"We have almost no exposure to countries with big problems. We constantly examine where we invest our [foreign currency] reserves, and I can promise you that you can relax," said Governor of the Bank of Israel Prof. Stanley Fischer in response to a question by a student at the Jezreel Valley College earlier this week. Israel's foreign currency reserves totaled $73 billion at the end of 2011, not including deposits with the IMF.
The issue was about how the Bank of Israel invests its foreign currency reserves is natural, following S&P's downgrade of the government bonds of nine Eurozone countries, including France.
"The Bank of Israel does not disclose the mix of currencies in its portfolio, let alone the composition of its portfolio," said the central bank. In his college lecture, Fischer said, "Assuming that we begin publishing where you invest, when you stop buying the bonds of a particular country, and stop investing in it (and this is published), we start getting complaints. So we don’t disclose. We have an external audit committee. You can assume that we are aware that there are problems in certain countries."
The market agrees, however, that there must be a tight link between the currency mix of the foreign currency reserves and the current proportion of trade with Israel, because the reserves cannot be separated from the actual economy. According to the Bank of Israel, the euro accounts for 32.6% of the nominal effective exchange rate (the geometric mean of the exchange rate of the shekel against 28 currencies, representing 38 of Israel's main trading partners, weighted by the volume of Israel's trade with those countries.) This translates into €17.1 billion of Israel's foreign currency reserves invested in European financial assets, such as investments in the currency, bonds, and deposits in European banks.
The last report by the Bank of Israel's Market Operations Division states that the new Bank of Israel Law (5770-2010) allows the bank to invest in equity. The Bank of Israel says that it will invest up to $500 million in pilot equity program in a few months. In 2010, the Bank of Israel began investing in public bodies in emerging markets.
The annual 25-page Market Operations Division report is singularly miserly with the information it discloses. The only detail it provides is a breakdown of the Bank of Israel's investment portfolio, 59.1% of which is government bonds. We can assume that at least a third of this amount is in bonds of European governments. In 2010, the Bank of Israel invested in Eurobonds, which carry a higher risk because they are not denominated in the currency of the country issuing them. 11.7% of the portfolio is invested in commercial securities, and there are also variable interest bonds, and deposits.
It is important to remember that the objective for the management of the Bank of Israel's reserves is different from any other financial institution, and it is not to maximize profits. In other words, the Bank of Israel seeks to make as much as possible, but there are far more important considerations than maximizing the yield. For example, one critical consideration is liquidity - the time needed to convert a financial product into cash - to deal with a crisis in the economy. Knowledgeable sources say that 90% of the Bank of Israel's portfolio can become liquid within hours.
The Market Operations Division report says that portfolio is managed against a benchmark - a predetermined hypothetical and fundamentally risk-free portfolio. To check the yield, the portfolio is not denominated in a single currency, but against the numeraire - a hypothetical currency, a kind of basket of currencies of Israel's trade partners.
The 2010 annual report states that the holding-period rate of return on the reserves in terms of the numeraire was 1.24% in 2010, compared with a return of 1.14% by the benchmark portfolio. The return in shekel terms was minus 7.1%, due to the appreciation of the shekel against most leading currencies in 2010. It is important to remember that compliance rules greatly restrict the portfolio managers' flexibility in managing the portfolio.
How would the collapse of a European bank affect the portfolio? What would happen to its return if a peripheral European were to declare insolvency, or even just a haircut?
These are legitimate questions, for which there are no clear answers. However, a hint can be obtained from the events during the second quarter of 2010, when the active management's contribution plummeted. "The negative contribution in the second quarter is due almost totally to the capital losses incurred by assets whose prices were adversely affected by developments in the European debt crisis.," states the 2010 annual report.
Published by Globes [online], Israel business news - www.globes-online.com - on January 19, 2012
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