Reserve Management: A view from De Nederlandsche Bank
During most of the nineties, the Dutch Central Bank was seen as one of the villains of the gold market. It was not easy for us to come to conferences like this because we were always being asked difficult questions. In 1993, I worked for a while for the Bank of England with Terry Smeeton and his colleagues and these guys sometimes gave me a hard time. But then I always stuck to my motto: "if you ain't Dutch, you ain't much". Well, I would say that after being here now for two days in this beautiful place, I realise that even though you may not be Dutch - you can be very much.
Now let's concentrate on the topic I was asked to say a few words about - how we manage reserves at the Dutch Central Bank. Actually, I think that 'reserves' is not always the correct word. It tends to have some kind of positive connotation a nest egg that can be sav cl for a rainy day. But if' you are working for the Dutch Central Bank, which during several times in the 90' was forced to buy weak currencies and pay for them with our own strong currency, you have a different view of the meaning of reserves. I would therefore rather call them foreign exchange assets than foreign exchange reserves, but nevertheless, for this presentation, I will stick to the word reserves.
There is a very broad spectrum for the function and purpose of reserve for central banks that have a freely tradable currency. On one hand, reserves are u ed purely for the purpose of monetary policy. You can use foreign currencies to defend your own currency
When it is weak. In that circumstance, the currency composition and asset allocation are totally based on policy considerations. On the other side of the spectrum, you find a more asset management based approach in which you consider how much income can be generated with your foreign currency assets. I think most central banks are not at one of the two extremes. They are somewhere in between, but at very different places.
Looking at our overall situation, we have had a decade of stable exchange rates. Long before EMU, we had a kind of a quasimonetary union with Ger many. We had a stable strong currency and there was basically no need to support it, no need to intervene to defend our currency. On the contrary, as I said earlier, we had to help other currencies when they became too weak. This resulted in a strong rise of our reserves during the 90s: they more than doubled. Gradually we realised that we did not need all these reserves for the purpose of monetary policy, hence we started to move downwards along the line that I pictured earlier. As we were moving towards a more asset-management based philosophy with more emphasis on income, we became much more aware of the risks and costs that come with holding foreign exchange reserves.
What are these risks and costs? Central bankers traditionally look at three risks- liquidity, market and credit.
Liquidity is very important to them. If their currency is weak and they want to intervene, then they must have the asset to do that. The money mu. t be ready for use when it is needed. Market risk is obvious - no one likes losing money. As far a credit risk is concerned, I think central banks are slightly different from commercial banks. We do not like to face losses stemming from credit risks or default because that could hamper our reputation. I think it is because of these three risks that many central banks have held a large portfolio of liquid dollar assets and of gold.
Holding these assets has some cost. The first one is obvious -if you hold gold, it does not bring much income. We can lend a little but given the total size, it results in barely any income. Holding, super-liquid UST-bills also come at a price. If you don't need super liquidity, it may not be worthwhile paying that price. The second thing is that in a mark-to-market world, where we central banker also live nowadays, we have to mark our books to market. If you are a euro-based investor and you have a balance sheet that is made up of dollars and gold, the value of your assets will swing widely. I think bank supervisors would not like to see their banks have a balance sheet such as we have had, for instance.
So, all this meant that we wanted to implement some changes. The first one is that we no longer look at the foreign asset in isolation. They have lost part of the special status that they used to have, and we have moved to a kind or as et and liability management similar to that practised by many commercial companies. Second, as I made clear earlier on, we saw no need for having super-liquidity on our balance sheet for which we pay a premium. And third, would seem to be having the best or all possible worlds - less market risk combined with more income - but given the structure of our balance sheet, this was possible.
What was the outcome? We now hold only a small amount of liquid US Treasury paper, quite a step for a central hank. Most central banks have at their core holding a UST-Bill or T-note portfolio. We have mostly done away with that and have moved into less liquid in. Instruments from which we get a better return. Secondly, we wanted to bring our gold holdings (or the cost of our gold holdings) more in line with other major holders. At the start of the 90s, we had over 1700 tons of gold, which meant that the burden that we put on our taxpayer was far higher than any other G10 country apart from Switzerland. We wanted to scale that back. But on the other hand, we still felt that gold was a kind of confidence builder, so we only wanted to sell if it would not harm the market's confidence in us.
So, we could only do that when the country's finances were in very good shape. In the 90's we had a strong currency. The government deficit was much better than in the 80's. Last year for instance, for the first time in 25 years, we had a surplus. These positive developments made it possible for us to sell gold. As most of you know, we sold 400 tons of gold in 1992 and 300 in 1996. Even after those 700 tons, we felt that we had too much our gold holdings per capita were still much higher than the other G10 countries, again with the exception of Switzerland. It may not come as a surprise that we were one of the active parties in the 1999 Central Bank Gold Agreement that was published in September last year. Two months later we gave further details of our intention to sell 100 tons in the first year of the agreement and 200 tons over the remaining four years. As I am sure most of you know, we have sold most of the 100 tons over the last two and a half months already and we are quite pleased with the way things have progressed.
It must be remembered that as a central bank, we cannot act like an asset management company. We still have policy constraint while the chance that we have to intervene in the currency markets is much smaller than 10-15 years ago, ill nevertheless remains a possibility. So, we need to keep a certain minimum portion of dollars on our balance sheet because the US$ is still the main intervention vehicle.
Another policy constraint is that we want to remain one of the major gold holders. There is the usual war chest argument that if the worst comes to worst, you always have your gold to help you through a rain)' day. And as we feel that having gold on your balance sheets helps maintain the confidence of the outside world, we will not move all the way down in my spectrum to a pure asset management-based philosophy. As you know, the biggest asset of a central bank is not on the balance sheet. It is its reputation, its credibility. As a colleague of mine has said, 'There is nothing that a central banker loses faster than his credibility, whereas nothing takes longer than regaining lost credibility.
Jos R. Heuvelman has been Director of the Financial markets Department of De Nederlandsche Bank since spring 1997. In this capacity, he is directly responsible for the operations of the Bank in the national. And international money, capital and foreign exchange markets. Prior to this appointment as Manager, he has managed various portfolios for the Bank, and the Bank's Pension Fund.
He participated in various G-10 central bank working parties that discussed and analysed developments in international financial markets in general and derivatives markets in particular. Presently he is a member of the Market Operations Committee of the ESCB and of several G-10 central bank committees in the context of the Bank for International Settlements.