Currency intervention

• Prepared by Livia Chiu, Joaquim Gomes and Rolf Pauli This article begins with a review of the global trends in central banks foreign currency reserve holdings in terms of their size, adequacy and composition, and follows on to examine the ECBs foreign currency reserves.
• Global foreign currency reserves grew markedly after the Asian financial crisis of the late 1990s, with emerging markets accumulating large reserves to self-insure against potential shocks.
• While global foreign currency reserves have traditionally been invested primarily in US dollar-denominated financial assets, in recent years holdings have become more diversified in terms of both currency and asset classes.
• The way in which the framework involves the national central banks (NCBs) of the Eurosystem in the active management of the ECBs foreign currency reserves is both unique and intricate.

1 Trends in central banks’ foreign reserve holdings

• Foreign currency reserves generally refer to readily available holdings in monetary authorities safe external assets.
• Total official reserves are the broadest definition of international reserves, including both foreign currency reserves and non-currency reserves.
• Foreign currency reserves, which comprise external assets generally controlled by national monetary authorities, consist of securities and deposits.
• They are established by way of foreign reserve policy decisions on, for example, foreign exchange market interventions or the management of reserve portfolios.

1.1 Main objectives of holding foreign currency reserves

• A number of countries developed the practice of holding foreign currency reserves in the mid-nineteenth century to back their liabilities and domestic currency with a view to supplementing their gold and silver reserves.
• [2] Since then, the reasons for holding foreign currency reserves have evolved over time and across countries.
• One possible use of foreign currency reserves, common to both advanced and emerging market economies, is to enable them to carry out foreign exchange interventions, if deemed necessary.
• Foreign currency reserves are generally held for traditional operational purposes as well as for precautionary and non-precautionary policy objectives.
• [6] As for the ECB, the main purpose of holding foreign currency reserves is to ensure that the Eurosystem has a sufficient amount of liquid resources, whenever needed, for its foreign exchange policy operations involving non-EU currencies.
• The ECBs foreign currency reserves were therefore only used to fund interventions in September/November 2000 and in March 2011.

1.2 Size of global foreign currency reserves

• Around two-thirds of global foreign currency reserves are held by emerging and developing economies.
• After the Bretton Woods system was brought to an end, global foreign currency reserve holdings grew sharply, particularly among advanced economies, despite the fact that it was widely expected that the shift to floating exchange rates would reduce the appeal of holding foreign currency reserves.
• [9] Following the Asian crisis, emerging market and commodity-exporting economies also began accumulating sizeable foreign currency reserves, with China accounting for the largest share of that increase.
• Global foreign currency reserve holdings continued to grow in the wake of the global financial crisis, as some countries were reluctant to use their reserves, fearing that doing so might send a negative signal about potential exchange rate pressures.
• [10] More recent developments suggest that foreign currency reserves have levelled off since 2015 (see Chart 1).
• [14] Chart 1 Developments in global holdings of foreign currency reserves and breakdown by main country groups (USD trillions)
• In the case of the ECB, its total official reserve assets, including both foreign currency and non-foreign currency reserves, were equivalent to around EUR 68.6 billion at the end of 2018.
• [15] These reserves comprise around EUR 49 billion in foreign currencies (US dollar, Japanese yen and onshore Chinese renminbi) and around EUR 18.2 billion in gold, with the remaining assets held in IMF SDRs.
• Official reserves were initially transferred to the ECB by the NCBs of those EU Member States that had adopted the euro,[16] in proportion to their share in the ECBs capital subscription[17].
• At the end of 2018, the entire Eurosystem held EUR 719 billion in total official reserve assets, including the ECBs official reserve assets.
• As this figure indicates, the NCBs hold significant additional official reserves on top of those held by the ECB.

1.3 Adequacy of foreign currency reserves

• Whether the level of foreign currency reserve holdings is deemed to be adequate hinges on several factors.
• As a result, countries with open financial markets should hold foreign currency reserves proportionate to the size of their banking systems.
• One common metric used in this context is that foreign currency reserves should cover at least 20% of broad money to account for capital flights.
• [22] Advanced economies, particularly major reserve currency issuers, have a less pressing need to hold reserves.
• Given the free-floating currency regime, the traditional metrics mentioned above, developed essentially for emerging market economies, are less suited to assessing reserve adequacy in advanced economies.
• Although it is difficult to assess the optimal level of foreign currency reserves to be held for conducting effective foreign exchange interventions, recent research has found that the average daily intervention volume in the foreign exchange markets (of 33 emerging and advanced economies) equals around 0.02-0.05% of a countrys GDP, depending on the currency regime (higher for narrow-band regimes, lower for floating regimes).
• Under floating currency regimes, the baseline success rate of the foreign exchange interventions is around 60%, considering the intended objective of the intervention as identified.
• For example, they can use foreign exchange swaps without immediate depletion of foreign currency reserves.

1.4 Global trends in the currency composition of global foreign reserves

• Global foreign currency reserves are mainly invested in US dollar-denominated financial assets, while the euro is the second most-used reserve currency.
• Based on IMF Currency Composition of Official Foreign Exchange Reserves (COFER) data[26], at constant exchange rates, the US dollars share of globally disclosed holdings of foreign exchange reserves stood at around 62% at the end of 2018, against 69% in 2007 (i.e.
• The euro accounted for roughly 20% of global foreign exchange reserves at the end of 2018, against 22% in 2007 and 19% in 1999.
• The share of the Chinese renminbi reached almost 2% of global foreign currency reserves at the end of 2018, double that of early 2017 (see Chart 3).
• Chart 3 Currency composition of global foreign currency reserves Developments in the shares of the euro, US dollar, non-traditional currencies and other currencies in global official holdings of foreign exchange reserves (percentages; at constant Q4 2018 exchange rates)
• [31] Anecdotal evidence aside, recent research on the role of economic and geopolitical considerations in the currency composition of foreign exchange reserves found support for both.
• [32] The ECBs official reserves are currently invested in US dollars, Japanese yen, Chinese renminbi, gold and SDRs.
• The currency composition of the ECBs official reserves reflects policy considerations, in other words, the ability to conduct and fund effective interventions in euro against other major currencies.
• [33] Where the ECB engages in foreign exchange transactions to adjust the composition of the foreign currency reserves, it is to ensure compliance with the Foreign Exchange Global Code (FXGC).
• Chart 4 Composition of the ECBs official reserves
• The CBGAs signatories included the Eurosystem and the central banks of Sweden, Switzerland and initially the United Kingdom.
• The first CBGA[36] was set up in 1999 for a five-year period, when concerns about the negative market impact of uncoordinated gold sales by central banks were evident, and increasing, in the gold market.
• The terms of the last two CBGAs became less and less stringent, reflecting the improving conditions in the gold market.
• The market impact on gold prices in CBGA announcements, including the one on the expiry of the last CBGA, was negligible.
• Chart A Gold sales by CBGA signatories and gold price developments (Tonnes; US dollar per troy ounce)
• Since 1999 the gold market has grown and matured in terms of liquidity and investor base.
• [37] The structure of the gold market differs from that of other financial assets, as gold does not only serve investment purposes, but also has practical uses.
• These flexible and liquid investment vehicles helped broaden the range of investors by easing the access of retail and pension funds to gold exposure.
• [39] Market liquidity and its ability to absorb large-volume gold transactions have improved continuously, thereby lowering the need for the CBGA.
• Central banks and other official institutions have become net buyers of gold over the current decade, mainly as a result of demand from emerging markets.
• Several factors may have supported this renewed interest in gold, mainly from developing countries[40] (see Chart C).
• First, gold has benefited from its status as a safe-haven asset with the ability to preserve wealth over the long term with no risk of default.
• Other supporting factors are the low or negative interest rate environment in major reserve currencies, the reshaping of the global geopolitical landscape and the authorities efforts, in some countries, to back the national currency with physical assets.

2 The management of the ECB’s foreign currency reserves

The investment framework for the management of the ECB’s foreign currency reserves is designed to ensure that they are readily available for policy purposes.[44]

2.1 From high-level objective to concrete investment principles

• The main investment principles for the portfolio management of the ECBs foreign currency reserves are, in order of importance, liquidity, security and return.
• This means that it must be possible to convert the portfolio into cash balances in a short time frame and at minimal cost.
• To achieve this, a large share of the foreign reserves is invested in US and Japanese government bonds with a relatively short residual maturity.
• Subject to the principles of liquidity and security, the investment framework is designed to maximise investment returns.

2.2 The organisational structure of foreign reserve management

• The management of the ECBs foreign currency reserves is organised in three layers: i) a strategic benchmark; ii) a tactical benchmark; and iii) day-to-day portfolio management by NCBs (Figure 1).
• Figure 1 The three layers for the management of the ECBs foreign currency reserves
• A through-the-cycle component identifies efficient portfolio allocations based on long-term expectations of risks and returns through the economic cycle.
• modified duration, allocation per maturity bucket and asset class) for each currency, the ECBs risk management unit translates those characteristics into an investment portfolio, providing security-level detail.
• This committee has members from the investment, risk management and compliance units of the ECB.
• The management of the ECB portfolio by NCBs constitutes the second active layer, the investment returns of which are measured against the tactical benchmark.
• Unlike the internally maintained strategic and tactical benchmarks, the actual management of the investment portfolios is organised in a decentralised manner within the Eurosystem.
• Subject to the rules set by a guideline governing the NCBs management of the ECBs foreign currency reserves, the NCBs act as agents of the ECB.
• The Eurosystem has a dedicated working group which regularly discusses all issues related to the foreign currency reserve management framework and the actual management of the ECBs foreign currency reserves.
• Every three years the Governing Council reviews the allocation of portfolios and may decide to change the currency allocation.

2.3 The active management of the ECB’s foreign currency reserves – incentives and management styles

• Active management, competition between NCB portfolio managers and diversification of portfolio management styles are key characteristics of the ECBs foreign currency reserve management framework, which is intended to generate a steady stream of additional investment returns compared with the strategic benchmark.
• Over time, all active layers have made a positive contribution to the strategic benchmark returns for all reserve currencies.
• As illustrated in Chart 5, for the US dollar portfolios, all individual NCB portfolios have, on average, contributed positively.
• Chart 5 Risk and return in NCB portfolios for the USD portfolio (percentage points, annual averages 2006-18)
• Active portfolio management takes place within a specific risk budget for both the tactical benchmark and the actual portfolios.
• The ECBs independent risk management function is responsible for defining and maintaining the parameters within which portfolio managers can actively take risk.
• The risk budget allocated to the tactical benchmark typically exceeds that of the NCBs portfolios by a factor of 2.
• The role of the NCB portfolio managers (anticipating day-to-day developments in markets) can be expected to involve more moderate risk adjustments, but with greater flexibility.
• In addition, the investment framework includes incentives for the active layers to actively use the risk budget.
• At the tactical benchmark level, the incentive consists of an internal target, set by the ICO, for outperforming the strategic benchmark.
• This is in line with best asset management practices, which allow portfolio managers to better calibrate their positions in order to reach the target.

Conclusion