Financial Sector Assessment

Foreign Exchange Reserve Management

Countries hold official reserves to meet a range of objectives that will vary from country to country. Typically, reserves are held to limit external vulnerability by maintaining for­eign currency liquidity (a) to absorb shocks; (b) to provide a level of confidence to mar­kets that a country can meet its external obligations, including the government’s ability to repay its external debt; (c) to maintain confidence in policies for monetary and exchange rate management; and (d) to maintain a reserve for national disasters or emergencies.

Specifically, reserves play a key role in preventing the cascading of sectoral liquid­ity problems into national liquidity and even solvency problems (through the effect on interest rates). Claims on reserves can arise from public and private sector risk and liquidity management. The size of short-term (by remaining maturity), economy-wide, external debt in relation to available international reserves is typically the starting point in determining reserve adequacy for emerging market countries. However, in the absence of effective capital controls, short-term foreign currency debt between residents can also result in pressures on reserves. Therefore, with flexible exchange rates, overall maturity mismatches in foreign currency are the chief concern as they can spill over into claims on reserves and national liquidity problems (see IMF 2004). When exchange rates are fixed and capital controls are weak, all domestic private sector liquidity problems can spill over into national liquidity problems: Domestic claims that fall due or are available on demand can be turned into claims on the limited foreign exchange reserves.

In all cases, reducing currency mismatches,—and for banks also maturity mismatches in the foreign currency book—and more generally strengthening private sector risk man­agement through improvement in the quality of prudential supervision can contribute to mitigating external vulnerabilities by decreasing the chances of confidence and liquidity crises. Reducing the mismatches might also reduce the need for holding large stocks of international reserves by the monetary authorities. Generally, maturity mismatches in
foreign currency are the chief concern because they can spill over into claims on reserves and national liquidity problems. Policies to contain this mismatch include both pruden­tial supervision and macroeconomic debt management policies.11

The overriding objective of reserve management is to ensure that an adequate level of foreign exchange reserves is available for meeting a defined range of objectives and that the security and liquidity of those reserves are safeguarded. The generation of a reason­able return is usually subordinated to such considerations. The Guidelines for Foreign Exchange Reserve Management (IMF 2001a) spells out the objectives and good practices in meeting those objectives.12 The guidelines could be used as a framework to review reserve management practices, although the guidelines are not an international standard against which country practices are to be assessed. Key issues regarding the reserves’ adequacy, transparency, and accounting and measurement of reserves are also covered in IMF’s work on Article IV surveillance and on the Safeguard Assessments. Measurement and disclosure issues are also dealt with in the Data Template on International Reserves and Foreign Currency Liquidity. The guidelines provide additional focus on whether existing reserves are effectively managed so that they are available to monetary authorities in the event of crises, and the guidelines avoid reputational risk to the central bank that could undermine its authority (see section 1-4 of the guidelines). The guidelines spell out a range of institutional and operational practices that are based on a wide range of country experiences and that encompass (a) the clear objectives for management of reserves; (b) a framework of transparency that ensures accountability and clarity of reserve manage­ment activities and results; (c) the sound institutional and governance structures; (d) the prudent management of risks; and (e) the conduct of reserve management operations in efficient and sound markets. The following aspects of the guidelines would merit special attention:

• Reserve management strategy and coordination

- Are their clear investment guidelines? Are the degrees of freedom of the vari­ous decision-making levels to deviate from the strategic asset allocation appro­priate, or do they provide too much leeway for taking market risk at low levels in the organization?

- Are methodologies to establish the strategic asset allocation appropriate in light of the objectives of holding reserves? The currency composition is espe­cially important, but so is also the maturity, credit, and liquidity profile.13

• Transparency and accountability

- Is there a clear allocation of reserve management responsibilities and roles between the government, the reserve management entity, and other agencies, and is that allocation publicly disclosed?

- Is the conduct of reserve management included in the annual audit of the financial statements, and is the audit performed by independent external audi­tors? Is the auditors’ opinion publicly disclosed?

- Is information on official foreign exchange reserves publicly disclosed on a pre­announced schedule? Does information on the pledging of assets and the use of
derivatives relative to domestic currency need to be officially disclosed? Is there any such activity taking place?

• Institutional framework

- Are the reserve management entity’s responsibilities and authorities clearly established through a legislative framework?

- Are general principles for internal governance to ensure the integrity of the reserve management entity’s operations in place? More specifically, is there a clear decision-making hierarchy, and are operational responsibilities adequately separated, preferably between a front office (initiating transactions), a middle office (performing measurement, management, and reporting of risks), and a back office (arranging settlements of transactions)?

• Risk management framework

- Is there a framework for identifying and assessing the risks of reserve manage­ment operations?

- Are risk exposures monitored continuously to warrant that exposures stay within acceptable limits?