Executive Summary

Directors expressed strong support for exploring in more detail the possibility of establishing the Investment Account (IA) during the March 2005 seminar on the Review of the Fund’s Finances and Financial Structure. The Second Amendment of the Fund’s Articles of Agreement which became effective in 1978 authorized the Fund to establish an IA in the General Department. That authority has yet to be exercised.

Incremental income could be generated by investing the Fund’s reserves. The opportunity cost of the resources that could be invested is equal to the SDR interest rate, since these balances are currently used to lower the Fund’s remunerated positions. The impetus for seeking to establish the IA at this time stems in part from the accumulation of sizeable Special and General Reserves—totaling SDR 5.7 billion—whose investment could generate additional income for the Fund.

The investment objective of the IA would be to exceed the return on the SDR interest rate over time while minimizing the frequency and extent of negative returns and underperformance over a 12-month investment horizon. The assets of the IA would be invested in a portfolio that would include the domestic government bonds of the euro area, Japan, the United Kingdom, and the United States, as well as the bonds and other marketable obligations of eligible national and international financial organizations, and deposits with the Bank for International Settlements (BIS).

The IA portfolio would be managed against a 1–5 year bond benchmark weighted to reflect the currency weights of the SDR basket. Our analysis of the historical returns of bond portfolios of various maturities suggests that a 1–5 year bond benchmark has risk and return characteristics in line with the IA’s investment objectives. This benchmark has generated a higher return than the SDR interest rate under most market conditions, while offering higher risk-adjusted returns than the alternative benchmarks considered. The investment policy planned for the IA is similar to that pursued by a number of central banks and other reserve managers.

The proposed investment strategy for the IA is also similar to that already in place for the investment of SDA, PRGF, and PRGF-HIPC resources. Prior to April 2000, the assets of the SDA and the PRGF and PRGF-HIPC Trusts had been invested in six-month SDR-denominated deposits with the BIS. Since the adoption of a new investment strategy in April 2000 through end-June 2005, the return on the SDA, PRGF and PRGF-HIPC assets has added an annual average of about 81 basis points, net of fees, over and above what would have been achieved if the assets had remained invested in six-month SDR-denominated deposits with the BIS. It is hoped that the IA would be able to earn a similar level of excess returns over time.

The IA will build on the existing organizational structure for the SDA, PRGF, and PRGF-HIPC resources, thus limiting the budgetary impact of its activation. It is anticipated that 1½ additional staff positions in FIN would be required to handle the increased investment volume and the associated reporting requirements.

Based on the views expressed by Executive Directors on the general modalities for the IA and their risk-return preference, staff will prepare a paper covering implementation issues, including proposed decisions. Issues for consideration are presented in Section VII.

I. Introduction

1. During the March 2005 seminar on the Review of the Fund’s Finances and Financial Structure, Directors discussed a range of issues relevant to the Fund’s finances. Specifically, with the aim of broadening the Fund’s income base, Directors expressed strong support for exploring in more detail the possibility of establishing an investment account, into which currencies held in the GRA could be transferred for immediate investment. Many Directors also noted the need to adopt a prudent investment approach based on carefully developed risk guidelines.

2. Consideration of the establishment of the IA is taking place in the broader context of the Review of the Fund’s Finances. The financial benefits of starting the IA’s operations stand on their own, although the IA has interlinkages with a number of other financial policy issues, such as financial risk assessments, the overall structure of charges and the financing of Fund operations. This paper discusses issues regarding the operation of the IA, but no decisions for its activation are proposed. Following discussion of this paper, a paper containing operational decisions could be presented to the Executive Board. The Executive Board will have an opportunity to discuss the adequacy of precautionary balances, in connection with an assessment of the financial risk, shortly after the Annual Meetings. On charges and maturities, in follow-up to the Board discussion in June, staff will build on existing work by exploring further the options for aligning surcharges on a level- and/or time-based system and will return to the Board with a staff paper in due course.

3. This paper is structured as follows. The paper reviews the IA’s precursors and the rationale for its authorization at the time of the Second Amendment of the Fund’s Articles of Agreement (Section II), identifies the key decisions and actions needed to establish and fund the IA (Section III), specifies the investment authority and the range of eligible securities and investment strategies of the IA (Section IV), explains the rationale for the investment strategy and guidelines planned for the IA (Section V), and considers how the assets and earnings of the IA may be applied (Section VI). The next steps in activating the IA and issues for consideration by Executive Directors are set out in Section VII. How the operation of the IA would affect the Fund’s income and financial statements is considered in Annex I. An analysis of the risk and return characteristics of alternative investment strategies is provided in Annex II.

II. The Investment Account’s Precursors and Rationale

4. The Fund has undertaken investments to broaden its sources of income in the past. These investments were made before the authorization to establish an IA was included in the Articles of Agreement. In 1956, the Fund initiated an investment program under which gold was sold to the United States for the purpose of investing the proceeds in U.S. treasury bills (Box 1). These investments were made to offset the deficit that had accumulated as income regularly fell short of expenditure in the early years of the Fund’s operations. The investments were continued after the deficit had been cleared and were accumulated in a Special Reserve. Further administrative deficits were to be written off first against this Special Reserve. The investment program in U.S. treasury securities of various maturities was continued through 1972, but terminated in 1972 on concern that a change in the par value system that pegged the price of gold in dollars would expose the Fund’s investments to exchange risk.

5. The Second Amendment of the Fund’s Articles of Agreement authorized the Fund to establish an IA to broaden the sources of Fund income and protect its capital.¹ The experience of previous administrative deficits helped motivate the amendment to authorize the establishment of an IA. This experience highlighted the desirability of accumulating reserves to strengthen the Fund’s ability to absorb net income shortfalls and other contingencies, and of diversifying the Fund’s sources of income.

III. Establishment and Activation of the Investment Account

6. The reasons for authorizing the establishment of the IA at the time of the Second Amendment—the desirability of increasing the Fund’s resilience and expanding its sources of income—remain salient.² A number of steps are required to establish and make the IA operational (Table 1).

Table 1.

Steps to Activate the Investment Account

Table 1.

Steps to Activate the Investment Account

Decisions		Required Majority/Action
1. Establish the Investment Account (IA)		Majority of votes cast
2. Fund IA from:
	● profits from gold sales	85 percent majority of total voting power
	● transfer of currencies in the GRA	70 percent majority of total voting power
3. Transfer currencies from GRA		Provision for transfer to be included in Financial Transactions Plan
4. Use of member’s currency to make investments		Consultation with member
5. Adoption of IA rules and regulations		70 percent majority of total voting power

View Table

Table 1.

Steps to Activate the Investment Account

Decisions		Required Majority/Action
1. Establish the Investment Account (IA)		Majority of votes cast
2. Fund IA from:
	● profits from gold sales	85 percent majority of total voting power
	● transfer of currencies in the GRA	70 percent majority of total voting power
3. Transfer currencies from GRA		Provision for transfer to be included in Financial Transactions Plan
4. Use of member’s currency to make investments		Consultation with member
5. Adoption of IA rules and regulations		70 percent majority of total voting power

Key decisions to establish and activate the Investment Account

7. The decision to establish the IA may be taken by a majority of the votes cast. The funding of the IA may be derived from two main sources: the transfer of currencies from the GRA, or transfer of profits from the sale of gold held by the Fund on the date of the Second Amendment. The maximum amount that may be transferred from these sources to the IA is limited to the level of General and Special Reserves held in the GRA. The IA would initially be funded through transfers of currencies from the GRA. Such transfers would require a decision adopted by a 70 percent majority of the total voting power. Funding through the transfer of profits from gold sales would require a decision taken by an 85 percent majority of the total voting power. The IA may retain income generated from its investment activities without limit. This income as well as the proceeds of securities sold and of maturing securities may be reinvested by the IA.

Funding the Investment Account

8. The IA would be funded through the transfer of currencies from the GRA. As discussed in greater detail in Section V, the funding of the IA would be phased over time to avoid concentrating its initial investments at a particular level of yields. The transfer of currencies from the GRA would not change the Fund’s total assets and liabilities or the level and composition of its reserves. However, the transfer would change the composition of the Fund’s currency holdings in the GRA. On the asset side, the Fund’s holdings of some members’ currencies in the GRA would be reduced while currencies held in the IA would be increased. On the resource side, reserve tranche positions of some members would increase and the Fund’s usable currency resources would decline by the amount transferred to the IA (Annex I).

9. The transfer of currencies from the GRA would be undertaken through the Financial Transactions Plan (FTP) in accordance with existing procedures and principles. The funding of the IA would increase the reserve tranche positions of creditor members, who would acquire a liquid claim on the Fund in exchange for the investment of the Fund’s holdings of their usable currencies. These reserve tranche positions would be remunerated at the SDR interest rate.

10. It would be necessary to secure the concurrence of members whose currencies are used to make investments. In order to minimize currency risk, such transfers would be in the currencies included in the SDR basket (see Section V below). Thus, the concurrence of the countries in the euro area, Japan, the United Kingdom, and the United States would be needed.

IV. Investment Authority and Range of Eligible Investments

11. The investment authority of the IA is specified in Article XII, Section 6(f)(iii) of the Fund’s Articles of Agreement:

The Fund may invest a member’s currency held in the Investment Account in marketable obligations of that member or in marketable obligations of international financial organizations. No investment shall be made without the concurrence of the member whose currency is used to make the investment. The Fund shall invest only in obligations denominated in special drawing rights or in the currency used for investment.

12. The investment authority is quite restrictive and identical to the provisions of the Articles that address the investment authority for SDA resources. Decisions and interpretations that have been taken with respect to the investment of SDA resources are thus relevant in the IA context. As noted in the Commentary to the Second Amendment, eligible IA investments include income-producing and marketable obligations of the members whose currencies are used for the investment (including the obligations of their central banks and official agencies) denominated in its currency or SDRs. Eligible IA investments also include income-producing and marketable obligations of international financial organizations such as the World Bank, the European Investment Bank, regional development banks, and the Bank for International Settlements denominated in the currency used for investment or in SDRs.

13. The investment authority poses practical problems and limits the scope to add value. The range of ineligible securities encompasses many that are commonly included in the investment portfolios of central banks and other reserve asset managers. For example, derivative securities and most credit spread products such as most U.S. agency securities, corporate bonds, and swaps would not be eligible investments for the IA, as the issuers of such instruments do not qualify. As discussed in greater detail below, credit instruments that are obligations of eligible issuers, such as the medium-term instruments of the BIS, represent one of the few ways in which the IA would be able to try to add value by taking credit exposure.

14. The legal authority does not impose any limit on the currencies in which eligible securities may be denominated (other than being denominated in the currency used for investment or in SDRs). However, in order to minimize exchange rate risk, the benchmark planned for the IA portfolio would be based on the SDR. The IA would be invested in securities denominated in SDRs or in the constituent currencies of the SDR with the latter weighted to reflect the share of each currency in the SDR basket.

15. There is some merit, however, in considering whether in future currencies other than those included in the SDR basket could be included in the IA’s portfolio. Doing so would broaden the range of eligible investments and, in particular, create the possibility to capture the higher credit spread that may be available on such securities. However, such investments would need to be strictly limited as they would entail an unhedged currency exposure. In addition, in order to avoid any potential conflict of interest or appearance of impropriety, decisions on such investments would need to be delegated to external investment managers operating within agreed guidelines clearly removing Fund staff from decisions to buy and sell particular securities denominated in currencies not included in the SDR basket.

16. Despite the restrictive investment authority, the Fund’s experience of investing SDA, PRGF and PRGF-HIPC resources and past bond market performance suggest that a judicious extension of duration from the SDR interest rate has the potential to add value, albeit at the cost of a higher level of return volatility.

V. Investment Strategies and Implementation

17. There are a number of parallels between the IA and the assets of the SDA and the PRGF and PRGF-HIPC Trusts, which currently total SDR 9.6 billion.

• The IA and the SDA have identical investment authorities.

• Both sets of portfolios would have similar investment objectives. While the investment strategy for SDA and PRGF and PRGF-HIPC assets aims at exceeding the six-month SDR interest rate in most market conditions,³ the strategy envisaged for the IA would aim at exceeding the (three-month) SDR interest rate.

• Given the similar investment authorities and objectives, the range of securities included in the IA portfolio would be similar to those in which the assets of the SDA, the PRGF, and PRGF-HIPC assets have been invested.

• The approach to controlling currency risk would also be similar in each case.

• Finally, the same administrative arrangements adopted for the investment of SDA, PRGF, and PRGF-HIPC assets would be followed in the case of the IA.

18. The assets of the SDA and the PRGF and PRGF-HIPC Trusts had been invested in six-month SDR-denominated deposits with the BIS prior to April 2000. In April 2000, these assets were shifted to a portfolio that consisted mainly of government bonds with an average maturity of about two years denominated in the constituent currencies of the SDR with each currency in the bond portfolio weighted to reflect the currency weights of the SDR basket. This average maturity was maintained through January 2002 when maturities were shortened in response to the increased risk of loss on the bond portfolio resulting from the low interest rate environment. The risk of loss has since declined, and the timing of an eventual extension of maturities is being considered, and would coincide with the investment of IA assets. Since its inception in April 2000 through end-June 2005, the investment strategy for the SDA, PRGF and PRGF-HIPC assets has added an annual average of about 81 basis points net of fees over and above what would have been achieved if the assets had remained invested in six-month SDR-denominated deposits with the BIS.

Investment objective and benchmark

19. The investment objective of the IA would be to exceed the return on the SDR interest rate over time while minimizing the frequency and extent of negative returns and underperformance over a 12-month investment horizon.

20. There is no guarantee that this objective would always be met. However, the investment strategy would seek to increase the likelihood of consistently generating incremental returns while minimizing the frequency and extent of performance shortfalls. The investment strategy planned for the IA is similar to that pursued by a number of central banks and other reserve managers. A similar strategy was also adopted for the management of the assets of the SDA, and the PRGF and PRGF-HIPC Trusts.

21. The staff analyzed the historical returns of bond portfolios of various maturities to identify a benchmark with risk and return characteristics in line with the IA’s investment objectives. The details of this analysis are provided in Annex II. The analysis illustrates the range of past outcomes generated by different bond portfolios under a variety of market conditions. It also gives an indication of the likely prospective risk and return characteristics of bond portfolios of different maturities. Over time, bond portfolios with longer maturities have generated higher returns than those with shorter maturities, albeit at the cost of increasing return volatility (Figure 1).

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Cumulative Bond Portfolio Returns and Probability of Monthly Returns, 1989–2005

Citation: Policy Papers 2005, 089; 10.5089/9781498331241.007.A001

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22. Of the benchmarks considered, the 1–5 year benchmark bond appears promising. This benchmark bond index has in the past exhibited a risk and return profile consistent with the IA’s investment objective.⁴ The interest rate sensitivity of the 1–5 year is somewhat higher than the 1–3 year benchmark index adopted for PRGF-HIPC assets at the time of the adoption of a new investment strategy for those assets in 2000.

23. In the past, the 1–5 year index has generated a higher return than the SDR interest rate under most market conditions, while offering higher risk-adjusted returns than the alternative indices considered. During the past period for which data are available, the 1–5 year index did not experience a negative return in any rolling 12-month period, although it has experienced negative returns in past quarterly and semiannual periods.

24. Over a two-year investment horizon, the 1–5 year index has consistently performed better than the SDR interest rate. However, its return did fall short of the SDR interest rate in about one fifth of the rolling 12-month periods over the last 16 years. Thus, while the index has a track record of adding value over time and in most 12-month horizons, some return variability should be anticipated. The variability of investment returns would increase that of the Fund’s income and may require compensating action. It is expected, however, that such short-term fluctuations would be compensated by higher returns over time.

25. The timing of the investment in line with the 1–5 year index would influence initial returns. In order to avoid undue concentration of exposure to market interest rates prevailing at a particular point in time, it would be desirable to phase the initial investment over time. The current low absolute level of interest rates and the low spread between the three-month SDR interest rate and the yield on longer maturities suggests the need for caution in determining the timing of an extension of maturities, further reinforcing the merits of undertaking a phased approach. As already indicated, similar considerations would apply to the extension of the maturity of SDA and PRGF and PRGF-HIPC investments.

26. The 1–5 year government bond benchmark index would be complemented by investments in medium-term instruments (MTIs) in a similar maturity range. MTIs are based on the AA-rated swap yield curve and are issued and custodied by the BIS. They typically provide a higher initial yield than investments in comparable government bonds, but are subject to risk arising from a widening of the credit spreads. The share of MTIs in the total portfolio would be adjusted in response to changing market conditions. Given the restrictive investment authority for the IA, MTIs are one of the few means available to attempt to add value by capturing credit spreads. Investments in MTIs were made successfully in the case of the Fund’s PRGF and PRGF-HIPC assets. Including MTIs in the IA’s portfolio has the potential to increase its risk-adjusted returns and to provide a limited diversification benefit. The IA’s portfolio would also include SDR-denominated deposits of various maturities with the BIS, although such deposits would in most cases be limited.

27. In sum, the assets of the IA would be invested in a portfolio that includes the domestic government bonds of the euro area, Japan, the United Kingdom, and the United States, as well as the bonds of eligible national and international financial organizations, MTIs, and deposits with the BIS. In addition, uninvested residual cash balances held by the bond managers would be swept by the custodian bank into short-term instruments that are consistent with the general investment authority to which the IA is subject. Under most conditions, these assets would be combined to provide a risk and return profile for the total portfolio similar to that of the 1–5 year benchmark index.

28. Investment managers will be encouraged to attempt to outperform the 1–5 year benchmark index. An investment benchmark provides an independent rate of return against which the performance of investment managers is measured. A benchmark defines the neutral position around which asset managers are expected to structure their portfolios. It thus embodies the investment objectives, constraints, and risk tolerance of the investor. The managers of IA assets would be given the latitude to deviate from this neutral position within predefined limits when they perceive opportunities to add value. These active management decisions would mainly include adjustments to the benchmark duration. Managers will be encouraged to adjust the duration of the portfolio around the benchmark index in response to changing market conditions.

29. Deviations from the benchmark duration could also be initiated in response to market conditions. In particular, such deviations would include the tactical shortening of the benchmark duration to preserve capital. Decisions on such tactical deviations from the investment benchmark would be based on an assessment of the probability of loss to the portfolio over a 12-month horizon, absolute yield levels and spreads, and yield volatility. As outlined above, such tactical changes have been applied to the assets of the SDA, and PRGF and PRGF-HIPC Trusts.

Investment benchmarks of comparable institutions

30. The tripling of official reserve assets over the past fifteen years has contributed to a number of changes in reserve asset management practices. With the rapid growth in reserves, there has been a tendency for reserve asset managers to increase the duration and broaden the range of assets included in their portfolios. Credit spread products represent an area of particular growth. Interest in credit spread products has been motivated as a source of diversification, and, in a low interest rate environment, a means to boost yields. There is also a view among asset managers that investments seeking to benefit from credit spreads are a more reliable source of adding value than those based on duration decisions.

31. The IA’s investment benchmark would fall well within the range of benchmarks adopted by central bank reserve managers (Box 2). As in the case of the IA, most reserve managers favor the shorter end of the yield curve, although some reserve asset managers have adopted benchmarks with longer average durations. The range of assets included in central bank reserve portfolios is typically broader—encompassing credit spread products such as U.S. agency securities, asset-backed securities, corporate bonds, and in some cases equities—all of which are precluded by the IA’s more restrictive investment authority. Many reserve asset managers use derivative securities to take or hedge positions.

32. The IA’s investment benchmark also appears broadly consistent with the investment policies pursued by other international organizations.

• The BIS has adopted a longer duration benchmark for its reserves (also denominated in SDRs) to capture the term premium of yield curves that are typically upward sloping. This benchmark, while likely to earn higher returns over time, is also subject to a greater risk of loss in the short- and medium-term than the benchmark selected for the IA. This risk of loss has prompted the BIS to consider tactical shortening of the benchmark in certain market conditions. The BIS manages portfolios for each of the constituent currencies of the SDR and rebalances these portfolios quarterly to limit currency exposure. Credit exposure encompasses investments in U.S. agencies, asset-backed securities, supranational bonds, and pfandbrief-type instruments (European mortgage-backed securities). Assets are subject to a minimum rating of AA, but EMU countries rated below this threshold are also eligible, within strict limits.

• The World Bank manages a number of bond portfolios for its own account and for others, including the Fund. While the duration of the benchmarks for these comparable portfolios is broadly in line with that selected for the IA, the Bank’s portfolios include a much broader range of credit spread products, reflecting the less restrictive investment authority for the Bank’s portfolios.

Implementation

33. The administrative arrangements for the investment activities of the IA would mirror those adopted for the investment of SDA, PRGF, and PRGF-HIPC resources. External asset managers—including the BIS, the World Bank, and private managers—would be entrusted with buying and selling individual securities in accordance with the IA’s investment guidelines and benchmark. The BIS would act as the custodian for the MTIs and deposits it provides. A private custodian bank would be charged with holding all other assets in safekeeping and providing consolidated reporting on the IA’s assets.

34. The external bond managers would be given the following mandate:

• Assets are to be actively managed and invested in income-producing and marketable obligations of the members whose currencies are used for the investment, including their central banks and official agencies, or of international financial organizations. Assets are thus to be actively managed and invested in the domestic government bonds of the euro zone, Japan, the United Kingdom, and the United States, as well as bonds issued by eligible international financial organizations in SDRs or a currency included in the SDR basket. Active management is expected to outperform the benchmark index, while limiting downside risk.

• The portfolio benchmark is a customized index comprising the Merrill Lynch 1–5 year government bond indices for the euro area, Japan, the United Kingdom, and the United States with each market weighted to reflect the currency composition of the SDR basket. Managers may invest in eligible securities across the maturity spectrum, so long as the sensitivity of the portfolio to interest rate changes remains in line with the benchmark index.

• Managers may operate with some latitude in a duration range of ±6 months around the benchmark. Provided that the total portfolio’s duration range and the prohibition on short positions (see below) are observed, there are no limits on the duration of the portfolio’s currency components.

• Investments may be made only in cash securities; positions in derivative securities are not permitted. There may be no short selling or any form of leverage.

• Foreign exchange risk is to be controlled through regular portfolio rebalancing aimed at keeping the weight of the euro, yen, sterling, and the U.S. dollar in the portfolio in line with their respective weights in the SDR basket. No currency hedging using derivatives is permitted.

35. In addition to the government bond portfolios managed by the World Bank and private investment managers, the IA’s assets would include MTIs and bank deposits with the BIS. Investments in these instruments would be made on behalf of the Fund by the BIS.

36. The custody arrangements currently in place for PRGF and PRGF-HIPC assets would be used for IA assets. Investments in MTIs and BIS bank deposits would be held in custody by the BIS. In the case of the IA’s other investments—the portfolio of government bonds and the bonds of eligible national and international organizations—the current custodian for PRGF-HIPC assets would be retained. The custodian’s chief responsibilities would include safekeeping assets, settling trades, capturing income, valuing assets, maintaining records, measuring performance, and monitoring compliance with established investment guidelines. It is also standard practice for the custodian bank to sweep idle cash balances into a short-term, income-generating fund whose investments are consistent with the investment authority to which the IA is subject. A small amount of residual cash balances would be so invested from time to time, a practice that has been followed in the case of PRGF and PRGF-HIPC investments.

Risk controls

37. The incremental return of the IA would be derived largely from extending maturities. Interest rate risk will thus be the main risk to which the portfolio would be exposed. In addition, the portfolio would take limited credit risk exposure mainly through investments in MTIs.

38. Interest rate risk—the risk of fluctuations in the portfolio’s market value due to changes in market interest rates—would be controlled by the 1–5 year benchmark index. As detailed in Annex II, this level of interest rate exposure has in the past provided an efficient tradeoff between risk and return, and resulted in returns that exceeded that of the SDR interest rate in most market conditions.

39. Limited currency risk would arise since the portfolio would include securities denominated in the constituent currencies of the SDR basket, rather than being limited to securities denominated in SDRs. To control currency risk, the weight of each currency in the portfolio would be adjusted to reflect its weight in the SDR basket. However, since such instruments will change in value over time and generate cash flows, the weight of each currency in the portfolio will differ slightly from the weights in the SDR basket, generating some residual currency risk and necessitating regular rebalancing of the portfolio. The experience of investing PRGF-HIPC assets has shown that this residual currency risk can be kept low and that the amount of rebalancing needed to contain currency risk is manageable.

40. Liquidity risk is judged to be small given the low likelihood of an unanticipated call on the IA’s assets and the inherently liquid nature of the planned investments, which would consist primarily of marketable short- and medium-term government securities.

41. Credit risk is similarly limited in a portfolio strategy that features BIS deposits, MTIs, the securities of highly rated international financial organizations, and the domestic government bonds of countries whose currencies are included in the SDR basket.

42. Operational risk, arising from errors or compliance failures, would be controlled by carefully structured due diligence reviews of external managers and custodians, the checks and balances provided by the reconciliation of portfolio valuation by managers and the custodian, and stringent performance measurement and reporting requirements.

Incremental budgetary costs

43. The IA would utilize the existing investment structure already in place for the SDA, PRGF and PRGF-HIPC resources. The Finance Department (FIN) would be responsible for the day-to-day administration of the IA’s investment activities, including: maintaining the official records of the IA; ensuring that the IA’s investment and other activities conform with the adopted rules and regulations; monitoring the structure and evaluating the performance of the total portfolio; hiring and firing external investment managers and assessing their performance; supervising custodial arrangements; evaluating the continued appropriateness of the investment policy and objectives and the portfolio benchmark; adjusting the allocation of the portfolio in response to market conditions and the Fund’s financing needs; undertaking short-term deviations from the investment benchmark in light of changing market conditions; preparing quarterly reports to Management and semiannual reports to the Executive Board on investment performance, compliance, and on changes in institutional arrangements. The IA would be subject to audits by the Office of Internal Audit and by the Fund’s external auditors.

44. The incremental budgetary costs to the Fund would be small. The required additional staff resources in FIN are estimated at about 1½ staff years, equivalent to about US$300,000 at current standard costs for A9–A15 staff positions. The incremental costs arising from external investment management and custodial fees would likely be no higher than the 7–9 basis point range incurred in the case of the assets of the SDA and PRGF and PRGF-HIPC Trusts. On investments of SDR 5.7 billion (US$8.3 billion), these fees would amount to about SDR 5 million (US$7.2 million) annually, and would be charged against investment income.

VI. Use of the Investment Account’s Earnings

45. The transfer of currencies from the GRA for investment by the IA has no impact on the overall balance sheet of the General Department (which includes the GRA, the SDA and IA, see Annex I). The Fund’s total assets, liabilities, and resources of the combined General Department are unchanged. The transfer of currencies to the IA also has no impact on the level or composition of the Fund’s reserves: the General and Special Reserves remain intact. However, rather than using the resources provided by the reserves to lower the balances that finance credit (reserve tranche positions), these balances would be invested.

46. The transfer of currencies from the GRA to fund the IA would thus increase members’ reserve tranche positions and the Fund’s remuneration expense. This increased cost would be offset to the extent that the IA’s earnings net of asset management and custodian fees exceed the SDR interest rate.

47. In order to avoid reopening the decisions taken in April 2005 concerning burden-sharing and the rate of charge, any additional remuneration cost arising during FY 2006 from the funding of the IA could be offset by IA earnings. The activation of the IA once established would thus not affect either the net income target or the margin for the rate of charge in the current (FY 2006) fiscal year.

48. The earnings generated by the Investment Account can be retained in the Account or used to meet the expenses of conducting the business of the Fund. The issue of how and when to use the earnings and assets of the IA in subsequent years would need to be considered in the context of the ongoing broader review of the Fund’s finances.

VII. Issues for Consideration

49. The Executive Board’s views are sought on the following issues:

• Do Executive Directors agree that the IA’s investment objective should be to exceed the return on the SDR interest rate over time while minimizing the frequency and extent of negative returns and underperformance over a 12-month investment horizon?

• Do Executive Directors consider that the 1–5 year benchmark index appears to strike a balance between risk and return that is consistent with the IA’s investment objectives, and would be an appropriate benchmark for the IA’s assets?

• Do Executive Directors agree that the administrative arrangements currently in place for the investment of SDA, PRGF, and PRGF-HIPC resources should be used in the case of the IA?

50. In light of the Directors’ views, the staff would develop a final set of investment guidelines, draw up rules and regulations for the IA, and establish an action plan for activating the IA. These proposals and the requisite decisions for activating and funding the IA would be presented to the Executive Board for adoption.