Introduction and Overview Rationale for Holding Reserves

SEACEN-World Bank Treasury Dec 5-7, 2007 Siem Reap, Cambodia Introduction and OverviewRationale for Holding Reserves George Bentley Principal Financial Officer The World Bank Treasury

Foreign Exchange Reserves: Some Recent Trends • World reserves have tripled in the last 10 years from USD 1.2 trillion to USD 4 trillion, and doubled in the last four years • Share of emerging market and developing economies around two-thirds • Ratio of reserves to imports well in excess of three-to-four months, and far above the level of short-term foreign debt in many countries • “Excess” emerging market reserves on the order of USD 1.5 trillion, based on the Greenspan-Guidotti rule

Current Market Environment and Return Prospects • Current Treasury yield levels likely imply lower expected returns going forward…

Changing Landscape of Reserves Management • When reserves were held at levels that represented self-insurance against possible financial crisis, the case for their investment in maximally liquid, maximally safe form (assets) was compelling. • When reserves are far greater there would seem to be a case for more aggressive investment…in a much richer menu of international assets. Lawrence Summers, March 2006

Workshop Objectives • Explore key issues in Reserves Management: Front-, Middle- and Back-Office • Discussion the Range of Country-Specific Environments and Challenges • Highlight Implementation Paths on Select Topics • Identify Areas for Continuing Dialogue

Rationale for Holding Reserves (1) • Meet foreign exchange needs and external obligations • Service foreign exchange liabilities and debt obligations • Provide foreign exchange for operational purposes • Support and lend credibility to monetary and exchange rate management policies • Capacity to intervene in support of the domestic currency

Rationale for Holding Reserves (2) • Limit external vulnerability by providing a buffer to absorb shocks during times of crises • Provide confidence to markets • Timely discharge of external obligations • Backing of domestic currency by foreign currency assets • Maintain a reserve for national disasters and emergencies

Level of reserves – measures of reserves adequacy • In determining the appropriate level of reserves for a particular country, the analysis should focus on: • most vulnerable items on the balance of payments • potential drains on reserves • The ratio of reserves to imports is used to measure reserve adequacy with respect to the first criterion while debt-based and money-based measures are used with respect to the second.

Measures of reserves adequacy Source: IMF (based on 2006 data) Source: IMF (based on 2006 data) • A ratio between 3-6 months is generally considered adequate; • One drawback of this rule is that it includes all goods and services in imports irrespective of their impact on economic growth; • A ratio higher than 1 is generally considered adequate; • This measure does not take into account the remaining external debt repayment profile;

SAA framework • Rationale for holding reserves & assessment of reserves adequacy • Investment objectives, investment horizon and portfolio tranching • Multi-step approach for tranching, currency distribution, strategic benchmarks and active management

Portfolio Tranching Process of segregating the international reserves into multiple parts (Tranches) with specific objectives and guidelines for each part (tranche)

Tranching and Currency Composition should be based on • Transactional needs • Need for an adjustment mechanism to tide the country over short term periods of external imbalances • Liability immunization • Providing confidence to markets • Generating income to offset cost of carrying reserves

Tranching Considerations • Investment Horizon • Liquidity Requirements • Risk tolerance • Return considerations

Liquidity Requirements by Horizon • One month Horizon • Intervention requirements • Transaction needs (Projected payments/receipts) • One year Horizon • Import coverage • Short-term debt • Longer Horizon • Provide confidence to markets • Provision for Emergencies

The lower the draw-down probability ,the higher the scope to improve returns…. Lower liquidity Higher return instruments Investment Horizon Reserve adequacy Annual liquidity requirements Monthly liquidity requirements Day to day liquidity requirements

Divide into Tranches based on Objectives, Investment Horizon Core Reserves • Meet transactional needs • Intervene in FX market to manage short-term volatility • Purchase critical imports • Provide proof of ability to service STD Working Capital Liquidity Tranche Excess Reserves • Generate income • Provision for emergencies Investment Tranche

Tranche Characteristics • Handle Daily Cash Flow needs • One month horizon Working Capital • Liquid assets • Available to replenish WC or for other draw down requirements • Fairly Sensitive to volatility of returns Liquidity Tranche • Liquidity less of a concern • Low probability of draw down • Less sensitive to short-term volatility of returns Investment Tranche

Determining Tranche Size based on Tranche Objectives • Estimate of monthly transaction needs • Estimate of potential FX interventions Working Capital • Historical average of 3 months of imports* • Short-term debt (maturity < 1 year) • Factor in potential capital flight Liquidity Tranche • Excess reserves beyond Working Capital and Liquidity Tranche Investment Tranche * For Countries with littleor no access to international capital markets

Tackling External Imbalance • Purchase critical imports • Neutral Currency = Currencies of Imports Little or no access to international capital markets • Provide confidence to external creditors of capacity to service short-term debt • Neutral Currency = Currencies of STD Significant but uncertain access to international capital markets

Alternative approaches to currency composition and tranching • Return maximization through a Portfolio Optimization framework • Asset-Liability framework at the level of the central bank balance sheet or at the country level

Asset only – Joint Optimization • Analysis of risk/return profile of the overall reserves in domestic currency • Potential benefits from joint optimization • Better use of cross country diversification effects (interest rate risk and currency risk) • Investment constraints are less binding • Focus on the risk factor that matters most for the financial position of a central bank

Balance sheet approach • Balance sheet management on the level of the central bank, e.g. • Optimization relative to the costs of funding • Joint optimization of foreign reserves and domestic holdings with or without other balance sheet items • Management of the government’s consolidated balance sheet • Reserves management strategy is established against the consolidated balance sheet of the central government and monetary authority

Foreign currency assets funded by foreign currency liabilities on the central bank’s balance sheet Foreign currency matching will immunize the market value of equity and currency risk arising from balance sheet debt Liability Immunization Through an Asset-Liability Framework

Rebalancing Tranche Size and Currency Composition • Specify lower and upper bands for each tranche size and currency • Decide on rebalancing rule • Monthly rebalancing if tranche/currency size outside band • Other rule • Rebalance tranche size and currency composition based on rebalancing rule

Summary (1) • Portfolio Tranching and determination of Currency Composition are the first steps in the SAA process • Board Specifies reserves management objectives which may be multiple and possibly contradictory • Portfolio Tranching enables risk/return characteristics to be tailored to specific objectives

Summary (2) • Tranche size and currency composition should be based on the objectives (intervention, import coverage, etc.) and any liabilities • Benefits of Portfolio tranching and a well defined currency composition • Tailor risk/return to specific objectives • Immunize foreign liabilities • Facilitate portfolio and risk management

Summary (3) • Investment Policy • Set by the Board • Specifies structure and criteria • Guidelines • Developed by the Investment Committee • Specifies tranche and currency sizes and lower and upper bands

Introduction and Overview Rationale for Holding Reserves