Market Operations Department Annual Report, 2010

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The Economy and Economic Activity
Investment of the Foreign Exchange Reserves

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Israel's foreign exchange reserves grew by $10.2 billion in 2010, compared with an increase of about $17 billion in the previous year, and at the end of the year stood at $69.3 billion.2 As was the case in the previous two years, the increase in the reserves this year was due mainly to purchases of foreign currency by the Bank of Israel.
The upward trend of foreign exchange reserves in developed and emerging market countries continued in 2010, in line with the trend in Israel, as the global financial crisis, which began in 2008, underscored the importance of maintaining an appropriately high level of reserves.
The rise in the level of Israel's foreign exchange reserves in 2010 increased the ratios between the reserves and various aggregates of the economy, which are customarily used to assess the adequacy of the level of the reserves. Increasing these ratios serves the objectives that the new Bank of Israel Law stipulates for the Bank, and assists it in fulfilling its functions, as doing so strengthens the economy's resilience to crises and improves Israel's international financial standing.
The holding-period rate of return on the reserves in terms of the numeraire was 1.2 percent in 2010, compared with 3.8 percent on average in the years 2001–10. In shekel terms the holding-period rate of return of the reserves portfolio was negative, at –7.1 percent, due to the strengthening of the shekel against the dollar and the euro during the year. The number of currencies in the numeraire was increased in order to obtain better diversification and to reduce the possible consequences of the financial crisis for the reserves in extreme scenarios.
This rate of return in numeraire terms was largely affected by two factors: (a) the low interest rates and yields to maturity in the financial markets of the developed countries; and (b) 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––compared with an average contribution of 20 basis point in the past decade, but similar to the decade average if the exceptionally high contribution in 2009 is excluded. The main component of the active-management contribution in 2010 was the excess yield from asset selection in the portfolio, particularly from short-term spread assets.
The background conditions under which the foreign exchange reserves were managed this year were especially challenging. The global financial crisis entered a new phase in which the concern of investors in the international markets focused on uncertainty regarding the debt-service capability of some EU member countries. While dealing with the implications of the continuing crisis for the reserves portfolio, the Market Operations Department also dealt with its effects on the domestic financial markets, as well as with advancing several special projects, some of which are directly related to managing the reserves, as will be detailed below.
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 major decisions are taken in the Bank, including decisions on the desired long-term level of the reserves and their investment policy. The Bank’s new 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 has removed the legal obstacles that in the past prevented the Bank from investing the reserves in certain financial assets which it viewed as desirable investment channels in terms 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 addition to managing the reserves and examining the option of broadening the range of assets in which the reserves could be invested, the Market Operations Department of the Bank of Israel advanced several special projects in 2010: (a) implementation of a computerized Integrated Treasury Management System, which is expected to enhance and streamline the management of the reserves; (b) 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) completion of the organizational restructuring process with the addition of the state loans management function to the Department.