The Management of Foreign Exchange Reserves: Balance of Payments and External Debt Considerations, The Case of Israel

The Israeli government borrows internally and externally, and the Bank of Israel invests the foreign exchanges in various currencies. The borrowing interest rate is generally higher than the lending rate. In addition, the reserves are invested in relatively short-maturity safe assets, while borrowing is for relatively long maturities. This paper studies the structure of the government’s external debt in relation to the structure of the reserves held, and the duration risk of total assets and liabilities. We analyze the performance of the reserves portfolio relative to other benchmark portfolios, and show that the Bank of Israel could have greatly improved its performance had it invested in more risky assets. We also discuss the agency cost involved in reserves management. The Maurice Falk Institute for Economic Research in Israel Jerusalem: October 1998 • Discussion Paper No. 98.07 Management of Foreign Exchange Reserves with Balance-of-Payments and External Debt Considerations: The Case of Israel* Introduction The Israeli government borrows both internally and externally, and invests its foreign exchange reserves in various currencies. External borrowing is usually at higher interest rates than the interest the Bank receives on its reserves. This cost is offset by the benefit of holding reserves that can be used not only for emergencies, but also allows firms, citizens and the government to conduct transactions with foreign entities. In addition to the cost inherent in the differential interest rates, there may also be an interest rate risk exposure. This risk arises in the absence of maturity matching (or, more precisely, duration matching) of the reserve’s cash inflows and outflows. Since the government’s future needs are not specified in terms of a single currency, there is also a conceptual problem of defining the risk exposure, i.e., determining the numeraire in measuring the risk. Another problem arises from the division of labor between the Bank of Israel and the Treasury. The former manages the reserves while the latter manages the external debt. The purpose of the present study is to analyze the structure of Israel’s official government external debt in relation to the structure of reserves held. We then assess the performance of foreign exchange reserve management by the Bank of Israel in comparison with various benchmark portfolios. More specifically, our analysis of foreign exchange reserve management tests the long-run performance of portfolios that include stocks as an alternative to the less risky portfolio held by the Bank of Israel. We also suggest a method of deriving the currency composition of a minimum variance portfolio for the reserves, which may serve as a benchmark portfolio for assessing the Bank’s risk-return characteristics. * The authors are grateful for the research assistance of Yoel Hecht.