Economic exposure is tied to the currency of determination of revenues and costs. Since the world market price of oil is dollars, this is the effective currency in which PDVSA's future sales to Germany are made. Clearly the currency of determination is influenced by the currency in which competitors denominate prices.
Estimation of planning horizon as determined by reaction period. Determination of expected future spot rate. Estimation of expected revenue and cost streams, given the expected spot rate. Estimation of effect on revenue and expense streams for unexpected exchange rate changes. Choice of appropriate currency for debt denomination.
Estimation of necessary amount of foreign currency debt. Determination of average interest period of debt. Selection between direct or indirect debt denomination. Decision on trade-off between arbitrage gains vs. Decision about "residual" risk: consider adjusting business strategy. To protect her company, she arranged to sell Payment of the five million punt was to be made in days' time.
The dollar had recently plummeted against all the EMS currencies and Yamamoto wanted to avoid any further rise in the cost of imports. It can help, momentarily, but not by much. We do have a policy framework that would allow us to intervene in the unlikely event that it's needed. That could happen under two scenarios. The first would be a market breakdown with extreme price volatility. Buyers or sellers would be increasingly unwilling to transact, indicating a severe lack of liquidity in the Canadian-dollar market.
The second would be sharp currency movements that seriously threaten the conditions that support sustainable, long-term economic growth. In a market breakdown, intervention would aim to restore market functioning and would likely be quite short-lived. In extreme currency movements, it's understood that intervention would be part of a broader set of policy changes to re-establish confidence in Canadian economy.
This framework is transparent-it is posted on our website. Thus, we are ready to intervene, if necessary. But as I said, we have not seen the need to do so at any time throughout the past two-often turbulent-decades. There have, however, been a couple of occasions over that period when Canada participated in concerted intervention along with other countries. In , Canada joined an action to stem excess volatility and disorderly movements in the exchange rate of the Japanese yen following the earthquake and resulting tsunami and nuclear crisis at the Fukushima nuclear plant.
The intervention involved selling the yen against our respective domestic currencies to send a clear signal that the goal was to weaken the yen and not to strengthen other currencies. These episodes were in response to exceptional developments affecting other currencies of global importance, and were not specifically aimed at influencing the Canadian dollar. How, then, should we think about Canada's current level of foreign exchange reserves? Internationally, a number of factors influence reserve holdings.
In some cases, such as China, movements in international reserves are largely a by-product of the country's exchange rate regime and associated trade and capital flows. A number of countries, typically emerging-market economies, may choose to hold large reserves to offset volatility in capital flows and, in some cases, to ride out trade imbalances resulting from the fluctuations in the prices of their major exports.
In contrast, our flexible exchange rate and non-intervention policy allow us to keep a much smaller level of reserves. Given that we intervene so rarely, why do we hold any reserves?
And how do we gauge whether they are adequate for our needs? First, we must be prepared to intervene in case of events that are even more severe, and improbable, than those we have experienced in recent decades. We periodically examine such extreme scenarios and estimate the scale of intervention that would be required. A second important purpose of our foreign exchange reserves is to ensure that the Government of Canada can meet its payment obligations in situations where normal access to funding markets may be disrupted or delayed.
Reserves help insure against rollover risks for public borrowing. It opted for a larger buffer-and accordingly, beefed up both its demand deposits and its foreign exchange reserves. Third, Canada's foreign exchange reserves serve to reinforce confidence in the soundness of the Canadian financial system. They are among several factors that do so.
Canadian banks manage their risks prudently and are well-regulated and supervised. Even during the financial crisis, banks remained in good financial health and did not have to rely on direct official support. Ten years later, Canada's financial institutions have ample buffers of capital and liquidity and the system remains resilient.
Financial institutions are expected to take responsibility for managing their own foreign currency exposures.
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They implement hedging and funding strategies to that end. Indeed, so do other major Canadian foreign-currency borrowers, such as provincial governments. In the unlikely event that a Canadian financial institution had exceptional needs for liquidity in US dollars or other foreign currencies, the swap lines the Bank of Canada has established with other G7 central banks would enable us to obtain funds in any of four other currencies. These lines were introduced in response to the global financial crisis. They were renewed in response to market stresses in Europe and later turned into standing agreements.
The Bank of Canada has never drawn on these swap lines, nor has it faced a request to provide Canadian dollars. But these arrangements are available if needed. Even though it is very unlikely that Canada's foreign exchange reserves would need to be drawn down for financial stability purposes, their existence provides further reassurance of the safety and soundness of the Canadian financial system.
Such confidence, in turn, helps maintain stability in times of financial stress. All this considered, Canada holds foreign exchange reserves as a precaution against extreme events. Even though Canada has had no history of such events, we know from international experience that they are possible. So far, I've emphasized the role of Canada's reserves in serving Canadian purposes.
I should also mention the use of our reserves in our role as a good global citizen. Canada, like a number of other advanced economies, also makes a portion of its reserves available for IMF programs. Taking all these potential needs into consideration, Canada's level of liquid international reserves is set at a minimum of 3 per cent of nominal GDP-a floor which it generally significantly exceeds. This level is simple to communicate to the public, credit rating agencies and investors.
While, as I've noted, it is low relative to many countries, it is in line with a set of similar countries such as the United Kingdom and Australia. Together with our Department of Finance, we review this level periodically in light of various metrics and international comparisons-and particularly with regard to extreme scenarios that would imply a draw on reserves. The last such review, completed in , concluded that the 3 per cent minimum remains adequate to meet Canada's needs, even under such extreme conditions.
Given that the primary purpose of our international reserves is precautionary, a key strategic objective in managing them is to maintain a high standard of liquidity under all circumstances. The preservation of capital value and optimization of returns are also essential. To maintain liquidity, we hold reserves in assets that mature or can be sold on very short notice with minimal market impact. To preserve value, we minimize the risk of loss by holding a diversified portfolio of high-quality assets, managing liquid assets and liabilities on a matched basis. We aim to achieve the highest return while respecting the objectives of liquidity and capital preservation.
This reflects the fact that shorter-term securities are typically more liquid, and their value less sensitive to the interest rate, than longer-term securities by the same issuer and in the same currency. While our liquid reserves are diversified across currencies, more than half is held in US dollars, because of the greater liquidity of US-dollar markets and since potential foreign currency needs are most likely to be in US dollars.
The remainder is held in euros, pound sterling and Japanese yen.
Managing Global Financial and Foreign Exchange Rate Risk (Wiley Finance) by voltaer - Issuu
Let me expand on the point about asset-liability matching. These assets are funded by Government of Canada liabilities denominated in, or converted to, foreign currencies. They largely consist of foreign currency securities, which are mostly government treasury bills and bonds, and fixed-income securities issued by sovereign-supported issuers, sub-sovereign entities and supranational institutions. Other eligible assets include deposits with commercial banks, central banks and the Bank for International Settlements.
The assets in the EFA are matched in currency and duration to the government's liabilities that fund the liquid securities in order to minimize its exposure to currency and interest rate risks. These matching requirements are part of our asset-liability-matching ALM framework. To my knowledge, no other central bank exclusively manages reserves in this manner. The ALM framework, which allows us to earn a positive net return, is consistent with our floating currency. Indeed, if we intervened continuously, we would not be able to match assets to liabilities.
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This approach has proven to be an effective way to minimize interest rate and foreign exchange risk to the government's fiscal position. However, there is still residual market risk that is derived from the credit-spread exposures inherent in the assets and liabilities-and the lack of perfect correlation between the two. Since the EFA is predominantly funded with cross-currency swaps, there are non-zero levels of basis risk.
There is also an element of credit risk, both with regard to the issuers of reserve assets and swap counterparties. We conduct our own risk assessments, including credit risk, which we have significantly enhanced in response to the Financial Stability Board's call to reduce reliance on credit rating agencies. In large measure, the difference between our approach to reserve management and those of other reserve managers is related to the relatively small size of our reserves, our ALM framework and our focus on liquidity.
Moreover, most countries have a net asset position, which means they have outright exposure to currency movements. This increases the need for diversification into other currencies.
Corporate FX Risk Management
Because our portfolio is asset-liability matched, volatility in currency markets is a lesser concern to us. I should say a brief word here about gold.
Some countries continue to hold portions of their reserves in gold, sometimes for symbolic reasons. Canada doesn't. In the government implemented a policy of selling its gold at a gradual and controlled pace to enhance the return for the EFA. Gold bullion is not considered as liquid as, for example, US Treasury securities and, to the extent that physical delivery may be involved, could entail significant costs for secure transport and storage. As such, gold doesn't fit well within the asset-matching framework. Proceeds from gold sales were invested in high-quality, interest-bearing, foreign-currency assets.
While these assets may not have the reassuring physical heft of a gold bar, we believe they are better suited to the purposes for which we hold reserves. The last of the government's gold bullion was disposed of in The gold reserves that remained were coins, which have also since been sold. One of the relatively recent developments for our dollar that we are monitoring closely is its use as a foreign reserve currency by other countries. Following the global financial crisis, central banks and monetary authorities around the world began adding Canadian-dollar assets to their reserve portfolios.
The move to hold a portion of reserves in Canadian dollars is part of a broader strategy of reserve diversification. It is also, in some sense, a vote of confidence in Canada: reserve managers tell us they are attracted by Canada's sound financial system and fiscal position, as reflected in its high credit ratings.