For example, the Swiss National Bank has a fairly broad range of fixed-income instruments it can invest in, including government bonds, covered bonds, bonds issued by foreign local authorities and supranational organizations. [Swiss National Bank,“Foreign Exchange Reserves and Swiss Franc Securities,” available at http://www.snb.ch/en/iabout/assets/id/assets_reserves.] Over the last decade, the SNB expanded the list of eligible assets to include corporate bonds in 2004 and equities in 2005. [Swiss National Bank, Ninety-Eighth Annual Report 2005, available at http://www.snb.ch/en/mmr/reference/annrep_2005_komplett/source.] This change in asset allocation resulted from the elimination of legal restrictions on eligible investments in 2004—a move that allowed the SNB to improve the risk/return profile of its investments. [Swiss National Bank, Ninety-Seventh Annual Report 2004, available at http:// www.snb.ch/en/mmr/reference/annrep_2004_komplett/source.]
Several central banks utilize derivatives to manage their portfolios more actively or to mitigate risks. The Swiss National Bank is authorized to use equity futures to manage its equity investments. [Swiss National Bank,“Foreign Exchange Reserves and Swiss Franc Securities,” available at http://www.snb.ch/en/iabout/assets/id/assets_reserves.] Other central banks have stayed with more traditional interest rate and foreign exchange derivatives. For example, in managing the United Kingdom’s Exchange Equalisation Account, the Bank of England can use foreign exchange forwards, interest rate and currency swaps, overnight indexed swaps, bond and interest rate futures, swap notes and swap futures, and forward rate agreements. [Bank of England,“Composition of Reserves,” http://www.bankofengland.co.uk/ markets/Pages/forex/reserves/composition_reserves.aspx.] The Bank of Canada can also employ derivatives in managing its reserves; specifically, foreign exchange and cross-currency swaps are used for funding and currency hedging purposes. [Department of Finance Canada, Report on the Management of Canada’s Official International Reserves, 2011-12, available at http://www.fin.gc.ca/activty/oirrep/ oir-roli-12-eng.pdf.]
A challenge for each country is to have a portfolio that balances the benefits of short-term liquidity and safety against the costs of earning lower investment returns than might arise with a broader set of asset holdings. Such opportunity costs presumably increase with the restrictiveness of the investment portfolios,
and are magnified as portfolios grow in size. Limited information is available for comparing foreign exchange reserve portfolio returns across countries. However, we can derive some suggestive information on the consequences of restricting the investment composition of the euro and yen portfolios of the United States and Canada. [Switzerland makes information available on the returns to its entire portfolio without differentiating returns for the portfolios in specific currencies. Canadian data are reported in Department of Finance Canada, Report on the Management of Canada’s Official International Reserves, 2004-09, available at http://www.fin.gc.ca/ activty/oirrep/oir-roli-10-index-eng.asp.] The Federal Reserve publishes both the quarterly breakdown of foreign reserve assets held and the changes in balance by source (net purchases and sales, investment earnings, realized gains or losses on sales, and unrealized gains or losses from foreign currency revaluation). [See http://www.newyorkfed.org/newsevents/news/markets/2010/fxq310.pdf.] The Bank of Canada provides a decomposition of returns at an annual frequency, separating returns in U.S. dollar portfolios from those in euros or in yen. The Bank of Canada also provides liability benchmarks by currency for comparison with actual performance. This information facilitates a comparison of returns within euro assets and within yen assets.
Several central banks utilize derivatives to manage their portfolios more actively or to mitigate risks.
Chart 2 shows the differences in cumulative returns on euro and yen portfolio investments by the Federal Reserve and the Bank of Canada. Taking the end of 2003 as a starting point (and setting it equal to 1 for comparison purposes), we observe that the type of asset allocation undertaken by Canada appears to have produced returns on its yen portfolio similar to those realized by the United States. Given these relatively similar returns in yen, it seems likely that Canada’s yen portfolio, like the corresponding U.S. portfolio, is invested mostly in Japanese government bonds. By contrast, Canada may have realized superior returns with respect to its euro portfolios; the cumulative nominal value of the Canadian euro portfolio grew overall by 44 percent, compared with just 20 percent for the U.S. euro portfolio over a comparable interval. Canada’s euro portfolio likely provided greater scope for gains because of its larger universe of liquid fixed-income products, which carry higher credit risk than government securities but also yield higher returns. Overall, the evidence presented here suggests that allowing broader classes of investments in portfolios could reduce some of the opportunity costs of maintaining large balances of foreign exchange reserves.
Conclusion
The idea that a central bank should hold foreign currency reserves is widely accepted. Indeed, it is a central feature of the post–Bretton Woods international financial order. Nonetheless, as this article demonstrates, identifying what is optimal in the foreign exchange reserve practices of industrialized economies can be quite difficult.
Further work on the relationship between countries’ objectives in holding foreign exchange reserves and the size—whether “small”or“large”— of reserve holdings might be useful given the rapid growth and evolution of international financial markets and cooperative arrangements across central banks. If foreign currency reserve holdings are intended primarily for use in intervention actions that affect exchange rates through a signaling channel, perhaps small reserve portfolios might suffice. But if countries continue to accumulate large portfolios, then the opportunity cost of these holdings and their effectiveness in advancing foreign exchange reserve objectives might be further analyzed. The opportunity costs posed by large reserve portfolios might include not only low rates of return on large pools of country assets, but also the exposure of central banks and ultimately taxpayers to movements in exchange rates. Either way, the academic and policy communities would do well to engage in constructive discussion of the issues surrounding the size and composition of industrialized economies’ foreign exchange reserve portfolios. Overall, considerable uncertainty exists about the level of foreign currency reserves needed by industrialized countries for possible interventions in the foreign exchange market and the level that reserve balances should resume after periods of prolonged reserve accumulation.
[click on graphic below to enlarge]
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ABOUT THE AUTHORS
Linda Goldberg is a vice president in the Research and Statistics Group of the Federal Reserve Bank of New York; Cindy E. Hull is a policy and market analysis senior associate in the Markets Group; Sarah Stein is a research associate in the Research and Statistics Group.
The content co-editor of this article is Matthew Higgins.
Current Issues in Economics and Finance is published by the Research and Statistics Group of the Federal Reserve Bank of New York. Linda Goldberg and Thomas Klitgaard are the editors of the series.
Editorial Staff: Valerie LaPorte, Mike De Mott, Michelle Bailer, Karen Carter, Anna Snider
Production: Jane Urry, Jessica Iannuzzi, David Rosenberg
Back issues of Current Issues are available at http://www.newyorkfed.org/research/current_issues/.
The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System – reposted from Do Industrialized Countries Hold the Right Foreign Exchange Reserves?