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.

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%)

8. 1. Recent Trends

9. 1. Recent Trends

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
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