Investment of the Foreign Exchange Reserves, 2011

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Investment of the Foreign Exchange Reserves

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Israel's foreign exchange reserves grew by $4 billion in 2011 to $74.9 billion, compared with an increase of about $10 billion in the previous year. As was the case in the previous three years, the increase in the reserves this year was primarily the result of foreign currency purchases by the Bank of Israel.
The global financial crisis has emphasized 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 economic aggregates, which are customarily used to assess the adequacy of the level of the reserves. Increasing these ratios strengthens the economy's resilience to crises and improves Israel's international financial standing. In comparisons to other countries, Israel's reserves relative to most of these aggregates is above the median of both the developed and developing countries.
The management of reserves this year was influenced in particular by the spread of the debt crisis in Europe and its increasing severity, which led to the lowering of credit ratings for countries and banks throughout the continent and in other countries as well. These developments have begun to undermine the foundations of the euro zone and constitute a real threat to its continued existence in its present form. They also threaten the stability of the global financial system as a whole. The deterioration in the quality of credit of government issuers and large financial institutions worldwide, which until recently were considered to have a relatively low risk of default, has narrowed the traditional investment space for reserves managers worldwide and has raised the level of risk they are exposed to. Within the framework of compliance rules, which have been tightened since the start of the crisis in 2008, the Bank of Israel continued to introduce measures this year that are intended to reduce the exposure of the reserves to countries whose macroeconomic situation is deteriorating.
The holding-period rate of return on the reserves in terms of the numeraire was 1.3 percent in 2011, compared with an average of 3.3 percent during the period 2002-11. This rate of return, like those in previous years, was determined to a large extent by the low level of interest rates and yields to maturity in the financial markets and the continuation of short-duration reserve management relative to previous years. Short-duration management has been adopted due to the high risk of obtaining a negative holding-period rate of return on the reserves if yields to maturity increase from their currently low levels. 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.
In shekel terms, the reserves portfolio had a positive and high holding-period rate of return (7.1 percent), which was due to the weakening of the shekel against the numeraire currencies, particularly the dollar and the euro.
With the goal of improving the return to risk ratio of the reserves portfolio, the policy of investing part of the reserves in currencies and assets of developed countries with strong economies that are not included in the numeraire continued and was even expanded.
The active-management contribution in 2011 was 21 basis points, which was similar to its average during the last ten years. As in previous years, the main contribution of active management in 2011 was the investment of part of the reserves in the currencies and assets of countries whose currencies are not included in the numeraire and the benchmark. These investments performed better than the benchmark assets, primarily because the level of interest rates in those countries was higher than in the benchmark countries and also because they were managed with a longer duration.
The establishment of the Monetary Committee in October 2011, in accordance with the New Bank of Israel Law, strengthened the decision making processes related to reserve management. The application of the new law removed the legal obstacles that in the past had prevented the investment of reserves in certain types of financial assets, which the Bank considered worthwhile economically, and appropriate with regard to risk management. Since the new law went into effect, the Bank has begun to further diversify the assets in which it invests and, as part of that process, two percent of the reserves were, for the first time, invested in the US stock market at the beginning of 2012. Meanwhile, the Bank is continuing to identify and evaluate channels for exploiting the additional degrees of freedom granted by the new law in the selection of assets.