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Report on the Investment of Israel's Foreign Exchange Reserves in 2011
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The annual report on the investment of Israel's foreign exchange reserves for 2011 was published today*, the following are the main points in the report:
  Israel's foreign exchange reserves increased by $4 billion in 2011, compared with an increase of $10 billion in the previous year and at the end of 2011 they amounted $74.9 billion.[1] The increase in the reserves this year, similar to the increases of the preceding three years, was primarily the result of foreign currency purchases by the Bank of Israel.
  The financial global crisis highlighted the importance of holding a high and adequate level of reserves.
  The rise in the level of Israel's foreign exchange reserves in 2011 increased the ratios between the reserves and various aggregates in the economy which are customarily used as the basis for assessing the adequacy of the level of the reserves. Increasing these ratios strengthens the resilience of the economy in the face of crises, and improves Israel's international financial standing. Compared with other countries, Israel's level of reserves relative to most of these aggregates is above the median of both advanced and emerging economies.
  This year, the holding period rate of return on the reserves, in terms of the numeraire, was 1.3 percent, compared with 3.3 percent on average between 2002 and 2011. This return, similar to that of the previous year, was affected to a large extent by a low level of interest rates and yields to maturity in financial markets, and by continued management of the reserves with a shorter duration than in previous years. The decision to manage a shorter duration was based on the high risk of earning a negative rate of return on the reserves, if yields to maturity were to rise from their low level. A central bank's risk profile is a unique one, as it is based on the objectives of holding foreign exchange reserves. Thus it demands a very conservative investment management policy, which of course has an impact on the rates of return.
  The holding period rate of return on the reserves in shekel terms was high and positive this year, at 7.8 percent, the effect of a weakening shekel against the other currencies in the numeraire, mainly the dollar and euro.
  The investment of some of the reserves in currencies and assets of a number of advanced economies characterized by strong economic fundamentals, which are not included in the numeraire and the benchmark, continued and even expanded throughout the year. The reason for diversifying the investment, currency-wise and asset-wise, to additional countries was the desire to improve the risk-return ratio of the reserves portfolio.
  The active management contribution in 2011 was 21 basis points, similar to the average in the past decade. The main component of the contribution of active management this year, similar to the year before, was derived from the investment of the reserves in countries whose currencies and assets are not included in the numeraire and the benchmark. These investments yielded excess return over the benchmark assets, primarily because the level of interest rates in those countries were higher than the interest rate levels in countries that comprise the benchmark, and also because they were managed with a longer duration.
  The main focus this year was the debt crisis in Europe, which spread and intensified over the course of the year, accompanied by widespread credit rating cuts of countries and banks across Europe and beyond. These developments threatened the foundation of the Euro bloc, and presented a real threat to its continuation in its current form, and to the stability of the entire global financial system. The deterioration in credit quality of government issuers and large financial institutions around the world, which until recently were considered relatively safe from bankruptcy, narrowed the traditional investment space of reserves managers worldwide, and increased the risks to which they are exposed. Within the framework of compliance regulations, which had been tightened since the beginning of the crisis in 2008, the Bank of Israel continued to take additional steps to reduce the exposure of the reserves to countries whose macroeconomic situation was deteriorating.
  The establishment of the Monetary Committee, in October 2011, in accordance to the new Bank of Israel Law, enhanced the decision making procedures related to managing the reserves. In addition, the application of the new law removed the legal obstacles that in the past had prevented the investment of the reserves in certain financial assets, which the Bank considered worthwhile economically and appropriate with regard to risk management. Since the new law became effective, the Bank has been expanding the types of assets in which it invests and as part of that process, in early 2012, the Bank invested, for the first time, two percent of the reserves in the US stock market. Concurrently, the Bank continues to study how to identify and choose the appropriate ways of using the additional degrees of freedom that the new law grants it in selecting the assets in which to invest.
* The Hebrew version of the report was published today. The English version will be available within several weeks.
1 The level of the reserves includes allocations of Special Drawing Rights by the International Monetary Fund to member countries (SDR Allocation) and Israel's balance of the Reserve Tranche of the Fund. At the end of 2011 these reached $1.8 billion, compared with $1.6 billion at the end of 2010.