MacroScope

Central banks should hedge: Gary Smith

August 10, 2010

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.

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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.

Imagine the power of being able to announce during a currency crisis that foreign exchange reserves had received a positive impulse from the successful crisis management strategy of owning call options on gold, or put options on the S&P500. When all the news is bleak, the desire to announce any type of good news is immense. Why doesn’t this prompt a more detailed exploration of strategies that might have a positive pay-off during a crisis? My many conversations with NWMs around the world suggest that the principal reason is that local politicians are unlikely to fully understand, and hence sanction such a strategy (a strategy that would not be without costs, i.e. in the 73% of months of rising reserves, some of the upside would have to be used in order to pay for the insurance protection). For many, the use of derivatives is associated with speculative attempts to capture asset price appreciation, rather than insurance against the downside.”

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