History shows that holding, disclosing sufficient foreign currency reserves helps countries prevent, weather external crises (photo: Jeon Hyeong-Jin/AFP)
RESERVE MANAGEMENT CONFERENCE
The global financial crisis has put back in the spotlight the issue of countries maintaining enough foreign exchange reserves .
The IMF convened its second annual Roundtable of Sovereign Asset and Reserve Managers in Washington, D.C., in February, 2009. The event—designed to enable the exchange of ideas and experiences in sovereign asset and reserve management—was attended by delegates from central banks, ministries of finance and sovereign asset managers from 32 countries, representatives from select international institutions, and private sector representatives.
The theme of the roundtable was policy and operational issues confronting reserves and sovereign assets managers in the current financial crisis, and heightened market volatility.
Reserve adequacy revisited
Previous international financial crises have shown that holding and managing sufficient reserves of foreign currency, and disclosing adequate information on them to markets, helps a country prevent and weather external crises.
Core indicators of reserve adequacy, notably the ratio of reserves to short term external debt, have thus far been useful, but a key question is how buffers based on this criterion will hold up in a prolonged crisis, and with increased exposures to intrabank debt and portfolio flows.
The core indicator of reserve adequacy emerged after all from, and was tested in, crises when problems originated in emerging market countries and spread through contagion. The current problems are, however, closely related to the suppliers of capital—advanced-country banks in particular.
Bilateral swap lines, such as those arranged recently between some emerging market economies and the U.S. Federal Reserve, were well received. The lines were seen as both providing the option of gaining quick access to additional liquidity and mitigating the likelihood of a crisis due to the positive reputational effect even when countries did not draw on them.
Similarly, countries saw a need for additional fast-disbursing liquidity facilities of the IMF to augment resources available to countries to get through a prolonged crisis and expand the set of countries that can access additional foreign exchange liquidity at short notice. Such facilities would avoid the contractionary implications of countries raising reserves in the current environment.
Risk management at forefront
In the runup to the crisis many reserve managers had been contemplating, and taking on, some additional risk to reflect the vast buildup in reserves. While reserve managers’ primary focus on the safety and liquidity of reserves led to modest adjustments, some lessons emerged.
Longer-duration exposure going into the crisis, while increasing the risk of incurring mark-to-market losses, actually helped as high interest was locked in for longer periods and resulted in valuation gains. Increased credit risk, however, often required reevaluations. The onset of the crisis prompted more intense monitoring of individual exposures and instruments, and quite a few reserve managers have tightened their credit and counterparty limits. At the same time, however, reducing concentration risk has become more difficult as the number of eligible counterparties has declined due to bankruptcies, mergers, and downgrades.
Views remain divided on how to manage interest risk going forward. Some reserve managers argue in favor of an integrated sovereign asset and liability management (SALM) approach, which entails managing risk for the government balance sheet as a whole, as it could reduce net risk exposure significantly or yield higher net interest income. Others continue to favor a more traditional asset-only approach to managing risk, as the SALM approach may not be practical due to coordination constraints and to different objectives for the central bank and the ministry of finance.
Sovereign wealth funds
The crisis is also leading to some reevaluation among sovereign wealth funds’ (SWFs) investment policies. Typically, SWFs are resisting changes to strategic asset allocations since portfolio losses as such are no reason to change either the time horizon or risk aversion. However, a number of other reasons have led to some adjustments.
Expected declines in net resource transfers are reducing the time horizon of some (stabilization) funds and consequently their asset allocation; the depth of the crisis has brought some funds to take different views on expected returns, leading some to postpone investments and others to scoop up cheap assets; and some funds have seen their mandates change or have received additional (domestic) mandates and have had to adjust their investments accordingly.
Hedging risk
In light of the sizable increase in commodity price volatility a number of SWF managers and their owners are also looking more closely into hedging commodity price exposures. A few countries already use derivative instruments to directly hedge risk—for instance oil exporters hedging against a fall in the price of oil. These hedging markets have proven quite resilient against such large price shocks and no large failures have occurred.
However, many oil-funded SWFs are unable to use these markets given the still limited depth of the oil hedging market in relation to their oil production. Most countries thus consider the existence of stabilization and commodity savings funds as the main safeguard against commodity price fluctuations, providing both stability in fiscal revenues and a framework to ward off Dutch disease—the crowding out of other sectors of the economy when prices are high.
That being said, a number of SWFs and academics are looking at ways to improve hedges in recognizing that commodity exporting countries are massively exposed to commodity prices, namely through sizable deposits of resources that are not yet mined. Moreover there is some recognition that commodity price shocks are not necessarily mean reverting or symmetric and stabilization funds that work on the principle of saving when prices are high and spending when low may not create adequate hedges for price volatility.
SWFs in particular have scope for indirect hedging risk, by having an overweight allocation of assets in their portfolio that are negatively correlated with the price of the commodity that funds them. There are very significant savings to be gained from such strategies, which may include different sector weights and regional weights for equities and different allocations to bonds.
Similarly, there are significant gains to be made for pension SWFs that treat their objectives as liabilities and take account of the correlation of certain asset classes with these objectives. For instance, if the objective is a real return, inflation-linked instruments may be an excellent investment strategy.
Comments on this article should be sent to imfsurvey@imf.org
