Management of foreign exchange reserves

Ministry of education, science, sports and youth of Ukraine 
Donetsk National Technical University 
Highest school of economic and management

 

      Department  
of international  
Business activity

 

 

 

 

 

Course work 
On discipline “International finance” 
On theme: “Management of foreign exchange reserves”

 

 

 

 

 

Prepared by    _______________________                          ______________________ 
 
Checked by    ________________________                        _______________________

 

 

 

 

 

 

 

Donetsk 2012

Content

 

 

Introduction...............................................................................................................3

1.Theoretical aspects of foreign exchange reserves.................................................4

1.1. Objectives and  reasons for holding reserves...........................................4

1.2. The optimum size and ownership of the reserves....................................9

2. Delegation,control and reporting of foreign exchange reserves..........................12

2.1. Delegation and control...........................................................................12

2.2. The importance of reporting...................................................................17

 

3. Management of China's foreign exchange reserves............................................21

3.1. China's foreign exchange reserves and SAFE........................................21

3.2. Recommendations..................................................................................30

Conclusion...............................................................................................................36

 

 

 

 

 

 

 

 

 

 

 

Introduction

For many countries, especially in the emerging markets, the official foreign exchange reserves are both a major national asset and a crucial tool of monetary and exchange rate policy.  It is vital therefore that this national resource is used and

managed wisely and effectively.

Management of reserves is a complex and time-consuming business.  It requires clear objectives, extensive delegation, strong control systems, open and transparent reporting and a realistic appreciation of the constraints faced.  If conducted properly, openly and successfully it will greatly strengthen the public’s respect for and confidence in official policy, and can make a material contribution to successful macro-economic management.

Countries differ in a very great number of ways;  for example size of population, types of government system, state of development, wealth, openness to international trade, even between those who borrow exclusively in their domestic currency and those who also borrow in foreign currency.  But despite this, in nearly every case they see a need for holding foreign exchange reserves. Moreover, this is as true of countries with large self-sufficient economies (eg the USA) as it is of smaller, more open ones. In many cases, the official reserves are a major national asset.  Even in the rich and developed economies, reserves can measure several percentage points of GDP.  In some emerging countries, the corresponding figure is considerably higher.  Merely from the standpoint of preserving this national asset, therefore, the management of official reserves is an important one for almost all central banks.  But beyond this, poor management of the reserves may put at risk other elements of national policy (for example, an official exchange rate policy), and this can cause severe economic damage out of all proportion to the financial loss suffered on the assets themselves. This means that the management of official reserves assumes a doubly important role for the authorities:  in many cases not only is a large amount of money at stake, but also significant elements of national economic policy.

 

1.Theoretical aspects of foreign exchange reserves

1.1. Objectives and  reasons for holding reserves

The floating exchange rate is a distinctive component of the policy package adopted by the Central Bank to fulfill its mission of ensuring the stability of the currency and the normal functioning of internal andexternal payments. This exchange rate regime with an inflation targeting scheme, a prudent financial regulation and supervision, and full financial integration with the outside world, provide, along with the fiscal policy, a coherent framework that allows to maintain the essential macroeconomic equilibrium and to meet the different shocks that the economy faces, mitigating their effects.A key element in meeting these objectives is that the country, through the Central Bank, maintains a level of reserves that would support efficient economic policy decisions. In this sense, the main tenanceof FER can be justified for two reasons.

On one hand, reserves act as an insurance against situations where external funding sources are not widely available or are partially available, either due to endogenous or exogenous factors. This is called the precautionary motive. In this sense, the maintenance of liquidity in foreign currency allows using it in emergencies and helps to moderate the adverse effects of a balance of payments crisis. On the other hand, an appropriate level of reserves could help to reduce premiums for country risk.[1,7]

Foreign-exchange reserves (also called forex reserves or FX reserves) in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, special drawing rights (SDRs) and International Monetary Fund (IMF) reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, mostly the United States dollar, and to a lesser extent the euro, the pound sterling, and the Japanese yen, and used to back its liabilities, e.g., the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.[2]

Looking into the origin of foreign exchange reserves, we came to know that official international reserves in earlier times was just the means of official international payments, which formally consists only of gold and occasionally silver. But with the passage of time, there were changes in this international reserve. Under the Bretton Woods System, the US dollar started functioning as a reserve currency, so it soon became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System. But certain changes arise in the year 1968. After this year, only central banks could convert dollars into gold from official gold reserves.

Foreign exchange reserves history also reveals that after 1973 no individual or institution was allowed to convert US dollars into gold from official gold reserves. Another major turning point in the history of foreign exchange reserves is in the 1973, where no major currencies have been convertible into gold from official gold reserves. Like other commodities, individuals and institutions now buy gold in private markets. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves. With the passage of time of different changes were made in foreign exchange reserves, the quantity of foreign exchange reserves can change as a central bank implements monetary policy today[3].

Although almost all countries hold foreign exchange reserves, their reasons for doing so differ widely.  Before setting a strategic policy for the reserves, the authorities need to establish precisely why they are holding the reserves that they have.  Only then can a sensible debate be held on such issues as the optimum size of the reserves, their funding and their investment. The following are some of the main reasons for holding reserves[4, 6-9]:

   Reserves are sometimes held as formal backing for the domestic currency.  This is a very traditional use of reserves, especially gold reserves.  This use of reserves was at its height under the gold standard, and survived after the Second World War under the Bretton Woods system.  After the breakdown of the Bretton Woods system it became less common, though the use of gold especially to back a currency has never completely disappeared, and the idea of using foreign exchange reserves (rather than gold specifically) to back and provide confidence in a domestic currency has recently been revived with the rediscovery of currency boards.  For most countries this is not, these days, the prime use of the reserves.

More common is the use of reserves as a tool of exchange rate or monetary policy.  This is most obviously the case for those countries who are pursuing a fixed exchange rate policy, and who wish to be able to influence the market in their domestic currency so as to maintain a fixed rate.  In addition, countries may choose to use the FX markets to affect domestic monetary policy, by supplying domestic currency to the market or buying it in the market against foreign currencies.  This will affect the domestic money market balance and so domestic interest rates, and is a useful tool for those countries whose domestic markets are not yet fully developed

A third use of reserves is to provide funds for servicing foreign currency liabilities and debt obligations.  Clearly foreign currency is needed at the point in time when debt servicing payments fall due, to avoid a default.  While it would be possible to meet this need for foreign currency by buying it in the market as and when the need arises, this is not a course that many countries pursue, for several reasons[4, 8]:

−  the FX markets might be unfavourable at the time that foreign currency is needed;

−  the transactions might be disruptive to the markets;

−  the strategy entails large open currency risks on the liability portfolio;

−  this approach reduces credit rating agencies’ confidence in the country as an issuer, and as a result both reduces the attractiveness of the country to lenders and increases the cost of foreign currency borrowing.

Reserves can also be held as a source of funds to pay for government expenditure overseas.  For many countries, especially those with known import bills for the authorities to meet, it can be sensible to plan their financing using the reserves.  This is particularly the case when either foreign exchange receipts or outflows are “bumpy” or show a marked seasonal pattern.  In these cases the reserves can be used to smooth out the payment schedules.

Reserves can provide a defence against emergencies or disaster, by acting as a fund to finance recovery and rebuilding.  This is most likely to be appropriate for small countries that are not large enough to provide self-insurance; larger countries are more likely to fund recovery from a crisis in one part of their domestic economy from elsewhere in the economy.  But a small country may possibly be completely overwhelmed by a disaster;  for example, a natural disaster that wipes out the only export, or a collapse in their terms of trade, or even military disaster.  For such events reserves can provide a diversification of assets, a pool of readily usable funds and security and comfort for potential lenders. Finally, reserves may be held as an investment fund, primarily for financial gain.  This will not be a sensible reason for holding reserves for the majority of countries;  few countries will find that the monetary income on their reserves represents the best use of those assets in the wider context of their whole economy.

For any country, the reason it holds reserves will play a very important part in planning how those reserves should be managed and in what way they should be invested.  Policymakers who are planning their country’s reserves management, therefore, should start by running through the checklist above to identify the reasons for holding reserves.  Reserves held for no identifiable reason are seldom optimally used;  indeed, in many cases, the optimum treatment for reserves for which no other use has been identified may even be to return them to the taxpayer. 

Funding the reserves, and the cost of holding reserves

Many people see the reserves as an asset portfolio only;  that is, with no corresponding liability.  This leads to much debate on the correct investment of the reserves, but rather less on how the assets have been acquired.  This is a partial picture only, and a better approach includes a consideration of the funding of the reserves.  Only in this way can the true cost to the authorities of holding reserves be ascertained. There are broadly speaking three ways to fund the reserves.  They have in common the starting point that the authorities do not naturally hold assets in any currency other than their own, and that to acquire and hold foreign currency assets is therefore a conscious decision involving foregoing domestic assets.  In essence, holding foreign exchange assets means that the authorities have decided not to hold domestic assets, and it is in this light that the issue of funding the reserves should be addressed[5, 10].

The three methods of acquiring foreign exchange assets are to borrow foreign currency formally, to borrow foreign currency against domestic currency through the FX swap market, or to buy it outright against the domestic currency.

The three methods of funding the reserves have differing effects on the market:

−  Borrowing, whether via a foreign currency bond issue or some other means (eg an international loan) does not affect the FX market (ie exchange rate) directly at all.  There has been no transaction in the domestic currency and so there should be no direct effect on the exchange rate.

−  FX swapping has timing effects only on the FX market.  This is because although there is a transaction in the spot market to sell domestic currency and acquire foreign currency, there is an equal and opposite deal done for settlement in the future.  So the overall level of the exchange rate should not be unduly affected.

−  Outright purchases of foreign exchange against sales of domestic currency can affect the exchange rate however, as the overall supply of the domestic currency to the market has been permanently increased.

The value of this analysis of the funding of the reserves is that it enables the authorities to ascertain the true cost of holding reserves.  If the reserves are treated simply as an asset portfolio with no funding or corresponding liabilities, the income on the reserves looks like a net gain for the authorities.  An approach which takes into account the true method of funding the reserves will show that in many cases the net financial outcome from holding reserves may even be a loss, especially in those cases where comparatively low-yielding foreign assets are financed with higher-yielding domestic borrowings.  And even a positive return may not be optimal;  the key question is whether higher returns, after allowance for risk, could be made elsewhere. The choice of which of the three methods to use to fund the reserves depends on many things, from the authorities’ ability to borrow, to the state of the FX market, to the perception of the exchange rate.  Cost will also play a significant role for those countries with the ability to choose between the three methods.  Many countries will make use of all three methods at different times, depending on the relative costs of each method, the state of the market and the interaction with other policies.

1.2. The optimum size and ownership of the reserves 

The optimum size of the reserves. This is an important area that is often given insufficient attention, particularly in emerging countries where the background has traditionally been one of concern over having too few reserves rather than analysis of whether the authorities have too much.  Equally, there are often strong political pressures not to declare that “we have enough reserves now”.  Not only may there be a public perception that “reserves are good and the more reserves the better”, but also, the decision to stop accumulating reserves has only downside risk:  the authorities can never be shown to have too large a stockpile of reserves, but the market can dramatically expose countries that have too few reserves. Reserves are a tool of the authorities and an asset to be used wisely. The debate over the optimum size should not just be ignored or put in the “too difficult” box.  This is especially true for emerging economies, for whom reserves are an expensive asset which must therefore be used sparingly.

Any debate over the optimum size of the reserves has two main elements.  The first is the correct identification of the uses of the reserves and therefore of the minimum required to meet the identified needs.  No sensible discussion of the optimum size of the reserves can take place before this has been done.  The second element is a correct analysis of the cost of funding the reserves.  The debate over limiting the growth of the reserves will be easier to conduct if the true cost of reserves accumulation is known.

These two elements together provide a lower bound to the reserves and a pressure not to increase the reserves without limit above that.  It is not possible to identify the precise level that corresponds to the lower bound, as the process is not an exact science.  And most countries will wish to hold a “comfort margin” above the minimum they identify.  But it is important to realise that, except in rare cases, the authorities are unlikely to do best by accumulating reserves without limit.

Ownership of the reserves:  Government or Central Bank

The question of whether the government or the central bank should own the national foreign currency reserves is one to which there is no single right answer. In most countries, the reserves are owned by the central bank;  that is, they are on the central bank’s balance sheet and the ultimate decisions on reserves management are taken within the central bank’s management structure.  But there are several counter-examples to this (the United States, the UK and Japan, to name three) where the reserves are formally owned by the government, and the ultimate decisions on their management are thus taken by the government (usually the Treasury or Finance Ministry).

For any country, the decision between the two approaches will be determined by a number of factors.  Perhaps the most important one is precedent[6,112]:  - if a structure is already in place and if it works, there is often little reason to change.  But beyond that the following factors will have a bearing on the decision:

−  do the reserves play any part in backing the domestic currency or the note issue?

−  are the reserves used primarily for domestic monetary policy management? 

−  are the reserves primarily used to hedge foreign currency liabilities of the government? 

−  how is the central bank funded? 

What is however more widely true is that, whoever formally owns the reserves, they are nearly always managed by the central bank – either as principal or, in the case where the assets are owned by the government, as agent. Equally, whoever formally owns the reserves, they are treated identically by the international authorities as “national FX reserves”.

Finally, however independent a central bank is, the ultimate decisions on a country’s currency (exchange rate policy, significant intervention, union with another currency, or even “dollarisation”) are usually taken by the government, and these decisions will of course have consequences for the management of the reserves.  In such cases the precise legal ownership of the reserves is of lesser importance than the need for co-ordinated policy-making between government and central bank.

2. Delegation,control and reporting of foreign exchange reserves

2.1. Delegation and control

The correct use of delegation, while maintaining overall responsibility and control, is one of the fundamental elements of effective management.  This is particularly true in reserves management, where the trading and analysis involved in active portfolio management is too time-consuming, complex and detailed for senior management to undertake it themselves, but the sums of money and the risks of loss are too large to be left entirely to junior staff.

Instead senior management must delegate the day-to-day trading decisions, while retaining control over the overall strategy and large scale positions.  This necessitates a formal structure of decision-making, in which each level of management knows what they are responsible for and within which parameters or limits they are free to move;  and a formal monitoring system, through which senior management can ensure that more junior levels are not exceeding the authority that they have been delegated.  Given a system of controls to ensure that delegated power is not abused, there is no reason why junior staff should not be given relatively wide power, certainly in comparison with their peers elsewhere in the typical central bank.

In most reserves management operations, there will be three basic levels of management.  The top level consists of those who are ultimately responsible for the reserves.  This level will usually set the overall objectives and strategy of the reserves management operation.  Typical issues that this senior level of management will be concerned with are the size and broad currency split of the reserves, the overall interest rate exposure position, the credit risks and credit limits policy, whether or not to borrow and if so in which markets, legal questions such as whether the central bank has the vires to undertake certain operations, etc. The second level of management is the direct line management of the reserves management team.  This level is responsible for interpreting and implementing the strategy agreed at the higher level and reporting back to the higher level on results.  Typically this will involve decisions on which markets and which instruments to use, on the major positions to be taken, on the allocation of funds between the portfolios, on how much latitude to allow portfolio managers in implementing management positions, and on the form of the control and reporting procedures used.  The line management will also typically be responsible for the general staffing and operation of the reserves management team within the agreed budget[4, 17].

Finally there are the portfolio managers, who will be responsible for carrying out the instructions of their line management and providing the day-to-day management of the asset portfolios.  This is done by active portfolio management, ie direct investment operations with the market within agreed guidelines of flexibility and authority.  It is a feature of this devolved delegated approach that it is typically only the portfolio manager level that has direct contact with market counterparties. For this hierarchical approach to be effective, it is important that each level is clear what it is responsible for, and also that senior levels of management avoid seeking to reclaim for themselves decisions that have been delegated to a lower level.  This is best achieved through a formal benchmark process.

The process of delegation and control should be completed by a regular review and reporting schedule.  This will enable senior management to retain the overall control of the reserves management process.  If the structure is designed properly, it will also identify which part of the overall return stems from which decision, thus enabling all levels to see directly the results of their own decisions.  This direct and highly visible connection between decisions taken and profits earned is both essential feedback in analysing performance, and also an excellent motivator for junior reserves management staff.

If, on the other hand, senior management retains direct control of investment decisions, junior staff will act merely as order-processors, with little incentive to add value to the reserves management operation.  As well as being likely to result in missed profit opportunities, this is demotivating for the junior staff involved and fails to develop the next generation of senior managers.

Description of the benchmark process

The most commonly used method by which decisions from one level are passed down to the level below, and by which results of decisions are calculated and passed back up the management chain, is the Benchmark process. A benchmark is a notional or imaginary portfolio constructed to provide a yardstick or baseline against which the return on an actively-managed portfolio can be measured.  In most cases the composition of the benchmark will be a senior management decision, and it will be set up to conform to a given size, credit quality and average maturity.  Benchmarking provides a base or neutral position from which a manager can adopt his own position according to his judgment and market views, and acts as a comparison point against which to record the results of those decisions[7].

There are three fundamental properties of a benchmark-based decision process. Firstly, the decisions of one layer of management form the benchmark for the next layer down.  For example, the senior management of the central bank may agree a core strategy of keeping 50% of the reserves in US $ and 50% in euro.  This then becomes the base or core position around which the line management of the reserves management team operates.  They in turn decide such matters as whether to hold a small long or short in $ versus euro against the core strategy.  Their decisions on these points will then form the base positions from which the active portfolio management is run.

Secondly, it must be possible physically to match one’s benchmark.  This is true whatever level of management is being considered.  A manager is only responsible for the amount by which his own position deviates from his benchmark.  It follows that if he has no firm views on an element of the portfolio, he will wish not to hold a position there;  and this is achieved by matching his benchmark.  For example, the line management may have no views on, say, the future direction of currencies. With no views, there is no point in holding a position (as to do so is to run a needless risk).  The line management will therefore match the senior management’s currency position exactly. Finally, the results attributed to a manager must relate only to his position relative to his benchmark.  A manager, at whatever level, should not be responsible for a decision that was not his to make[8,19]. 

Alternatives to benchmarking

The complexity of the benchmark process, and the need to construct a bespoke benchmark for one’s own particular circumstances, has led to a number of less complicated alternatives being considered for use in official reserves management. The most common three are indexing, comparison to external managers and targeting a fixed rate. Indexing is the most common alternative. There is a wide range of public indices available for a central bank to match its portfolio to, with many of the investment houses producing them and most available on the wire services or electronically.  This is essential if detailed analysis is to be done of positions relative to the index.  The main advantages of indices are[8, 27]:

−  transparency – the index is publicly available and there is no doubt about its properties such as its duration, composition or value;

−  external measurement – the index returns are calculated by the index provider and cannot be disputed;

−  simplicity of use – using an index avoids complicated benchmark calculations.

Against this there are two major disadvantages with indices.  First, they cannot reflect a central bank’s individual circumstances.  Indices are of necessity general, and may contain instruments the central bank does not want to (or is not permitted to) buy.  Or they may not match the desired currency or duration position that the central bank wishes to adopt.  Although indices can be tailored to overcome these difficulties, much of the advantages of simplicity and transparency are lost in doing so. Second, indices can be too comprehensive and lead to too much trading.  Some indices contain hundreds if not thousands of securities and are rebalanced with great frequency.  A portfolio manager trying to match such an index is faced with the choice of multiple holdings and trades, which may not be efficient, or holding a subset of the index, which introduces the risk of different performance from the index (known as “tracking error”).  Often the only solution to this dilemma is a compromise between the two which is not entirely satisfactory on either count. An alternative approach which many central banks consider is to compare the internally managed portfolios to a portfolio given to an external manager.  The main advantage of this method is that it ensures that the comparator for the internal portfolios is realistic – it is itself an actively managed portfolio and faces all the same opportunities in the market to add value.  But the approach has a number of disadvantages[4,24]:

−  the comparison will only be fair if the external manager has exactly the same opportunities (investment instruments etc) and faces exactly the same constraints and limits as the central bank itself;

−  the comparison will reflect the performance of the external manager as much as the central bank’s;

 −  any analysis of the central bank’s own performance will therefore need considerable amounts of information on the performance of the external manager to understand the reasons for the relative performance;

−  the process does not help establish what the external manager’s benchmark should be;

−  the process cannot be used by central banks which do not want to (or are not allowed to) entrust money to external managers.

A final method of assessing the performance of the reserves management operation is to compare it to an absolute target.  For example, the target could be for a minimum return of say 5%.  This has the advantage of simplicity.  But it has many disadvantages.  The main one is that it takes no account of general market conditions – if market rates are high, or if the trend of prices is favourable, the target is too easy to beat, and so does not set a demanding test of performance, while if rates are low, the target is very difficult, and can tempt managers to increase risk too much to match it.  Moreover, such a target gives no opportunity for senior management to express a view about the overall direction they want the reserves management operation to pursue.

Because of these major disadvantages, few central banks will rely exclusively on absolute targeting for measuring their reserves management.  However, more for psychological reasons than for any more financial ones, it is less uncommon for a central bank to include an absolute target as one of the objectives for their reserves management.  For example, a common one is that the overall absolute return on the reserves should not be negative over the year.  This can have merit if it prevents a public loss of confidence in the reserves management process which a net negative result might produce.

 

2.2. The importance of reporting

Given the great degree of delegation in reserves management, the importance of maintaining overall responsibility and control as the counterpart to this delegation has already been observed.  As well as a formal structure of decision-making and a formal monitoring system to ensure that limits are adhered to, this requires a comprehensive reporting system, through which senior management can observe the consequences of the investment decisions their portfolio managers have undertaken. However, portfolio performance reporting is not simply the method by which senior management see how much return the portfolio managers have earned, important though this is both in monetary terms and for more general staff appraisal and management purposes.  It is also the way in which senior management can assess their own decisions. It provides the base data for more public reporting and accountability, for example to parliament.  And through published data and the statistics on reserves holdings given to the IMF it adds to the data available to those pursuing international financial stability and can act as an early warning of financial strain on a country’s foreign exchange position[9,12].

  Internal reporting.An internal reporting system should be regular, frequent, and timely.  Reports should be regular so that there is no possibility of awkward or unpleasant news being covered up.  They should be frequent so that management can maintain close control and stop a situation getting out of hand before it goes too far.  And they should be timely (ie, reporting should be as soon after the period being covered as possible) to ensure that if there are problems senior management can act before serious damage is done. The content of the internal reports will be largely for each central bank to decide for itself.  But as a minimum, internal reports should cover the external environment, the portfolio manager’s response, and the results of actions taken.

Thus a well-constructed report will give, as a minimum[10,4]:

−  a (brief) description of economic and market developments over the reporting period, to show management that the portfolio manager has been alert in his or her market analysis;

−  a description of the various positions taken during the month in response to market movements, to show management how the portfolio manager responded to his or her analysis of the market and what changes were made to the portfolio;

−  an analysis of the results of these actions and the returns made on the portfolio, to show how the profits earned relate to the positions taken.

Note that the purpose of the description of economic and market developments is to support the positions and returns analysis, not to provide an in-depth economic assessment.  Quite apart from the fact that the essence of the end-month note is timeliness, and overlong economic analysis will slow down its production, others in the central bank will be doing similar analysis anyway, and the reserves managers are unlikely to be the best placed to do this work.

A more detailed report might also include a forward-looking section to set out for management how the portfolio manager expects the market to develop, and how he or she is positioned to take advantage of this.  This may or may not include such details as scenario testing or stress testing, but should certainly include a list of all open positions (with, if possible, their current mark-to-market valuation).  A full position report might therefore read as follows:

A report such as this should be presented to management for each open position, with supporting text as required to explain the positions further or to explain how they fit into the portfolio manager’s overall analysis of the market and strategy for the portfolio.  Other elements of the report will depend more on individual circumstances and senior management preferences, but might include details of cash usage over the month, limit observances, risk positions, a breakdown of deals done with each counterparty, and so on.

As already stated in chapter 6, it is essential that hard figures such as positions, limit observances and returns are reported by the Middle Office.  This is to avoid any risk that portfolio managers could amend or hide uncomfortable news. Equally, judgmental elements of the report must come from the person responsible; ie  the portfolio manager.  This is to ensure that the reason behind every position or profit is given by the person taking it or making it.  The final report might therefore be structured as a body of text (analytic report, from the portfolio manager) with an

annex of figures (factual report, from the Middle Office accounting unit)[10,9].

  

External reporting. External reporting of a central bank’s reserves management operation serves two main purposes.  The first is Accountability:  the reserves are public assets and the central bank should account to the public for its management of them.  The exact method of making public the results of the reserves management operation (eg in the central bank’s annual report, or in a special report to parliament) and the degree of detail that is reported, is for each central bank to decide.  The most detailed reports will not only set out the size of the reserves but also explain the reserves management process, the benchmark used and perhaps even the returns due to active management against that benchmark.  Not all central banks will want or feel able to go into this much detail but as a minimum the central bank’s report should be sufficient to show that the reserves are all accounted for and are being managed according to established procedures[11].

The second purpose of external reporting is for Information, both to the IMF and others in the official sector and to other market participants.  The size of the reserves can show how much intervention a country has been doing, and can also provide reassurance to creditors on the creditworthiness of the country.  More detailed figures (as set out by the IMF’s current Data Dissemination Standards) provide valuable data for those in the official sector whose remit includes the maintenance of international financial stability.  Particularly for this purpose, it is important that the data is kept up to date:  confidence in a country’s external position can quickly be lost if regular reserves data releases start to be delayed or withheld from publication.

 

 

 

 

 

 

 

 

 

 

3. Management of China's foreign exchange reserves

3.1. China's foreign exchange reserves and SAFE

Chinese FX reserves have increased rapidly over the past, and such trend is likely to continue in the foreseeable future. As shown in Chart 1, in 1993 the size of Chinese FX reserves was only about USD 20.1bn, but this figure increased gradually to USD 165.6 bn in 2000, and this momentum has been accelerating since then. As a result, Chinese FX reserves amounted to USD 2.4tr. as of December 2009, accounting for 31.9% of global FX reserves in 2009 in comparison to 5.3% in 1995. Meanwhile, the Chinese FX reserves were approximately 48.9% of the country's GDP in 2009,[12, 3]

An increase in Chinese FX reserves has arisen from sizable surplus in both current and capital accounts, while in many other emerging economies, the increase mainly reflects surplus in the current account. Surplus in the current account in China is not surprising given that the country has been continuously running trade surpluses since the 1990s, and the level of the surplus got larger in 20065 and onwards – partly thanks to joining the WTO in 2001. It is reported that as of 2009 China exceeded Germany, becoming the world’s largest exporter. FDI inflow has also been far more than capital outflow in China, not only due to the strict capital control imposed by the Chinese government. Furthermore, since 2005 when the Chinese government announced to implement the new, more flexible exchange rate policy, it effectively induced increased amount of foreign capital inflow to China, and a large proportion of it was reported to be speculative international capital. How to manage the rapidly growing FX reserves has become a big challenge and somehow a burden for the Chinese authorities. Further, we consider how Chinese FX reserves are currently managed and the possible solutions available and conduct a detailed overview of the State Administration of Foreign Exchange (SAFE), i.e. the Chinese governmental agency in charge of administering China’s FX reserves.

SAFE is a subsidiary department under China’s central bank, namely People’s Bank of China (PoBC). However given the unique nature of SAFE, this institution is treated as equivalent to a vice-ministry agency. Therefore the head of SAFE has always been a deputy governor of the PoBC too. The legal foundation of SAFE relies on the Law on People’s Bank of China 1995, in which it is specified that the PoBC owns, administers and manages the country’s foreign reserves. In this context, PoBC delegates the tasks of administration and management to SAFE.

According to the Overview of Management of China’s Foreign Reserves (SAFE 2009), SAFE sticks to three principles concerning portfolio management, i.e. safety, liquidity and value appreciation. It is particularly stressed that maintaining the safety of China’s foreign reserves is the utmost task of SAFE[12,7].

Organisational structure. SAFE is headquartered in Beijing, and the head office in Beijing currently consists of eight departments.In addition, SAFE has 34 local bureaus and 2 foreign exchange administration centres across the country. Staff in local bureaus are mainly responsible for dealing with local needs on foreign trade and currency related issues, while management of reserves is centralised in Beijing. Meanwhile, SAFE has four offices abroad, i.e. in Hong Kong, Singapore, London and New York, where the offices in London and New York have their trading desks.

Investment strategy. Investment strategy of SAFE has been traditionally conservative, which is not surprising given that as a reserves manager, the main concerns are safety and liquidity. However, in the light of rapid accumulation of FX reserves in China, particularly over the past 10 years, SAFE has been becoming gradually more active. There are two main reasons for it[14,26].

1) Conservative management of the reserves creates huge opportunity cost6, if they continueto be invested in low-risk-low-return government bonds.

2) SAFE has been facing strong competition from its domestic rival, i.e. CIC over the past 2 years. It imposes significant pressures on the management of SAFE to increase return.

So far, SAFE mainly relies on its in-house team to manage and invest the reserves, i.e. staff from the Department of Reserves Management as noted above. However, since the late 1990s, SAFE has started to outsource some of its assets to external professional institutions, but its amount was reported to be very small. In addition, SAFE’s overseas offices have been able to conduct foreign trading. However, it is understood that staff in these offices mainly replicate portfolios of the head office in Beijing while benchmarked to pre-determined, strategic asset allocation. The exception might be the HK office, which has become more aggressive in recent years, i.e. investing in high risk and high return assets.

Asset allocation. China is one of the very few major countries which does not disclose portfolio composition data of its FX reserves. Different sources, however, have estimated such information. The market consensus is that by type of currency 60-70% of the reserves are invested in US dollars, 30-20% in Euro, and 10% in British pounds, Japanese yen and others (Zhang and He, 2008).

SAFE investment in the U.S. market. Table 1 gives the latest data for the top 3 countries in terms of holding value of U.S. securities.

It shows that as of June 2008 China as a whole held an amount equivalent to USD 1.2 tr. Of U.S. securities, accounting for 11.7% of the total U.S. securities held by foreigners, while Japan was still the largest holder by value .

Among the five broad groups of asset category, China has favoured long term debt, particularly long term treasury bonds and long term government agency bonds; the latter two almost accounted for 90% of the total investment, i.e. 43.3% and 43.7%, respectively as shown in Table 2. The heavy investment in US government agency bonds (e.g. mortgaged bonds) might explain why the Chinese government was so worried about the way in which the U.S. government bailed out Fannie Mae and Freddie Mac in 2009. In comparison, the largest holder (Japan) had relatively the same amount of U.S. Treasury bonds, but with much lower investment in the U.S. government agency bonds. Meanwhile Japan invested more than China in higher risky assets, i.e. equity and long term corporate debts. China is currently the largest holder of the U.S. treasury securities. As of November 2009

China held an amount equivalent to USD 789.6 bn of the U.S. treasury securities, in comparison to USD 757.3 bn for Japan [12, 16].

Recent trend of SAFE investment. For Chinese (FX) investment in the U.S. market, the pattern has undergone gradual changes over the past decade. As shown in Chart 2, in 2000 77.2% of assets were invested in U.S. treasury bonds, but in 2008 the proportion was reduced to 43.3%, almost a half reduction over the 8 years period. In the same period, investment in the U.S. government agency debt, however, increased significantly. It may reflect the changing behaviour of the SAFE, i.e. keep investing in safer assets but aiming to earn a higher return than that of the U.S. treasury bonds.

Although as of 2008 only 8.3% of the portfolio was invested in the U.S. equity market, much lower than what was invested in the U.S. treasury and agency bonds, the magnitude of the increase over the past 8 years was significant (i.e. almost an eight times increase). This observation again is consistent with the overall changing investment strategies of the Chinese government (i.e. SAFE).

SAFE has been recently receiving increasing attention both within China and abroad. Various factors have contributed to this.

In China • Rising assets and associated problems

AUM (asset under management) of SAFE stood at up to USD 2.4 tr. by 2009, and the rapid growth is expected to continue in the foreseeable future. In this context, the monetary authorities in China have been facing several serious problems, particularly with reference to monetary policy.

Firstly, PoBC has had to increase monetary supply in response to rapid accumulation of FX reserves. Chart 3 below shows that over the period between 1999 and 2009, Chinese monetary authorities witnessed rapidly increased credit creation due to accumulation of FX reserves. This in effect subjects monetary policy to foreign exchange policy in China, thereby creating inflexibility or difficulty in achieving intended monetary policy by PoBC[12, 17].