Ajith Nivard Cabraal: Foreign exchange reserve management
Inaugural address by Mr Ajith Nivard Cabraal, Governor of the Central Bank of Sri Lanka, at
the SAARCFINANCE seminar on Foreign Exchange Reserve Management, organised by the
Centre for Banking Studies of the Central Bank of Sri Lanka, Colombo, 15 August 2008.
* * *
Deputy Governors, Director of the CBS,
My dear friends,
1. I am pleased to participate at the opening ceremony of this SAARCFINANCE
seminar on foreign exchange reserve management. I also welcome all
participants to this course and extend to the participants from the central banks of
our neighboring countries, our resource persons from BIS, Deutsche Bank group,
Citigroup and Reserve Bank of India, a very warm welcome to our country as well.
2. At the 17th SAARCFINANCE Governors' meeting held in Washington in April 2008,
it was decided to organize a seminar in foreign exchange reserve management. It
was also decided that the Centre for Banking Studies (CBS) in Sri Lanka, with its
over 26 years of experience in training and developing financial sector
professionals, together with the International Operations Department of the CBSL,
should host this seminar, so as to provide a forum within the region to discuss
the latest challenges facing the managers of sovereign reserves at present.
3. My dear friends, foreign exchange reserve management has gained increased
importance in Central bank activities in the recent past, due to two factors.
Firstly, due to the phenomenal rise in reserve holdings of central banks, in our
region, and secondly, due to the intensive public scrutiny that reserve
management has attracted as a result of the significant increase of foreign
reserves in the national wealth of countries in our region.
The drivers of this sharp rise in reserves are many. High commodity prices, increase
of exports of natural resources, and increased remittances, have been among the
main contributors to this situation.
Consequently, many countries have been able to systematically accumulate large
foreign exchange reserves over the past few years, and, in a way, reserve
accumulation is now possible, not only for the wealthy industrialized countries, but
for the so-called developing countries as well.
4. However, these reserve accumulation has not been without pain.
In fact,
developing countries, being those still requiring improvements in their
domestic infrastructure and other systems, have found that the increasing of
This
their foreign exchange reserves has resulted in a huge opportunity cost.
is particularly so because the funds collected in the form of foreign exchange have
been generally applied to acquire low risk, low-return investments, mostly in fixed
income securities in industrialized countries. This situation has indirectly led to such
funds being used to fund the huge fiscal deficits of several Western countries, or the
expansion plans of their large corporations, instead of being utilized for domestic
infrastructure, which, on most occasions have been funded with high cost loans from
those very same countries.
This situation therefore, suggests that there must be now some innovative
rethinking, about this process of reserve management. It should also prompt the
reserve managers of the reserve accumulating countries to look beyond their
traditional methods, and intensely search for new avenues for performance
enhancement.
1. The philosophy in reserve management in our region has been historically based
upon a very conservative approach which focuses on managing foreign exchange
reserves, by limiting investment decisions to very low risk, very low return,
highgrade instruments.
Perhaps, as a result, there has been no significant cross investments of
foreign exchange reserves within the countries in the South Asian Region. Of
course, there is evidence of mostly concessional loans or similar types of direct
investments, but not in the case of traditional financial investments, issued by our
respective countries.
It may therefore, be useful for those of us in the South Asian Region,
particularly in the context of SAARC, to explore the possibilities of cross
investment in financing instruments within our own Region. In that way, we
would be able to shift and retain capital in this Region, which can then be
applied in the development of our own Region.
My dear friends, we speak of regional cooperation in lofty terms. We speak of our
historical ties. We speak of our shared destinies. We speak of our common culture.
But, we have still not been able to truly cooperate in this field of reserve
management, and it is perhaps time for us to take the preliminary steps to move
towards such practices in the foreseeable future. It may be controversial. It may
pose some new challenges. But, explore, we must. So, I hope you would also start
thinking about this new philosophy as well.
2. My dear friends, achieving higher returns, given the current financial turmoil
and other factors associated with it, is a challenge faced by many central
banks today. The manner in which central banks respond to this challenging task of
reserve management has also, had to change rapidly to meet with these new
conditions. In fact, it is seen now that central banks have started to gently move
away from traditional asset classes like the government Treasury Bills to more
sophisticated asset classes. With this development, we now witness changes in
the asset portfolios of central banks in the current context, since Central
Banks have moved into more dynamic instruments to achieve its return
objective within certain acceptable risk parameters. Consequently, gold and
Treasury bill holdings traditionally held by central banks are now being challenged
by investments like derivative products, securities lending and securitised products,
and this trend opens out a new canvas for the reserve managers of central banks.
3. The experience of the financial market turmoil has led to fresh new challenges as
well, which are quite formidable. At one time, mortgage backed and asset backed
securities of government owned or government sponsored agencies, were
considered good alternatives for the generation of added spreads for central banks.
However, today, the market fluctuations and credit concerns arising from the
mortgage and housing market crises due to overall market downturns and
increased mortgage defaults in developed countries, has exposed new
vulnerabilities and risks attached to such investment avenues. As a result, the
vital importance of managing risks associated with reserve management have been
increasing exponentially in recent times.
4. That development will lead us to another important aspect in this discussion. In the
past, measuring risk was mostly based on credit ratings. For this purpose, the
yardstick for measurement was usually provided by the rating agencies who were
supposed to rate countries and institutions in accordance with certain
predetermined norms. However, it is now clear that the rating agencies on whom
we relied heavily to provide us with independent assessments of the standing
of institutions and instruments, have obviously failed to warn of possible
weaknesses in the balance sheets of such institutions and investment
houses. In fact, perhaps unwittingly, they may have even contributed to the turmoil,
by their ratings of pooled assets with large vulnerabilities, as assets of prime class.
This may have been due to the weaknesses in their approaches, the lack of proper
skills or the weaknesses of their governance frameworks. But, whatever may be the
reasons behind these failures, the challenge that we now face is as to how to
manage risks optimally in this even more challenging environment, knowing that the
opinions provided by the rating agencies may not be too accurate, after all.
5. Let me now highlight another couple of recent developments. One such
development is the greater significance of the sovereign wealth funds in the
context of the phenomenal rise in reserves in non-Western countries. In the
midst of the recent sub prime crisis, these funds have injected significant amounts of
long term funds to the large ailing institutions to resurrect them or to prevent them
from continuing with poor financial health. In that sense, the sovereign funds have
acted as an immensely useful stabilizing force during the financial crisis. However,
the injection of such funds has been received with mixed feelings in the geo-political
context. I would think the debate on this development is just beginning and it would
be useful for all of us to carefully watch the movement of this issue in time to come.
Another important development in reserve management is the extensive use
of external fund managers. External fund managers are being increasingly
engaged by central banks, as many central banks are yet to acquire the technical
skills and competencies required to manage the new asset classes that are
developing in these dynamic market conditions. I would think this factor too, would
be one that we would have to give a lot of attention in the future, and as to how we
make use of such expertise without compromising central banks' core objectives,
would be a challenge for all of us.
6. My dear friends, given the importance of reserve management, it is timely to
organize a seminar on this subject. When reading through your program, I realized
that the organizers and the resource persons have done remarkably well in selecting
the topics to be covered. In my view, the topics and presentations are just the
right blend that a reserve manager would wish to focus on, in this day and
age.
Finally, let me take this opportunity to sincerely thank the resource persons who
have accepted our invitation to share their knowledge and experiences on various
subjects relating to reserve management, the Central banks of our member
countries for showing high interest in this program, our own CBS for organizing this
event, and I wish that all of us could benefit significantly from the program.
I wish this seminar all success.