1. International financial crises in the late 1990s underscored the importance of disseminating comprehensive information on countries’ international reserves and foreign currency liquidity1 on a timely basis. Deficiencies in such information have made it difficult to anticipate and respond to crises by obscuring financial weaknesses and imbalances. (See Box 1.1) Moreover, both the complexity and the importance of such information have increased as a result of the ongoing globalization of financial markets and financial innovations. The international financial activities2 that countries’ central banks and government entities undertake now occur in myriad forms, involve multiple domestic and foreign entities, and span locations around the globe. To assess countries’ foreign currency liquidity requires supplementing traditional data on international reserves that cover largely cross-border and balance-sheet activities with those on foreign currency positions and off-balance-sheet activities.
58. This chapter provides guidelines to assist countries in reporting data on the authorities’ foreign currency resources (comprising reserve assets and other foreign currency assets) in Section I of the template. Items I.A.(1) through I.A.(5) are used to report information on reserve assets and item I.B., on other foreign currency assets. All items in Section I refer to outstanding assets (stock) on the reference date. As noted in para. 42, to facilitate liquidity analysis, it is recommended that information on special features of the reporting country’s reserves management policy and major sources of funds for reserve assets and other foreign currency assets be described in country notes accompanying the template data. To enhance data transparency, it is also important to indicate in country notes specific changes in the reporting country’s exchange rate arrangements (for example, the implementation of dollarization) and their impact on the level of the country’s reserve assets.
138. Section II of the template is used to report the authorities’ predetermined short-term net drains on foreign currency assets. “Predetermined” drains are the known or scheduled contractual obligations in foreign currencies. Contractual obligations of the authorities can arise from on-balance-sheet and off-balance-sheet activities. On-balance-sheet obligations include predetermined payments of principal and interest associated with loans and securities. (See also footnote 6 of the data template.) Off-balance-sheet activities that give rise to predetermined flows of foreign currency include commitments in forwards, swaps, and futures contracts.
180. Section III of the template covers contingent short-term net drains on foreign currency resources. As discussed in Chapter 3, net drains refer to outflows net of inflows. Contingent inflows and outflows simply refer to contractual obligations that give rise to potential or possible future additions or depletions of foreign currency assets. Contingent drains are by definition off-balance-sheet activities, since only actual assets and liabilities are to be reflected on balance sheets. Section III of the template differs from Section II because foreign currency flows to be reported in Section III are contingent upon exogenous events. As with predetermined foreign currency flows covered in Section II of the template, contingent flows can arise from positions with residents and nonresidents.
236. Section IV of the template provides supplementary information covering (1) positions and flows not disclosed in Sections I—III but deemed relevant for assessing the authorities’ reserves and foreign currency liquidity positions and risk exposure in foreign exchange; (2) additional details on positions and flows disclosed in Sections I—III; and (3) positions and flows according to a breakdown or valuation criteria different from those found in Sections I—III.
The foreign exchange market is the world’s largest financial market by virtually any measure. It is the only truly global financial market: currencies are traded in financial centers around the world, connected by communications systems that allow nearly instantaneous transmission of price information and trade instructions. The market has grown rapidly over the last decade since cross-border capital flows have been liberalized and the regulatory constraints on institutional investments relaxed. The increased liquidity of securities markets, particularly in the industrial countries, which has resulted from privatization and from larger and more efficient markets for government debt securities, has also increased the range of foreign assets available to investors and made foreign investment easier. This expansion of cross-border capital flows has been actively promoted by governments seeking broader investor bases for their own debt and for securities issued by domestic firms. Improvements in trading and settlement practices and in technology have increased the liquidity of secondary markets for foreign exchange instruments and allowed participating financial institutions to handle larger volumes of transactions safely.
Trading in the foreign exchange markets takes place for a variety of motives. This annex discusses three aspects of foreign exchange transactions: first, the arbitrage that links the forward and spot markets; next, the use of foreign exchange markets as “synthetic money markets”; and then the use of foreign exchange instruments to hedge foreign currency risk, which covers first the basic hedging techniques typically used by individuals and investors and then the dynamic hedging strategies typically used by banks to hedge exposure associated with issuing currency options. The consequences of these various strategies for foreign exchange market behavior are also examined.
The relaxation of capital and exchange controls and the acceleration of financial innovation have clearly encouraged competition among financial institutions and improved efficiency in financial services worldwide. Increased competition has also presented financial institutions with new risks-including those associated with losses on open positions and with losses resulting from settlement failures. These risks are increased by the speed with which prices change, by the delays inherent in covering exposures and settling trades, and by the extension of credit to counterparties with non-zero bankruptcy probabilities.