MANAGEMENT OF FOREIGN CURRENCY RESERVES

Recent Challenges

Resource Constraints 

In our experience, central banks have had to grapple with a variety of resource constraints. These issues are obviously most relevant to countries managing relatively small foreign currency reserve portfolios but can even be an issue for countries that are rapidly accumulating foreign currency reserves (although, in their case, this is not a permanent problem but is more transitory).

The most important of these resource constraints relates to staffing, both in terms of the number of staff as well as their experience with financial market products. These problems tend to be exacerbated by two, largely self imposed, constraints – a reluctance by many central banks to hire staff from the private sector and the fact that the remuneration offered to these staff is often not competitive with the remuneration offered by the private sector. The consequence of these policies is that central banks must recruit staff from other areas of their bank and spend considerable resources training them as financial market analysts, traders and risk managers. Having trained them, it is often difficult to retain them.

The effectiveness of the reserves management operation, and the ability to control operational risks, also depends on the adequacy and efficacy of the central bank's technology infrastructure. A comprehensive reserves management platform needs to provide for the capture, confirmation and approval of transactions, the preparation of settlement messages, the reconciliation of nostro and security accounts, the generation of accounting data and a full audit trail of all transaction events. In addition to its trade entry and settlement systems, a reserves management operation must be supported by a sophisticated global telecommunications capability, real-time electronic media systems, risk management systems and analytical databases. While the costs of these systems have declined and their reliability and flexibility have increased over the past decade or so, these benefits are often diffused by the need to undertake regular system upgrades. In addition to the financial cost of these new systems, the implementation of these upgrades also involves a significant commitment of trading and technical resources to ensure that they are fully integrated within existing risk management systems.

Another important resource-related consideration for any reserves management operation is where to locate the trading, risk management and settlement staff. Many central banks manage the potential staff and technology constraints of a 24-hour operation entirely from their head offices while others, such as the Reserve Bank of Australia, have established dealing operations in several time zones. Essentially the decision comes down to whether the costs of a decentralised trading operation (both the financial costs and the costs relating to the fragmentation of resources and risk management) outweigh the benefits (more effective portfolio management, staff training and market liaison).

External Management of Reserves

One option considered by many central banks to overcome the resource-related problems highlighted above is to engage external funds managers to manage a portion or all of their foreign currency reserves. Superficially, this involves very little additional work. Aside from the initial due diligence aspects involved in engaging a manager, a central bank should only need to provide the external manager with the objectives and investment mandate developed internally.

The benefits of such an arrangement appear to be significant. In exchange for a management fee, central banks are able to indirectly access the institutional expertise of the manager and a wide range of sophisticated trading, settlement and risk management systems that they would otherwise not have access to. The benefits also often extend beyond the direct management of reserves. For example, external managers often assist in training central bank staff involved in reserves management (through secondments and client conferences). Further, some central banks also use the returns on the externally managed funds to validate their own internal benchmarks.

The costs associated with using external managers are not, however, limited to the readily identifiable management fees. Central banks need to recognise that there are significant costs associated with verifying the manager's performance and ensuring their compliance with the nominated investment mandate. Indeed, some central banks have found these costs to be so prohibitive that they have reduced their reliance on them in recent years.

Central banks should also recognise that their options aren't restricted to either managing reserves internally or placing them with a private fund manager. Central banks can also invest their reserves with the Bank for International Settlements (BIS) either through their funds management division or directly in BIS instruments. Further, some central banks, including the Reserve Bank of Australia, offer central banks some limited reserves management facilities in terms of cash management, custodial and investment services at relatively competitive prices.

Increasing Portfolio Returns

When formalising the investment mandate for the management of foreign currency reserves, an implicit trade off is made between liquidity and return. The rationale is that although instruments with shorter terms to maturity have lower rates of return, they provide the portfolio with greater liquidity. In recent years, this tradeoff has become less relevant. Indeed, the growth of a range of derivative market instruments such as foreign currency swaps and interest rate futures and the evolution of very liquid repurchase agreement (collateralised loan) markets has meant that central banks are now able to maintain significant exposures along the yield curve while at the same time being able to access a considerable amount of funds at very short notice.

The opportunity to increase portfolio returns without forgoing the liquidity characteristic of the foreign currency portfolio has been particularly timely as a combination of low inflation, reductions in public deficits and a concentration of funds under management have resulted in historically low portfolio yields. Although the strategy of increasing portfolio returns by increasing the average duration of the portfolio is attractive to many investors, it is worth noting that it would be accompanied by a commensurate increase in the variability of portfolio returns which may not be acceptable.

Central banks have also sought to increase the returns on their foreign currency reserves by modifying their investment mandate to include higher-yielding asset classes such as mortgage-backed securities, asset-backed securities and corporate bonds. This strategy is not, however, without its risks. In addition to increasing the likely variability of portfolio returns, these instruments require a greater commitment to developing appropriate risk management tools and educating staff about how to manage them. As discussed earlier, one option available to central banks is to engage external managers who have a comparative advantage in managing these instruments. While this addresses the explicit risk management issues associated with these instruments, central banks need to be aware that much of the increase in portfolio returns may be eroded by management service charges, and that they would still need to make a significant investment in terms of both staff and technology to monitor the managers.