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April 7, 2012

Foreign Reserve Management

Foreign Reserve Management – Overview

ž Foreign Exchange Reserves are those foreign currency deposits and bonds which are held by central banks and monetary authorities

ž Commonly includes foreign exchange and gold, special drawing rights (SDR’s) and IMF reserve positions

ž These are assets of central bank held in different reserve currencies mostly in US dollar and to lesser extent the Euro, UK pound and Japanese Yen used to back its liabilities


In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or fiat currency as IOUs). This action can stabilize the value of the domestic currency.

Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates

Objectives of Foreign Exchange Reserves:

Reserve management should seek to ensure that:

ž Adequate foreign exchange reserves are available for meeting a defined range of objectives

ž Liquidity, market and credit risks are controlled in a prudent manner

ž Subject to liquidity and other risk constraints, reasonable earnings are generated over the medium to long term on the funds invested

Foreign Exchange Reserves – Benefits:

i) Large reserves of foreign currency allow a government to manipulate exchange rates - usually to stabilize the foreign exchange rates to provide a more favourable economic environment

ii) The greater a country's foreign reserves, the better position it is in to defend itself from speculative attacks on the domestic currency

iii) Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defence, and are used to determine credit ratings of nations

iv) One objective of maintaining reserves is to guard against total ruin - Gold is an asset which, even in the most unsettled of times, is likely to find a willing buyer

v) As a political approach and a friendly nation, foreign exchange reserves are used to buy a country’s treasury bills or debentures when that country is suffering from natural calamities

In addition to fluctuations in exchange rates, the purchasing power of money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates

Foreign Exchange Reserves – Criticism:

ž Gold is that it is not an earning asset, and so the security of holding significant quantities of gold involves an Opportunity cost of the return of alternative investments which, in times of high interest rates, could be considerable

ž Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves

Eg: China holds huge U.S. dollar-denominated assets, but if the U.S. dollar weakens on the exchange markets, the decline results in a relative loss of wealth for China

II. Sovereign Wealth Funds

Sovereign Wealth Funds

ž A Sovereign Wealth Fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, real estate, or other financial instruments funded by foreign exchange assets.

ž These assets can include: balance of payments surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/or receipts resulting from commodity exports. Sovereign Wealth Funds can be structured as a fund, pool, or corporation

Sovereign wealth funds (SWFs) are special-purpose investment funds or arrangements that are owned by the general government. Created by the general government for macro-economic purposes, SWFs hold, manage, or administer assets to achieve financial objectives, and employ a set of investment strategies that include investing in foreign financial assets. SWFs have diverse legal, institutional, and governance structures. They are a heterogeneous group, comprising fiscal stabilization funds, savings funds, reserve investment corporations, development funds, and pension reserve funds without explicit pension liabilities.

The generally accepted principles and practices (GAPP), therefore, is underpinned by the following guiding objectives for SWFs:

i. To help maintain a stable global financial system and free flow of capital and investment;

ii. To comply with all applicable regulatory and disclosure requirements in the countries in which they invest;

iii. To invest on the basis of economic and financial risk and return-related considerations;

iv. To have in place a transparent and sound governance structure that provides for adequate operational controls, risk management, and accountability.

The purpose of the GAPP is to identify a framework of generally accepted principles and practices that properly reflect appropriate governance and accountability arrangements as well as the conduct of investment practices by SWFs on a prudent and sound basis. Elements of the GAPP have been drawn from a review of existing SWF practices used in a number of countries and a distillation of principles and practices applicable to SWF activities that are already in use in other international fora.

The GAPP is a voluntary set of principles and practices that the members of the IWG support and either have implemented or aspire to implement. The GAPP denotes general practices and principles, which are potentially achievable by countries at all levels of economic development. The GAPP is subject to provisions of intergovernmental agreements, and legal and regulatory requirements. Thus, the implementation of each principle of the GAPP is subject to applicable home country laws.

The GAPP covers practices and principles in three key areas. These include

(i) Legal framework, objectives, and coordination with macroeconomic policies;

(ii) Institutional framework and governance structure; and

(iii) Investment and risk management framework.

Sound practices and principles in the first area underpin a robust institutional framework and governance structure of the SWF, and facilitate formulation of appropriate investment strategies consistent with the SWF’s stated policy objectives. A sound governance structure that separates the functions of the owner, governing body(ies), and management facilitates operational independence in the management of the SWF to pursue investment decisions and investment operations free of political influence. A clear investment policy shows an SWF’s commitment to a disciplined investment plan and practices. Also, a reliable risk management framework promotes the soundness of its investment operations and accountability.

Some examples of GAPP principles:

GAPP 1. Principle

The legal framework for the SWF should be sound and support its effective operation and the achievement of its stated objective(s).

GAPP 1.1. Subprinciple. The legal framework for the SWF should ensure legal soundness of the SWF and its transactions.

GAPP 1.2. Subprinciple. The key features of the SWF’s legal basis and structure, as well as the legal relationship between the SWF and other state bodies, should be publicly disclosed.

GAPP 2. Principle The policy purpose of the SWF should be clearly defined and publicly disclosed.

GAPP 3. Principle

Where the SWF’s activities have significant direct domestic macroeconomic implications, those activities should be closely coordinated with the domestic fiscal and monetary authorities, so as to ensure consistency with the overall macroeconomic policies.

SWF Examples :


The Future Fund

Goals and objectives:

The Future Fund Act 2006 (the Act) commenced on April 3, 2006, and established the Future Fund Special Account (the Fund Account), the Future Fund Board of Guardians (the Board) and the Future Fund Management Agency (the Agency), collectively referred to as the Future Fund. The object of the Act is to strengthen the Commonwealth’s long-term financial position.

The Future Fund will make provision for unfunded superannuation liabilities that will become payable during a period when an aging population is likely to place significant pressure on the Commonwealth’s finances. The legislation quarantines the Fund, the balance of the Fund Account and other investments, for the ultimate purpose of paying unfunded superannuation liabilities and expenses associated with the investment and administration of both the Board of Guardians, and by direct transfer from the administered funds, the expenses of the Future Fund Management Agency.

How the fund is managed

The Future Fund is controlled by an independent Board of Guardians that is collectively responsible for the investment decisions of the fund and is accountable to the Australian Government for the safekeeping and performance of fund assets. The Future Fund Management Agency is responsible for the development of recommendations to the Board on appropriate investment strategies and for the implementation of these strategies. The functions of both the Board of Guardians and the Future Fund Management Agency are set out in the Future Fund Act. The Board of Guardians reports annually to the Australian Parliament on all aspects of the Fund’s performance, and the Fund is subject to independent external audit by the Australian National Audit Office.


China Investment Corporation

Incorporation and purpose

China Investment Corporation (CIC) was established on September 29, 2007, by the Chinese government in compliance with the Company Law of the People’s Republic of China. It is wholly owned by the Chinese government and has its own corporate entity status. The purpose of the CIC is to maximize return at acceptable risk tolerance and improve the corporate governance of key state-owned financial institutions.

Source of funds

CIC’s capital is funded through issuing special treasury bonds. With the approval of the Standing Committee of the 10th National People’s Congress, the Ministry of Finance issued Y1.55 trillion special treasury bonds and used raised funds to purchase foreign reserves (US$200 billion) to be injected into CIC as its registered equity capital. CIC has to pay dividends to the State Council as its owner, to cover the cost of these special treasury bonds.

Governance arrangements

As required by the Company Law, CIC has been working on its internal institutional setting and governance structure. It has established a Board of Directors, Supervisory Board, and management team. The appointment and dismissal of Board directors should be approved by the State Council. The chairman and vice chairman of the Board are appointed by the State Council. CIC’s development strategies and operational and investment guidelines are determined by the Board of Directors. Responsibilities and accountabilities within the CIC, across departments and desks, are clearly defined.

Reporting and auditing

CIC’s implementing performance and accounting are reported to the Board, and are subject to the scrutiny by the Supervisory Board. The Internal Audit Department carries out independent audits. The audit reports shall be approved by the Chairman of the Supervisory Board. CIC is subject to financial supervision by the Ministry of Finance and periodic external auditing by the National Audit Office.

Investment objectives and risk management

CIC’s investment objectives are first, to invest in a diversified portfolio of overseas financial instruments, to maximize long-term returns on CIC’s capital; and second, to recapitalize domestic financial institutions as a shareholder abiding by relevant laws in order to maintain and increase the value of stateowned financial assets in its wholly owned subsidiary—Central Huijin.

CIC focuses its overseas investment mainly on equity, fixed-income, and alternative assets. CIC will allocate assets prudently and effectively at acceptable risk tolerance.

CIC has established its preliminary system of investment decision-making, internal control, and risk monitoring and management. CIC has established a risk management structure in order to ensure legitimate, compliant, sound, and prudent operation.

III. India’s Forex Management:

After the East Asian crises of 1997, India has followed a policy to build higher levels of FER that take into account not only anticipated current account deficits but also liquidity at risk arising from unanticipated capital movements. Accordingly, the primary objectives of maintaining FER in India are safety and liquidity; maximizing returns is considered secondary. In India, reserves are held for precautionary and transaction motives to provide confidence to the markets, both domestic and external, that foreign obligation can always be met.

The conservative strategy adopted in the management of FER has implications for the rate of return on investment. Forex Investments are being made in foreign government securities (with maturity not exceeding 10 years), and the deposits are placed with other central banks, international commercial banks, and the Bank for International Settlement following a multicurrency and multi-market approach. The direct financial return on holdings of foreign currency assets is low, given the low interest rates prevailing in the international markets.

· Opportunity Cost:

However, the low returns on foreign investment have to be compared with the costs involved in reviving international confidence once eroded, and with the benefits of retaining confidence of the domestic and international markets, including that of the credit rating agencies.

Should India start a SWF?

The main policy rationale behind setting up a SWF is not to acquire strategic assets and secure supply of natural resources, as proposed by New Delhi. Such funds are established to manage excessive foreign exchange reserves, commodity exports, the proceeds of privatizations and fiscal surpluses. For instance, China established its SWF, China Investment Corporation, with a $200 billion corpus to manage its excessive forex reserves, which reached 2.4 trillion by end-June 2010.

SWFs help in diversifying and improving the return on a country's foreign exchange reserves or commodity revenues. Like central banks, SWFs deploy surplus forex reserves; but since SWFs are set up to diversify investment, they undertake long-term investments in illiquid and risky assets, whereas central banks typically undertake short-term investments in low-yielding liquid assets, such as government securities and money market instruments.

Unlike China and other East Asian countries, which have established such funds on sustained current account surpluses, India has been running persistent current account deficits. Its current account deficit touched $29.8 billion in fiscal 2009 as against $15.7 billion in fiscal 2007. Unlike West Asia, India does not have any dominant exportable commodity (such as oil or gas) so as to generate significant surpluses. It continues to be a huge net importer of oil and gas. The country's current account deficit is widening despite steady growth in software services exports and a rise in workers' remittances from overseas Indians.

Its persistent current account deficits have been financed by large capital inflows in the form of portfolio investments and other volatile capital flows that are subject to capital flight. Given the overriding presence of volatile capital flows in India's forex reserves, coupled with vulnerability to external shocks, it would be erroneous to consider its foreign exchange reserves ($280 billion) as a position of strength

India's external debt has been rising steadily for the past few years on account of higher borrowings by the Indian companies and short-term credit. Besides, India also runs a perennial fiscal deficit which means that raising substantial money for sovereign fund from budgetary allocation would be extremely difficult.

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