International Market Operations
Foreign Exchange Operations
On most business days, the Reserve Bank transacts in the foreign exchange market. These transactions are principally to facilitate client requirements, with the vast majority of this activity arising from the provision of foreign exchange services to the Australian Government. In the normal course of events, the Bank covers its sales of foreign currency to the Government by purchasing foreign currency in the market. The Reserve Bank has an existing stock of foreign currency assets and, during periods where the market for Australian dollars is stressed, it has the option of drawing on these holdings to meet the demand from the Government and other clients. These reserves would subsequently be replenished when the Bank judged that market conditions had stabilised.
The Reserve Bank also transacts in the market to manage the currency risk on its portfolio of foreign currency assets. As discussed below, the foreign currency assets on the Bank's balance sheet are managed to a benchmark. In order to maintain the currency composition of these assets at, or within modest deviations from, their benchmark weights, the Bank regularly rebalances its foreign currency portfolio. These rebalancing transactions, and any transactions necessary to accommodate a change in the benchmark weights, involve the Reserve Bank operating in both the foreign exchange spot and swap markets.
To implement monetary policy, the Reserve Bank frequently supplements its domestic market operations with foreign exchange swaps against the Australian dollar. These transactions are used in the same way as repurchase transactions to alter the profile of liquidity flows into and out of the banking system. The foreign exchange swap market is much larger and generally more liquid than the domestic repo market. The Bank is also an active user of foreign exchange swaps when managing the cash held within its foreign currency portfolio. All foreign exchange swaps executed by the Bank are for short periods, usually no more than three months' duration. The Reserve Bank's use of foreign exchange swaps has no implications for the value of the Australian dollar.
Some transactions undertaken by the Reserve Bank are intended to influence the exchange rate or conditions in the market for foreign exchange. Australia has operated a floating exchange rate regime for over thirty years and, over time, intervention by the Bank has become less frequent as the market has developed, hedging foreign currency risk has become more efficient and as awareness of the benefits of a floating exchange rate regime has grown. Nonetheless, the Reserve Bank has always retained the discretion to intervene in the foreign exchange market to address dysfunction and/or a significant misalignment in the value of the Australian dollar. Transactions undertaken for these purposes would usually be effected in the spot market. The Bank provides daily data (with a lag) on foreign exchange intervention on its website.
The Reserve Bank also operates in the foreign exchange market from time to time to manage the level of its foreign currency holdings. Traditionally, this has involved the Bank offsetting changes in its holdings as a result of prior intervention. To the extent that these transactions involve a change in the net foreign currency position of the Bank, they could be described as intervention. In practice, however, they differ from intervention transactions in that they are executed in a way that minimises their impact on the exchange rate and on market conditions more generally. They are typically executed in small amounts over long periods.
With the exception of its reserve position in the IMF, Australia's holdings of official reserve assets are held on the balance sheet of the Reserve Bank. Official reserve assets held by the Bank comprise both foreign currency assets as well as gold. The Bank holds foreign currency assets mainly to facilitate its policy operations in the spot foreign exchange market, although they are also used to augment operations in the domestic money market (see above). Assets denominated in foreign currencies expose the Bank's balance sheet to foreign currency risk and, as with the Bank's portfolio of domestic securities, foreign currency assets may carry interest rate, credit and liquidity risks. The optimal level of reserves represents a trade-off between these risk exposures and what is considered necessary to meet the Bank's policy objectives.
The mandate under which reserves are managed requires investments in assets of high credit quality and that the portfolio has sufficient liquidity to allow the Bank to meets its policy objectives. The major risks to the balance sheet are mitigated where possible, chiefly through maintaining a diversified currency composition. The investment process for foreign currency assets is guided by an internal benchmark, which represents the Reserve Bank's best estimate of the combination of foreign currency investments that maximises return over the long run, subject to an acceptable level of risk and the overarching requirements for security and liquidity.
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Investments within the benchmark currencies are limited to sovereign, quasi-sovereign and supranational debt instruments and cash investments secured by high-quality debt under repurchase agreement. Sovereign credit exposures are limited to the United States, Germany, France, the Netherlands, Canada, Japan, the UK, China and South Korea.
The Reserve Bank also has investments in a number of Asian debt markets through participation in the EMEAP Asian Bond Fund (ABF) Initiative. This was established to assist in the development of bond markets in the region in the wake of the Asian currency crisis in the late 1990s. The Bank has modest holdings in both the US dollar denominated fund, ABF1, and the local currency denominated fund, ABF2. The two funds are managed by external managers and sit outside the Bank's internal benchmark framework.