The Market Operations Department of the Bank of Israel Today* Publishes the 2010 Annual Report on the Foreign Exchange Reserves

The Market Operations Department of the Bank of Israel Today* Publishes the 2010 Annual Report on the Foreign Exchange Reserves
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Israel's foreign exchange reserves increased by $10.2 billion in 2010, compared with an increase of $17 billion in 2009, and at the end of December 2010 stood at $69.3 billion.[1] As was the case in the prior two years, the increase in the reserves this year was due mainly to the Bank of Israel's purchases of foreign exchange. The upward trend of foreign exchange reserves also continued in 2010 in other advanced economies and emerging market economies as well as in Israel, as the global financial crisis drew attention to the importance of maintaining an appropriately high level of reserves. The increase in the foreign exchange reserves in 2010 led to an increase in the ratios of the reserves to various aggregates which are customarily used to assess the adequacy of a country’s reserves. The high levels of these ratios strengthen the economy’s resilience to crises and improve Israel's status in the international financial environment, thus enhancing the Bank of Israel's ability to achieve its objectives as defined in the new Bank of Israel Law.
The holding period rate of return on the reserves in terms of the numeraire (the currency composition set as a benchmark for the reserves) was 1.2 percent in 2010, compared with an average rate of return of 3.8 percent in the years 2001–10. In terms of the shekel (NIS) the holding period rate of return on the reserves portfolio was negative, at –7.1 percent, as a result of the strengthening of the NIS against the dollar and the euro during the year. The number of currencies in the numeraire was increased in 2010 in order to obtain better diversification and to reduce the possible consequences of the financial crisis for the reserves in extreme scenarios. The rate of return in terms of the numeraire was affected by two major factors––the low rates of interest and of yields to maturity in the financial markets of the advanced economies, and the average duration of the reserves, which was shorter than in most of the previous years. The decision to shorten the average duration was taken in light of the high risk of receiving a negative holding period return which would be taken on by holding the reserves at a longer duration when interest rates and yields to maturity are so low. The active management contribution in 2010 was 10 basis points (b.p.), compared with an average contribution of 20 b.p. in the last ten years, but similar to that average if the exceptionally high contribution in 2009 is excluded. The main component of the contribution of active management in 2010 was that from the selection of assets in the portfolio, in particular the choice of short-term spread assets. It should be noted that this year the background conditions under which the foreign exchange reserves were managed were especially challenging in light of the fact that the global financial crisis entered a new phase, in which the concern of investors in the international markets focused on the uncertainty regarding the debt service capability of some EU member countries.
In March 2010 the Knesset passed the new Bank of Israel Law, which went into effect on June 1, 2010. The new Law defines the Bank’s objectives and functions, one of which is holding and managing Israel’s foreign exchange reserves. The Law changes the framework in which the main decisions are taken in the Bank, including decisions on the desired long-term level of the reserves and their investment policy. The Bank’s Monetary Committee, to be appointed in accordance with the Law, will play a central role in this process. As part of the Bank’s reporting responsibilities, the Law defines the periodic reports on the level of the reserves and their management that the Bank must present to the Minister of Finance, the government, the Knesset Finance Committee, and the public. The new Law removed the legal obstacles that had in the past prevented the investment of the reserves in certain financial assets which the Bank considered desirable investment channels, from the viewpoint of economic worth and risk management. Since the new Law became effective, the Bank has been studying how to identify and choose the appropriate ways of using the additional degrees of freedom that the new Law grants it in selecting assets for investment, including the possibility of investing in the global equity markets.
In 2010 the Market Operations Department advanced several special projects: (a) the implementation of an integrated treasury management computer system, which is expected to enhance and streamline the management of the reserves; (b) the establishment of a Bank of Israel Representative Office in New York; (c) preparations to meet the requirements of the new Bank of Israel Law, broaden the areas of activity as permitted by the new Law, and produce the reports as defined in the Law; and (d) the completion of the organizational restructuring process with the addition of the State loans management function to the Department.
* In Hebrew. The English version will be available within several weeks.
[1] The quoted level of the reserves does not include the IMF allocation to Israel of Special Drawing Rights (SDRs) or the balance of Israel's Reserve Trance in the IMF. At the end of December 2010 these two totaled $1.6 billion, compared with $1.5 billion at the end of 2009. For a broader discussion of this issue see the Bank of Israel Financial Statements for 2010.