Foreign Exchange Reserve Level Optimisation
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The document discusses foreign exchange reserves, including what they are, why countries hold them, who manages them, and debates around optimal levels. It addresses recent trends showing growing reserves held mostly as foreign currencies, with diminishing gold reserves. Motivations for holding reserves include transactions needs, intervention for stability, and diversification. There is no agreed framework for determining optimal levels, but factors like monetary policy, exchange rates, external exposure, and financial market development are relevant.
![4. Conclusions and Outlook
FX intervention back ‘en-vogue’ in low-inflation, low-interest
rate environment
Large scale intervention by Japanese MoF
– Cumulative amount US$ 375bn since mid-2002
– Approx. US$ 145bn during Q1 2004
RBNZ announces intervention as official policy tool for
“insurance purposes”
– “[…] an additional instrument to achieve Policy Target
Agreement obligations”
– “[…] restore order to dysfunction in the foreign exchange
market”
Anecdotal evidence of ECB and SNB intervention activity](https://image.slidesharecdn.com/01reserveleveloptimisationbieri-160108042646/85/Foreign-Exchange-Reserve-Level-Optimisation-32-320.jpg)
Foreign Exchange Reserve Level Optimisation
- 1. David S. Bieri, Head of Business Development BIS-AMF Seminar on Foreign Exchange Reserve Management 6 June 2004, Abu Dhabi Reserve Level Optimisation and its Implications for Reserve Management
- 3. What are foreign exchange reserves? Why are such reserves needed? Who manages those reserves? How are they managed? How much reserves is sufficient? Is there an optimal level? What impact do foreign exchange reserves have on the global financial system? What is behind the renewed interest in reserve management?
- 4. 0. De quoi s’agît-il? ASSETS LIABILITIES Gold Foreign Currency SDRs Net Foreign Assets Cash Bank Loans Securities (OMO) Fixed Assets InternationalDomestic Notes + Coins Banks’ Reserves Treasury Deposits Capital + Reserves Domestic Foreign Liabilities
- 5. 0. De quoi s’agît-il? Gold Foreign Currency SDRs Foreign Assets Cash Bank Loans Securities (OMO) Fixed Assets Notes + Coins Banks’ Reserves Treasury Depos Capital+Reserves Foreign Liabilities 1,224 - 2,152 41 27 2,740 31 275 60 142 9,246 3 75 154 1,346 981 23 1,498 299 1,681 6,125 2,130 110 3,373 1,253 NZ PE NZ PE Source:RNZandBCRP2002Annual Reports - Total Assets Total Liabilities6,174 11,298 6,174 11,298 GDP: 57,800 62,700 Import cover: 3 months 15 months
- 6. Overview 1. Recent trends in reserve management 2. Motives for holding reserves 3. The optimal level and composition of reserves 4. Conclusions and outlook
- 7. 1. Recent Trends Central banks hold around USD 3.4 trillion in reserves (~10 times Swiss GDP, S&P 500 top 10 market cap) – 85% in foreign exchange – 10% in gold – 5% in reserve positions at IMF Diminishing role of gold as a reserve asset (down from ~50% in mid 1980s) Growth in global reserves continues after Asian and LTCM crises at post-Plaza Agreement rates (~10%)
- 10. 1. Recent Trends
- 11. 1. Recent Trends
- 12. 1. Recent Trends
- 13. 1. Recent Trends Post-Bretton Woods growth as result of managed float Increase in cross-border capital flows, with trade volumes lagging despite ‘globalisation’ Floating exchange rates no longer a panacea to absorb exogenous shocks (eg. Asian crisis, declining US$) changing nature of purpose of reserves Emergence of ‘confidence reserves’ rather than 3 traditional functions (transactions need, intervention and wealth diversification)
- 14. 1. Recent Trends
- 15. 1. Recent Trends
- 16. 1. Recent Trends
- 17. 1. Recent Trends Currency composition with persisting US$ bias (~65%) USD dominance cannot be explained by international trade flows or risk-adjusted returns – SDR weights reflect trade flows of goods and services – USD 46%, EUR 25%, JPY 17% and GBP 12% Securities market liquidity as main explanatory variable for USD bias Growth potential for EUR (ECB policy, increasing liquidity, diversification benefits)
- 18. 1. Recent Trends – Diversification
- 19. 2. Motives for Holding Reserves - Demand Transactions Needs – Flexibility for government to manage currency composition of liabilities – Improve country’s status in international financial environment (easing access to capital markets) Interventions (precautionary) Needs – Short-term (sterilized) FX rate management vs. medium-term stabilization policy – Strategic reserve of liquidity and crisis prevention Wealth Diversification – Increasing scrutiny
- 20. 2. Motives for Holding Reserves
- 21. 2. Motives for Holding Reserves Nature of exchange rate regime and intervention policy Relative openness/flexibility of economy – Constraints on trade and capital flows – Vulnerability to external shocks (geographic and economic diversification) Principles of monetary policy Level of development of domestic capital market External exposure of economy – Size of international financial transactions – Volatility of export receipts Opportunity cost of holding reserves
- 22. 2. Motives for Holding Reserves Interest Rates Money Supply Consumption Investments Government BoT BoP = D Reserves Sterilization Interest Rates Money Supply Consumption Investments Government BoT BoP = D FX Rate Fixed Exchange Flexible Exchange
- 23. 2. Factors Determining Size of Reserves Monetary policy anchor Exchange rate regime Volatility of export receipts Size of international financial transactions Relative openness of economy (vulnerability to external shocks)
- 24. 3. Optimal Level of Reserves Traditional approach focuses on macroeconomic adjustment costs vs. opportunity cost – Trade related measures of adequacy – Buffer stock models (e.g. Frenkel and Jovanovic, 1982) – Shift of focus from current to capital account Recent financial crises (LatAm, Asia) exacerbated by inadequate reserves …? (e.g. Feldstein, 1999): – Capitals flows vs. trade financing – Lack of liquidity of foreign assets vs. liabilities – Runs on domestic banks – Contagion
- 25. 3. Optimal Level of Reserves Emergence of new ‘post Asia crisis’ adequacy measures – ‘Guidotti rule’ (1999) – Average maturity of ext. debt + ‘Liquidity-at-risk’ (Greenspan) Minimum benchmark of reserve adequacy for Emerging Market Countries (e.g. De Beaufort et al., 2001) contains 3 familiar elements – Import cover – Short-term external debt – Broad money supply (proxy for internal demand of reserves)
- 26. 3. Optimal Level of Reserves
- 27. 3. Optimal Level of Reserves
- 28. 3. Optimal Level of Reserves
- 29. 3. Optimal Level of Reserves
- 30. 3. Optimal Level of Reserves
- 31. 3. Optimal Composition of Reserves Lack of unified framework leads to portfolio ‘tranching’ approach – Liquidity and buffer portfolios – Investment portfolio (wealth maximization) Limitations of mean-variance approach – Institutional arrangement may preclude optimization of NET foreign assets – Definition of reference basket – Susceptibility of Markowitzian optimization to inputs and numerical techniques (time dependency + measurement errors corner solutions portfolio resampling + constrained weights) – Non-diversifiable risks of fixed-income portfolios (highly correlated risk factors)
- 32. 4. Conclusions and Outlook FX intervention back ‘en-vogue’ in low-inflation, low-interest rate environment Large scale intervention by Japanese MoF – Cumulative amount US$ 375bn since mid-2002 – Approx. US$ 145bn during Q1 2004 RBNZ announces intervention as official policy tool for “insurance purposes” – “[…] an additional instrument to achieve Policy Target Agreement obligations” – “[…] restore order to dysfunction in the foreign exchange market” Anecdotal evidence of ECB and SNB intervention activity
- 33. 4. Conclusions and Outlook
- 34. 4. Conclusions and Outlook
- 35. 4. Conclusions and Outlook Are central banks holding adequate reserves? Are reasons for holding reserves additive? Do flexible exchange rates undermine any of these reasons? Can there be too much of a good thing? Are there side effects from holding excessive reserves? – Le mieux est l’ennemi du bien – Moral hazard (firm’s liquidity management, sustainability of government policies) – Appropriateness of central bank as nation’s “wealth manager”
- 36. 4. Conclusions and Outlook “The kind of situation which economists are prone to consider as requiring corrective governmental action is, in fact, often the result of governmental action.” R. Coase (1960)
- 37. References • Aizenman, Joshua and Nancy Marion. “Foreign Exchange Reserves in East Asia: Why the High Demand?”, FRBSF Economic Letter, No. 2003-11, Federal Reserve Bank of San Francisco, April 2003. • Bank of Israel. “Investment of the Foreign Exchange Reserves and Developments in the Foreign Currency Market”, Foreign Currency Department, Annual Report 2002. • Caballero, Ricardo and Arvind Krishnamurthy. “International Liquidity Illusion: On the Risks of Sterilization”, Working Paper, No. 8141, National Bureau of Economic Research, February 2001. • De Beaufort Wijnholds, J. Onno and Arend Kapteyn. “Reserve Adequacy in Emerging Market Economies”, Working Paper, No. 01/143, International Monetary Fund, September 2001. • Feldstein, Martin. “Self-Protection for Emerging Market Economies”, Working Paper, No. 6907, National Bureau of Economic Research, January 1999. • Frenkel, Jacob and Boyan Jovanovic. “Optimal International Reserves: A Stochastic Framework”, The Economic Journal, 91:507-514, June 1981. • Greenspan, Alan. “Currency Reserves and Debt”, Speech before World Bank Conference on Recent Trends in Reserve Management, April 1999. • Hoffman, David. “Adequacy of Foreign Exchange Reserves: Evidence from Panel Time Series Modeling”, Working Paper, Bank of Israel, January 2003. • Horii, Akinari. “The Evolution of Reserve Currency Diversification”, BIS Economic Paper, December 1986. • Humpage, Owen F. “On the Rotation of the Earth, Drunken Sailor, and Exchange Rate Policy”, Federal Reserve Bank of Cleveland Economic Commentary, February 2004. • IMF. “Issues in Reserve Adequacy and Management”, Monetary and Exchange Affairs Department and Policy Development and Review Department, October 2001. • IMF. “Guidelines for Foreign Exchange Reserves Management: Accompanying Document”, Monetary and Exchange Affairs Department, March 2003. • Jensen, Michael and William Meckling. “Theory of the Firm: Managerial Behaviour, Agency Costs, and Ownership Structure”, Journal of Financial Economics, 3(5):305-360, 1976. • Kletzer, Kenneth and Mark M. Spiegel. “Sterilization Cost and Exchange Rate Targeting”, Working Paper, Federal Reserve Bank of San Francisco, April 2000. • Miller, Merton and Daniel Orr. “A Model of the Demand for Money by Firms”, Quarterly Journal of Economics, 80(3):413-435, August 1966. • Scott, Roger. “The Management of Foreign Exchange Reserves”, BIS Economic Paper, No. 38, July 1993.