The Great Debate

from MacroScope:

Central banks should hedge: Gary Smith

Gary Smith, head of central banks, supranational institutions and sovereign wealth funds at BNP Paribas Investment Partners, has written a special guest blog for Macroscope in which he argues that central banks should consider ways to hedge their FX reserves against the crisis.

"After the 2008 crisis, a mathematical approach to measure the adequate level of foreign exchange reserves – import cover or an equation relating to short-term debt – no longer has much credibility. In the absence of sensible guidelines on adequacy of reserves there is now a general desire to have plenty of reserves.


What is lacking from the reserves debate, however, is whether National Wealth Managers in general (and central bank reserves managers in particular) should invest in assets that might increase in value during a crisis.

The traditional approach of investing in short dated, high grade government bonds is based on the desire to be in safe and liquid assets, which is logical enough. However during a crisis, it is not the stable value of the assets in which reserves are invested which is of interest to the currency speculators, but the pace at which reserves are being spent to defend the value of the domestic currency. Foreign exchange reserve managers do not invest in assets which might appreciate during a crisis for two probable reasons, firstly these investments would be based on the use of derivatives, and secondly such a strategy, as with any insurance policy, would require the payment of premiums. But perhaps using a small proportion of the many monthly increases in the value of foreign exchange reserves to help insure against the intense pain that can be created during a crisis might make some sense?

reservesThis chart shows the monthly change in Asian foreign exchange reserves in each month during a 15 year period 1995-2010. In most months (73%) foreign exchange reserves increased, usually by a small increment. What is also clear is that although months in which reserves fall are considerably less frequent, a fat-tail decline can be debilitating for the NWMs, and indeed for the nation.

from Funds Hub:

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