Reserve management: Objective, scope and coordination

Reserve management should seek to ensure that (1) adequate foreign exchange reserves are available for meeting a defined range of objectives; (2) liquidity, market, and credit risks are controlled in a prudent manner; and (3) subject to liquidity and other risk constraints, reasonable earnings are generated over the medium to long term on the funds invested.
Reserve management forms a part of official economic policies, and specific circumstances will impact on choices concerning both reserve adequacy and reserve management objectives. In order to ensure the availability of reserves, and as part of setting appropriate investment priorities, the reserve manager needs to have an assessment of what constitutes an adequate level of reserves. Such an assessment may be made by the reserve management entity, or it may involve consultation between the reserve management entity and other agencies. There are no universally applicable measures for assessing the adequacy of reserves and the determination of reserve adequacy falls beyond the scope of these guidelines.


Relevant factors have traditionally included a country's monetary and exchange rate arrangements, and the size, nature, and variability of its balance of payments and external position. More recently, financial risks associated with a country's external debt position and the volatility of its capital flows have received particular attention, especially for economies with significant but not fully certain access to international markets. In the process, ensuring the availability of reserves will be influenced by the exchange rate system, and the particular objectives for which they are held.
To ensure that reserves are available at the times when they are needed most, liquidity-which is the ability to convert quickly reserve assets into foreign exchange-usually receives the highest priority, albeit with a cost that usually involves accepting lower-yielding investment instruments. Closely following is the need for the management and control of risks to ensure that asset values are protected. Market and credit risks, for instance, can lead to sudden losses and impair liquidity. Finally, earnings are an important outcome of the management of reserve assets. For some countries, they play a role in offsetting the costs associated with other central bank policies and domestic monetary operations, which among other things fund the acquisition of reserves. In other cases, such as where reserves are borrowed in foreign markets, earnings play an important role in minimizing the carrying costs of reserve assets. Accordingly, achieving an acceptable level of earnings should be a priority within clearly defined liquidity and risk constraints. In sum, the reserve management entity should seek to maximize the value of reserves, within the prudent risk limits that form the framework for reserve management, so that reserves are always available when they are needed. As a consequence, reserve asset portfolios tend to be highly risk averse, with a consequent priority for liquidity and security before profit or carrying cost considerations. This necessarily involves making a trade-off between risk and return in the context of setting reserve management priorities.
SCOPE:  Reserves consist of official public sector foreign assets that are readily available to and controlled by the monetary authorities. Reserve asset portfolios usually have special characteristics that distinguish them from other foreign currency assets.
First and foremost, official reserve assets normally consist of liquid or easily marketable foreign currency assets that are under the effective control of, and readily available to, the reserve management entity. Furthermore, to be liquid and freely usable for settlements of international transactions, they need to be held in the form of convertible foreign currency claims of the authorities on nonresidents.
Reserve management activities may also encompass the management of liabilities, other short foreign exchange positions, and the use of derivative financial instruments.
Depending upon a country's or union's specific policy objectives and settings, the reserve management entity may also be involved in the borrowing of foreign exchange, or drawing against committed credit lines, as part of its responsibility for maintaining an adequate level of reserves.
Managing reserves may also involve liability positions that derive from repurchase agreements, forward exchange and swap agreements, as well as positions arising from operations involving futures and options. In the latter respect, many countries now use derivative financial instruments as an integral part of reserve management operations to establish hedges against currency and interest rate exposures.
RESERVE MANAGEMENT STRATEGY AND CORORDINATION: Reserve management strategies should be consistent with and supportive of a country's or union's specific policy environment, in particular its monetary and exchange arrangements. Reserve management strategies will be shaped by the specific reasons for which reserves are held.
In the context of monetary and exchange arrangements, the exchange rate regime and the degree to which exchange and capital controls have been liberalised are of particular relevance. Under a free float, a public commitment by the authorities not to operate in the foreign exchange market gives the reserve manager greater latitude to structure the duration and liquidity of the portfolio. In practice, however, the authorities may seek to maintain a capacity to ensure orderly markets during times of very sharp adjustments of the exchange rate or market pressures, or more generally to be able to counter unforeseen internal or external shocks.
In countries with fixed exchange rates, including those that operate currency boards, the authorities may need to operate often in the foreign exchange market and will therefore need reserves that can be readily converted into foreign exchange. Especially in these cases, reserves are needed to provide confidence in the currency peg and deter speculation. For these purposes, reserves tend to be invested in a form that facilitates their ready availability.
Intermediate exchange rate regimes, such as managed float or peg arrangements, require the authorities to operate in support of the arrangement. This may call for more or less active operations depending on market evolution and conditions with consequences for the choice of the appropriate level of liquidity that would need to be maintained.
Evaluation of alternative reserve management strategies and their respective implications for reserve adequacy are likely to be facilitated by a cost-benefit analysis of holding reserves. Such analysis would aim to place values on the costs and benefits of holding more or less reserves, for example, by weighing the costs of raising and holding additional reserves against expected benefits of less volatile capital flows, increased foreign investor confidence, and reduced risk of contagion.
Reserve management strategies may also need to take into account strategies for the management of external debt for purposes of reducing external vulnerability. Mutually consistent and supporting policies for debt and reserve management can be important elements of crisis prevention. At the public sector level, this might involve a coordinated approach that considers the assets and liabilities of several official institutions including, where relevant, positions of sub-national authorities. The aim in these circumstances is to determine whether a country's official "whole of government" balance sheet has an adequate level of reserves to provide liquidity as needed, and to allow time to absorb shocks in situations where access to borrowing is curtailed or very costly. In some economies, short term external private debt may also be an additional factor in determining reserve adequacy. In countries where reserve management and debt management responsibilities are entrusted to the same authority, consistent strategies can be achieved through a well-coordinated asset-liability risk management approach. Where reserve management and debt management responsibilities are split between authorities, however, the respective policy objectives may differ. In situations where, for example, the reserve management entity has a primary responsibility for monetary policy, care should be taken to ensure that coordination efforts are not seen as compromising the separation between monetary policy and debt management. In such situations, coordination might also seek to ensure that the authorities' respective actions send out clear signals and avoid contradictory messages.
TRANSPARENCY AND ACCOUNTABILITY:
The main issues of transparency in the context of good governance and accountability in reserve management are addressed in the IMF's Code of Good Practices on Transparency in Monetary and Financial Policies: Declaration of Principles, September 1999 (MFP Transparency Code) and illustrated in the Supporting Document to the Code. The MFP Transparency Code aims at promoting transparency practices for central banks in their conduct of monetary policy, and for central banks and other financial agencies in their conduct of financial policies (Box 1). In doing so, it contains several elements of good transparency practices relating to foreign exchange policies, reserve management, and related foreign exchange market operations.
In addition to identifying a range of general disclosures concerning foreign exchange policies and institutional responsibilities for reserve management, the MFP Transparency Code aims to promote transparency through accountability. The subsections of this chapter follow the respective headings of the Code that relate to reserve management. It should be noted that within the specific sections of these guidelines, references to the level of disclosure by a reserve management entity reflect those levels implied by the relevant section of the MFP Transparency Code, and where applicable, other relevant standards.
Jamaluddin Ahmed, PhD FCA is the General Secretary of Bangladesh Economic Association and a member of Board of Directors of Bangladesh Bank. [email protected]