December 11, 2006	Monday	Ziqa'ad 19, 1427

Both theory and practice of foreign exchange (FX) reserve management have developed enormously over the last decade. The theory has developed to the point where the FX reserve management is now regarded as a distinct sub-field of the theory of finance and has become a separate subject in the master’s and the MBA programmes.

The subject has attracted a huge amount of intellectual energy not just from the finance specialists but also from the specialists in physics. The most important factor contributed to this transformation of the FX reserve management was, as mentioned in the beginning, the high level of instability in financial markets. The other factors were rapid developments in information technology, huge increase in trading activity and development of new financial instruments, namely, derivative instruments.

As a result of these developments along with the globalisation of financial markets, every country/institution is more exposed to changes in world economies and financial markets. This has led all institutions, including central banks to develop new processes in their organisations to manage risks in a more systematic way, although they had implicit risk management practice. Parallel to these developments in risk management, the practice of reserve management by most central banks has changed significantly over the last decade. Once characterised by passive short-term investment strategies to preserve principal value and maintain maximum liquidity, many central banks now use a broad range of instruments, extend their portfolio duration and develop performance benchmarks. These performance benchmarks however, need to be continuously monitored and changed with timely decision making in accordance with the changing market trends. Any delay in decision making process would lead to inefficient performance levels.

This increased attention to risk management and new approach to reserve management by central banks has come about not because of any change in the central bank missions, but because of the growing recognition that the conduct of core businesses inevitably involve exposure to financial risks and also because of an increased attention to the contribution of central bank profits to national treasuries.

Advances in financial risk management brought more scope for central banks to consider increasing their portfolio returns together with maintaining the desired level of liquidity, which is the primary target for central banks. In other words reserve management should seek to ensure that: (i) reserves provides funds for servicing external debt and liabilities; (ii) liquidity, market, and credit risks are controlled in a prudent manner; (iii) reserves are held as a defence against unforeseen emergencies or as a cushion against unanticipated exogenous shocks;(iv) reserves are used as a tool of exchange rate and monetary policy management; and (v) to enhance the FX income of the country by prudent reserve management.

In order to carry out the above mentioned objectives,the FX reserves, a national asset, need to be invested with relevant consideration given to safety, liquidity and return.

As Pakistan’s work on reserve management has progressed during the establishment process, we have seen that our reserve management needed to be restructured to have an efficient risk management. As late as 2000, Pakistan was plagued by the problem of low reserves and gigantic trade deficits. Or in other words liquidity and security management was the government’s main concern. Due to prudent policies, fiscal reforms etc., of the current regime, the situation in the country in the context of reserve management started to improve.

The gradual but persistent increase in reserves has taken place due to proactive monitoring and liaison with inter-bank market, effective exchange rate management, minimising the exchange volatility, wining back the confidence of investors, implementation of new computerised systems to keep complete track of FX cash flows and removal of abnormalities in the kerb market. These are some of the steps which eventually led to stabilisation, as well as improvement in the reserve situation during the present decade. The funds improved to such an extent that the State Bank of Pakistan decided to opt for outsourcing a portion of reserves in 2002.

FX reserve management via financial instruments vs inter-bank market investments: Even though things have improved, still it should be kept in mind that approximately 25 per cent ($2229.1 million) of Pakistan’s FX reserves are being held by commercial banks and an inefficient risk management strategy can see this high level of reserves deplete very quickly. Also, it is worth mentioning that an inter-bank market investment strategy eliminates the option of timely movements in the financial markets as inter-bank market investments are usually on a fixed and long term basis.

Very few banks qualify for AAA rating (given from international credit rating institutions such as Standard & Poors and Moody). For example, in Europe only Rabobank is an AAA rated bank. In case of prudent reserve management, an institution can not only deploy in upgraded securities better than banks but also off-load them in efficient two-way markets hereby achieving increased liquidity.

Selection of benchmark: It is very important that the benchmarks, created for reserve management are continuously monitored and altered according to changing market scenarios. For example, in a highly bullish market where international securities are increasing in price, it would be better to issue securities with shorter duration as one can afford to offer lower yields to the market. Similarly, in a bearish market, the government paper needs to be offered at a longer duration to attract the investors with greater yields.

Alpha generation in reserve management: There are three components of alpha generation to enhance the returns on underlying assets. It is needless to mention that a prudent fund manager would generate around two per cent to 2.5 per cent over the normal inter-bank placement which ranges between LIBID and LIBOR.

•Duration of a paper for liquidity purposes/duration based hedging: Duration adjustment on securities can be used as a useful tool for offering a variable rate of return.

In case of Pakistan, prudent duration based hedging would ensure that the duration of government paper is matched with the duration of current liabilities of the GoP. Once the durations of government securities and liabilities are matched, liquidity exposure will be hedged to a great extent in addition to extra return due to longer duration.

•Credit Risk: Higher credit rating would imply lower returns and vice versa. But in case of Pakistan, a sovereign fund manager can afford to diversify in friendly government securities even at BB+ to achieve higher returns and to have special arrangements to offload against any counter liabilities as per the netting arrangements.

•Currency diversification (don’t put all eggs in one basket): Holding the right portfolio of currencies is a key factor in managing the external debt of Pakistan. This is because having the right currency mix would ensure cost effective external debt management.

Having the Asset Swap Deal arrangements at the right time would ensure that currency holdings which might increase the debt burden of Pakistan could be off-loaded and replaced with currencies involving lower interest rates and better exchange rates.

Managing the FX reserves and external debt (a balance sheet approach): proposed model for Pakistan: For managing sovereign risk of government of Pakistan (GoP), a good option will be to manage the balance sheet involving assets and liabilities of GoP. In other words the cash flow generating units of GoP and the external and internal borrowings need to be managed via a single entity which can then develop an appropriate risk management strategy by taking both assets and liabilities into account.

Since in Pakistan, assets and liabilities are being managed by different institutions, it leads to a lack of co-ordinated policy to manage them efficiently. The solution to this problem is: the average duration of both the assets and liabilities is monitored and is then equated. This is known as the duration matching or portfolio immunization strategy.

This strategy would ensure that shifts in external factors such as interest rate movements etc., will have little if no impact on the value of the portfolio of assets and liabilities of the country. This strategy has already been implemented very successfully by the GIC Singapore who has utilised the Balance Sheet Approach for managing their assets and liabilities. In other words, the assets and liabilities are being managed centrally by a single government institution rather than a number of different government bodies.