A basic guide to the process
Active management of reserves by central banks and a greater diversification of their reserve portfolios came into vogue in the 1970s. This process was fueled by the desire of central bank authorities to maintain the real value of their reserve assets, or at least to increase their nominal returns during a period when world liquidity was rising sharply. Producers of oil and other commodities found it necessary to better manage their increasing reserves during the 1970s, particularly in the face of wide fluctuations in interest rates and exchange rates.
The approach to the management of foreign exchange reserves by central bankers varies across the globe, ranging from a policy of benign neglect to detailed and highly mathematical calculations of alternative moves to reduce risk and increase profitability. Many developing countries still have not set up formal mechanisms to measure their reserve needs or set objectives for managing their reserves. This subject has not been widely studied in recent years, leaving many policymakers without much guidance on the issues behind this activity. To help fill this gap, this article provides a basic framework for setting and implementing a policy on managing foreign exchange reserves.
A country needs to hold reserves in order to prevent excessive short-term fluctuations in the exchange rate as a result of factors such as fluctuations in export receipts, import payments, and capital flows. Formulating a reserves management policy is essentially a three-step process entailing first, the adoption of an appropriate investment philosophy that is both prudent and profitable; second, the selection of currencies in the reserve pool (the currency mix); and third, the investment of the chosen currencies in suitable instruments in the various capital and money markets under appropriate portfolio management guidelines.