Foreign Currency Department, Annual Report 2000

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Part 1: Investment of the Foreign Exchange Reserves

Main developments
  • The management of the foreign exchange reserves portfolio is subject to the Bank of Israel Law, 1954, and the relevant legal interpretations which have been added over the years. The investment policy of the reserves is a product of the spirit of the Law and of the need to ensure that the reserves have a high degree of liquidity. This is the case because for many years the main functions of the reserves were defending the exchange-rate system and intervening in the foreign currency market, and also providing a cushion of liquidity in emergencies.
    Changes in the financial environment globally and in Israel seem to make the main role of the reserves today the lowering of the probability of a crisis in the foreign currency market. Based on initial studies and according to indices which feature in international discussions, the current level of Israel's reserves, about $ 21.9 billion, is not higher than that required to fulfill this role. The question nevertheless arises as to what is the appropriate policy for today for the foreign exchange reserves portfolio, a subject still under review in the Bank of Israel (see Boxes 1.1 and 1.2).
  • The investment policy of the reserves results in conservative management of exposure of the portfolio to the various financial risks. The main risks are: credit risk, controlled by a system of rules and quotas; interest-rate risk, controlled mainly by setting a target for the average modified duration of the portfolio of each currency (neutral duration); and currency risk, controlled by defining a neutral currency composition-the numeraire-which serves as a risk-free currency portfolio and as a metric in which the holding-period rate of return on the portfolio is measured (see Box 1.3).
  • For each currency portfolio a neutral benchmark is selected, consisting of a hypothetical portfolio with neutral duration, whose assets (i.e., the types of assets and their dispersion along the yield curve) are characterized by low risk and high liquidity, reflecting the Bank's long-term investment strategy. The benchmark serves as a risk-free portfolio for the manager of that currency portfolio, from which he or she may deviate within the permitted degrees of freedom. It also serves as a basis for assessments of the actual performance of the portfolio. The neutral benchmark for the whole portfolio is a hypothetical portfolio consisting of the neutral benchmarks of the currency portfolios, weighted according to their weights in the currency numeraire (see Boxes 1.4 and 1.5).
  • The holding-period rate of return on the foreign reserves, measured in terms of the numeraire, amounted to 6.79 percent in 2000, compared with 3.26 percent in 1999.
    2 This rate of return reflects the fall in the yields to maturity in various bond markets in 2000, following their sharp increases in 1999. In the long term there are relatively large fluctuations in the annual holding-period rates of return on the reserves portfolio, due to the different developments of the yields to maturity from year to year. Hence the importance of viewing the long-term average holding-period yield: over the last decade this stood at an annual 6.05 percent.
    The holding-period yield on the portfolio in terms of NIS was 1.8 percent in 2000, following a yield of –0.8 percent in 1999, and 27 percent in 1998. The high volatility of the holding-period yield in NIS terms reflects the movements of the NIS against the other currencies in which the reserves are invested: following its marked weakness in 1998, the NIS strengthened against the those currencies in 1999 and 2000. Over the last ten years the holding-period yield on the portfolio in terms of NIS was 12.61 percent in annual terms, and after deducting domestic price rises over that period, it came to an annual 3.55 percent.
  • The yield on the neutral benchmark portfolio of the reserves was 6.78 percent in 2000. The difference between the actual yield and the benchmark yield, which reflects the overall active management contribution, was very small in 2000-
    one basis point-and it was the result of a positive contribution from asset selection for the portfolio (investment in assets not included in the benchmark) offset by a negative contribution resulting from other management decisions (see Box 1.6). Much time and energy has been invested in the last few years in the topic of asset selection. On the other hand, the extent of positions in the field of duration management and currency management have declined, as a result of the policy of reducing risk exposure in these areas.
    A deviation from the benchmark composition entails taking on risk. In the last ten years the higher risk has been accompanied by an incremental yield of 18 basis points, in annual terms, compared with the benchmark. In only two of those ten years was there a negative incremental yield compared with the benchmark.
  • The currency management contribution in 2000 was a negative 15 basis points. The currency management contribution over the years is volatile, and in the last decade currency management contributed 4 basis points, in annual terms, to the yield difference between the portfolio and the benchmark.
  • Duration management made no contribution to the yield in 2000. In the last eight years it contributed an average of 5 basis points a year.
    3 The durations of the currency portfolios were slightly below neutral at the beginning of the year and close to neutral thereafter. The position of shortening the portfolio was taken at the beginning of the year on the basis of the assessment that further measures of monetary restraint were expected, both in the US and Europe, beyond the steps introduced in 1999. The US Federal Reserve, the European Central Bank (ECB), and the Bank of England did indeed raise the rate of interest several times in the course of the year. As a result, the yields to maturity in the short end of the yield curve rose at the beginning of the year, and declined in the longer end. Later in the year the yield curves in the different markets declined. At the same time the yield spread between Treasuries and assets issued by other entities widened.
  • The asset management of the portfolio-i.e., the selection of assets and their distribution along the yield curve-contributed 20 basis points to the yield on the portfolio in 2000. Since 1993 it has contributed an average of 3 basis points in annual terms.
    The contribution of the selection of assets amounted to 19 basis points in 2000, arising from investments in assets not included in the benchmark (called "spread assets"), mainly in the dollar portfolio. A significant part of the asset management contribution derived from loans of securities undertaken independently by the Foreign Currency Department. Concurrently, in 2000 the lending of Bank of Israel securities by two financial institutions which had them in custody continued. Lending of securities by the department yielded $ 8.2 million. Lending by the other institutions yielded a further $ 1.2 million.
    The contribution of the dispersion of the portfolio vis-?-vis the benchmark was very small in 2000, just one basis point. Most of the dispersion derived from the dollar portfolio, and part was the result of investment in spread assets.
  • The Department's decision to invest in GNMA mortgaged-backed securities led to a 4 basis point loss (against the benchmark) on the portfolio. The fact that the performance of the GNMA market was below that of the Treasury market was the outcome of the widening of the yield spread between them. Over the years the decision to invest in the mortgage sector made a positive contribution of 2 basis points, annual average, to the yield on the portfolio.
  • A comparison of the performance of the Bank of Israel's dollar portfolio to the performance of other managers who are similar to the Bank of Israel in certain respects, and who invest in the US government bond market, shows that the performance of the Bank's portfolio was generally within the range of the other managers' achievements.
  • The exposure of the reserves to the banking system is relatively low. In 2000 it was higher than in 1999, due to easing of concern regarding instability in the global financial system.
  • About three-quarters of the reserve portfolio is invested in very liquid assets. The other quarter is invested in assets with slightly lower liquidity. In the light of the high level of the reserves, it would appear that they are sufficiently liquid even if it should prove necessary to use them.
  • In the last few years a contraction of the US Treasury market has been evident, in the wake of the reduction of the US government deficit and its actual conversion into a surplus in 1999. These changes have implications for the depth of liquidity of the market in which the greatest part of the reserves portfolio is invested. This process may require Israel to expand the range of investment channels in which it is permitted to invest the reserves; this in turn would require the Bank of Israel Law to be amended (see Box 1.2).

Part 1, in PDF format


Part 2: Developments in the Foreign Currency Market in 2000


  • During the year 2000, the NIS (New Israeli Shekel) strengthened against the currency basket by 5.5 percent, and against the dollar by 2.7 percent. The difference reflects the strengthening of the dollar against most other currencies on world markets. The exchange-rate band widened from 35.5 percent at the beginning of the year to 39.2 percent at the end (calculated in terms of the average of the band’s limits), while the slopes of the upper and lower limits remained the same as in 1999-6 percent and 2 percent respectively.
  • During the year 2000 the Israeli currency market was characterized by low volatility. External events, which affected the NIS in previous years, exerted only minor influence during 2000. This development reflected the unprecedented inflow of foreign capital, invested primarily in the technology sector, and the high degree of confidence which the market has in the Bank of Israel’s monetary policy, aimed at achieving the inflation target set by the government. The volatility of the exchange rate of the NIS against the currency basket has risen slightly in the last few years. In 2000 it was 6.4 percent, below that of other comparable currencies.
  • The interbank bid-offer spread of the NIS/dollar exchange rate was 0.062 percent in December. This is wider than that of other liquid currencies such as the euro and the Canadian dollar, similar to that of the currencies of other European countries such as Sweden and Norway, and narrower than that of currencies like the Czech koruna and New Zealand dollar.
  • Average daily turnover in the foreign currency market reached $ 1.25 billion in 2000, an increase of 54 percent from the level in 1999. The rise in swaps made a significant contribution to the increase in turnover, and reflected the rise in activity in Israel of foreign investors. Despite the growth of turnover of the NIS, it is still small compared with that of other currencies. Since June 1997 the Bank of Israel has not intervened in the market, except for six days at the end of 1997. This policy is based on experience gained from those periods when it did intervene, and on the experience of other central banks. This experience shows that such intervention is efficient on rare occasions, and then for only short periods.

    Part 2, in PDF format