency reserves to supplement domestic liquidity operations would place a relatively high emphasis on investing in highly liquid, short-term investments. The same central bank may also consider that its foreign currency reserves are an important national asset that are expected to meet long-term public financing obligations (such as pension obligations). In this circumstance, the relative importance of liquidity and wealth generation (income) is unclear.

When presented with conflicting policy objectives, some central banks (such as Norway, Korea and Singapore) have established independent investment vehicles with their own unique investment mandates. Even in the case of countries that don't create separate investment vehicles, many address this problem by segregating their foreign currency portfolios into smaller portfolio tranches – the most common of these being a liquidity tranche and an investment tranche – and manage each of them against a unique investment mandate designed to reflect a specific policy objective.

A multi-tranche approach may not be particularly practical, however, even when there are several conflicting policy objectives. Consideration needs to be given to the size and relative stability of the reserves portfolio. A multi-tranche approach would be more appropriate in the case of a country that has experienced a sharp (and permanent) increase in the size of its reserves portfolio; for example, as a result of intervention or from the sale of a national asset such as oil reserves or fishing rights. On the other hand, in the case of countries where the size of foreign currency reserves is relatively stable, a single mandate can be readily designed that meets all security, liquidity and return objectives. Even in the case of countries where there is an expectation that the level of reserves is variable, a single investment mandate may be more practical as it would eliminate the need for regular (and costly) top-ups or draw-downs between the investment and liquidity tranches.

Investment Universe

Implicit in any reserves management mandate is the need to ensure that the instruments available to portfolio managers are consistent with the security, liquidity and return characteristics associated with the identified policy objectives. Given the trade off between these characteristics, central bank mandates are often restricted to combinations of short-dated cash instruments and medium-term securities that are issued by highly-rated governments and supranational agencies.

Again, the amount of reserves under management is an important consideration when mandating the eligible range of instruments. Mandating too many instruments could stretch available resources too thinly and, in the case of credit products, may not result in sufficient diversification within the particular instrument class.

Management Styles

Although there is a great deal of commonality between their respective reserves management objectives, central banks often adopt quite different approaches, or investment styles, when managing reserves. Investment styles are generally defined in respect of two extreme styles:

• Passive management provides very little discretion to portfolio managers. One example of a passive strategy involves buying foreign currency assets and holding them to maturity. Another is where the portfolio managers regularly rebalance their foreign currency portfolios to replicate a benchmark such as a market standard benchmark (for example one of the Lehmans Aggregate Indices).
• An active management framework gives portfolio managers scope to change positions in the expectation of market developments. This style implicitly assumes that a portfolio manager is able to identify and exploit short-term market anomalies or that they have a comparative advantage in identifying longer-term economic developments.

There are differing views on the relative merits of each investment style. One of the challenges for a central bank is to decide which of these styles best suits its objectives and risk tolerances. Ultimately, the decision will depend on the central bank's particular circumstances – in particular, senior management's confidence in the capacity of their staff, internal procedures and systems to control financial and operational risks.2 Generally speaking, however, the more rigorous the risk management framework, the more comfortable senior management are likely to be approving a more active style.

Footnote

2. Central banks with large foreign currency portfolios may also be reluctant to aggressively manage their portfolios if they believe that they may adversely affect financial markets. (back to text)