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The COVID-19 crisis
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Due to the outbreak of the coronavirus pandemic, in 2020 there
was a sharp slowdown in real activity and an increase in risks worldwide. In
financial markets, this was reflected in steep declines in equity and
corporate bond prices and in a sharp decline in yields on government bonds
around the world, particularly in the US and Germany in the first quarter of
the year. However, over the course of the rest of the year, risk assets increased
in value and most ended 2020 with positive rates of return. During the year,
a sharp increase in volatility was seen in all financial assets.
The Bank of Israel, as a long-term investor, maintained
the share of investment in risk assets in the reserves portfolio while taking
various steps intended to minimize the financial risks to which it is exposed
through the investment in such assets. In addition, in view of a marked
deterioration in economic conditions in the domestic economy due to the
spread of the COVID-19 pandemic and the steps taken to halt it, the Bank of
Israel used a range of tools to aid in handling the crisis. Among other
things, the foreign exchange reserves were used for the first time and the
Bank began to execute swap transactions in the foreign exchange market with
the goal of supplying dollar liquidity to the domestic banks.
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Level of the reserves
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Israel's foreign exchange reserves were $173.3 billion at
the end of 2020, an increase of $47.3 billion over the course of the year,
compared with the preceding year. The level of the reserves relative to GDP increased
from 31.9 percent to 43.3 percent.
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Sources of the change in the reserves
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The increase in the reserves derived from foreign
exchange purchases totaling $21 billion by the Bank of Israel as part of the
implementation of the monetary policy, from the government’s deposits
totaling $14.6 billion, and from profits, revenue, and exchange rate and
price differentials (mark to market) totaling $11 billion.
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Composition of assets in the reserves
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At the end of 2020, 64 percent of the reserves were
invested in government assets, 15 percent in equities, 14 percent in spread
assets, and 7 percent in corporate bonds.
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Financial conditions
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From a full year perspective, financial markets were
supportive of the portfolio’s performance. The decline in yields to maturity
on government bonds, in parallel with an increase in the prices of risk
assets, equities, and corporate bonds, contributed to the return, while at
the same time an increase in risk was reflected in a sharp increase in
financial asset volatility.
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Return on the portfolio
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The rate of return on the reserves portfolio
in 2020 was 4 percent in terms of the numeraire, which is a basket of
currencies, primarily comprised of the dollar and euro. Over the past three
years, the rate of return has averaged 3.4 percent per year, and over the
past five years, it has averaged 3 percent per year (Table 1a).
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Table 1a
Rate of return on the foreign exchange
reserves portfolio, annual and multiyear perspectives, in
terms of the numeraire, annual terms
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2020
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3 years
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5 years
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Reserves
Portfolio return
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4.0
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3.4
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3.0
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Benchmark
return
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0.6
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1.1
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0.7
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Excess
return
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3.4
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2.3
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2.2
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Contribution of active management
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The contribution of active portfolio management, measured
by comparing the portfolio return with the risk-free portfolio (the basic
benchmark) return, was 3.4 percent in 2020. The main contribution to this was
from equities—1.8 percent, primarily through the investment in US equities—1.76
percent, as well as from duration—1.5 percent.
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Risk level in the portfolio
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The portfolio’s volatility, which represents its risk
level, rose to a record this year. Due to the high volatility in equity
indices and due to their high share in the portfolio compared to previous
years, the standard deviation of the portfolio’s return, which measures such
volatility, reached 3.35 percent in 2020, compared to a level of
approximately 1 percent, on average, in the past decade.
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Review of investment policy objectives
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The marked increase in the level of the reserves, which
derives from the Bank of Israel’s foreign exchange purchases as part of the
implementation of the monetary policy, led the Bank to examine the objectives
on which the reserves investment policy is based and the policy’s characteristics,
such as the investment horizon, risk profile, share of investment in risk
assets, as well as the currency for measuring the return on the reserves.
Subject to achieving the safety and liquidity objectives, it is important
that the investment policy of the reserves portfolio achieve a return in
shekel terms that in the long term will at least cover the financing cost of
holding the reserves (the cost of the liabilities on the Bank’s balance
sheet). In view of this, the holding rate of return on the reserves portfolio
is reported in shekel terms as well (Table 1b).
In 2020, the return in shekel terms is negative, due to
the appreciation of the shekel vis-à-vis the main currencies in which the
reserves are held, particularly against the dollar. Despite the prolonged appreciation
of the shekel vis-à-vis the investment currencies, the return is only slightly
negative in the 1-year and 5-year terms, and is even positive in the 3-year
term.
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