Foreign Currency Department, Annual Report 2007

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The Economy and Economic Activity
Investment of the Foreign Exchange Reserves

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The average level of the Bank of Israel's foreign exchange reserves in 2007 was about $28 billion.
This level of reserves is equal to 4 months of imports or to 69 percent of Israel's short-term external debt, a decrease of 0.7 months and 2.7 percentage points, respectively, relative to 2006. The reserves were only 72 percent of the desired level as calculated based on the estimate of possible uses of the reserves, as against 76-78 percent in 2004-2006.
Israel's reserves have grown by only 27 percent over the past nine years, as against reserve growth of 127 percent in the OECD countries and 418 percent in the non-OECD countries.
In light of these developments, the Bank of Israel in March 2008 announced a program to increase the level of the reserves significantly by buying foreign currency in the market. According to the program announced, the Bank will increase the reserves by about $10 billion over a two-year period by acquiring about $25 million per day.
The management framework of the reserves, based on their possible uses and benefits to the economy, was unchanged in 2007. The principles of the management framework, and its various aspects, are reviewed on an ongoing basis by the Bank.
The holding-period rate of return on the reserves in terms of the numeraire was 6.9 percent in 2007, up from 3.8 percent in 2006. The return reflected the decline in yields to maturity of US government bonds during the year reviewed, which resulted in capital gains coupled with declining interest income.
In 2007, the holding-period rate of return on the reserves was almost identical to the benchmark return. The spread between these rates of return reflects the contribution of active management of the portfolio. The absence of a spread in 2007, as against positive spreads in previous years, was due to the turbulence in the financial markets in the second half of 2007 and primarily to the widening of yield differentials on spread assets relative to government bonds during this time, due to the US subprime crisis.
The average exposure of the reserves to the world banking system was 33 percent in 2007. This exposure is managed under a system of quotas and rules, which plays a central role in credit-risk management of the portfolio.
Although the US subprime crisis had an adverse effect on liquidity in the financial markets, the liquidity of Israel's reserves remained very high: about 91 percent of the portfolio was invested in high-liquidity assets and the rest in liquid assets which have a lower level of liquidity.