FOREIGN RESERVE ACCUMULATION

1
FOREIGN RESERVE ACCUMULATION
THE MEXICAN EXPERIENCE
Manuel Ramos Francia
October 20, 2006
2
The Mexican Experience

• As a result of the currency crisis on December
  1994, Banco de México was forced to abandon the
  predetermined exchange rate regime and float the
  peso, thus changing the nominal anchor of the
  economy.
• Banco de México withdrew from actively
  intervening in the foreign exchange market and
  gradually converged towards an inflation
  targeting regime.

• Fixed exchange rate
• Monetary policy subordinated to the exchange rate
  regime

• Flexible Exchange Rate
• Inflation Targeting

3
The Mexican Experience

• The free floating regime has simplified monetary
  policy management, since the exchange rate can
  adjust more rapidly to domestic and external
  shocks.

Overnight Interest Rate and Exchange
Rate (Percent and Pesos per Dollar)
Source Banco de México.
4
The Mexican Experience

• Banco de Méxicos operations in the foreign
  exchange market are divided in two categories
• Operations with the Federal Government and PEMEX.
• Operations for international reserve management.

• Federal Government external debt service
• PEMEX export revenues
• and external debt proceeds

FEDERAL GOVERNMENT AND PEMEX
FX OPERATIONS OF BANCO DE MÉXICO
FOREIGN EXCHANGE MARKET

• Rule Based Operations
• (1996-2001, 2003 onward)
• Discretional Interventions
• (last intervention in Sep. 1998)

5
The Mexican Experience

• Operations with the Federal Government and PEMEX.
• Both are required to undertake all their foreign
  currency operations with the Central Bank.
• Although these operations are not carried out in
  the foreign exchange market, they are settled at
  market prices.
• Banco de México sterilizes completely the
  monetary effect of its foreign exchange
  operations.

Flows of Net Foreign Assets Decomposition by
Source (1996-2006)1/
1/ Million dollars. Include net income
generated by investing Banco de Méxicos
international assets. As of September, 2006.
6
The Mexican Experience

• Operations for international reserve management.
• Since the 1994-1995 crisis, several mechanisms
  have been adopted for the management of
  international reserves
• Initial Stage (1995-1998) Low level of
  international reserves and highly volatile
  foreign exchange market. Restore orderly market
  conditions.
• Intermediate Stage (1996-2001) Increase the
  level of international reserves and provide
  liquidity to the foreign exchange market in face
  of shocks (high volatility episodes).
• Current Stage (2001 to date) Promote a cleaner
  float and prevent excess accumulation of foreign
  reserves.

7
The Mexican Experience

• The mechanisms adopted allowed for a fast buildup
  of international reserves and promoted orderly
  conditions in the foreign exchange market in face
  of different shocks. This contributed to the
  development of a deep foreign exchange market.

International Reserves and Foreign Exchange Rate
As defined in the Banco de Mexico Law of
1994. 1 Initial Stage. 2 Intermediate Stage. 3
Current Stage.
8
The Mexican Experience

• Rule Based Operations
• Between August 1996 and July 2001, the Foreign
  Exchange Commission (FEC) developed well defined
  mechanisms for the accumulation of international
  reserves and to limit the volatility of the
  exchange rate.
• Monthly auction of options to sell dollars to
  Banco de México (August 1996 to June 2001).
• Daily dollar auction to financial intermediaries
  (February 1997 to July 2001).
• Once the FEC concluded that the benefits from
  continuing the accumulation of international
  reserves were less significant, a mechanism to
  reduce Banco de Méxicos rate of accumulation was
  put in place (since May, 2003).
• Discretional Interventions
• Banco de Mexicos last intervention in the
  foreign exchange market took place on September
  10th, 1998 for 278 million dollars.

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The Mexican Experience
Net International Reserves (Billion Dollars)
Red lines represent dates when Moodys improved
Mexicos credit ratings. Source Banco de México.
10
The Mexican Experience
International Reserve Accumulation through
Automatic Mechanisms (Billion Dollars)
Source Banco de México.
11
The Mexican Experience
Daily Dollar Auctions (Million Dollars)
Exchange Market Volume (Million Dollars Monthly
Average)
Includes operations in the spot, swap and
forward markets. Source Banco de México.
Source Banco de México.
12
The Mexican Experience

• Sterilization of International Reserves.
• International reserves have grown more than the
  monetary base.

Reserve Accumulation and Monetary Base
Growth (Cumulative Flows, Billion Dollars)
Monetary Base (Percent of GDP)
Source Banco de México.
Source Banco de México.
13
The Mexican Experience
Monetary Regulation Bonds (BREMS) and Compulsory
Deposits (Amounts Outstanding Billions of
Mexican Pesos)
Since August 17th, Banco de México uses BONDES
D for monetary purposes instead of
BREMS. Source Banco de México.
14
The Mexican Experience
Sources and Uses of Financial Resources (Effective
Flows as Percent of GDP)
1/ Refers to non-sectorized assets, capital and
results accounts, technical reserves accounts,
capital reserves, physical assets of financial
intermediaries, preemptive reserves, investment
in stocks, commercial banks external resources,
financing to non-residents, INFONAVIT liabilities
other than those submitted by workers, financial
intermediaries liabilities other than bank
credits, net position of trusts (fideicomisos)
with the banking sector, the difference between
development banking domestic financing to the
private sector and to financial intermediation,
and non-monetary liabilities of IPAB, among
others. 2/ Corresponds to dollar sales according
to the mechanism for reducing the rate of foreign
reserve accumulation (see Foreign Exchange
Commission press release of March 20,
2003). Source Banco de México.
15
The Mexican Experience

• Benefits and costs of holding reserves in Mexico.
• Benefits
• The economy is insured against sudden stops the
  exposure to external shocks is much lower.
• The countrys credit worthiness improves the
  country has Investment Grade since March 2000 and
  has already developed a market for long-term
  instruments in domestic currency.
• Costs
• Carry cost of reserves.

At the margin, increasing reserves holdings is
progressively yielding lower net benefits.
16
The Mexican Experience

• Optimal Reserves in Mexico Methodology of
  Ben-Bassat and Gottlieb.
• The Central Bank chooses the level of reserves to
  minimize expected costs of holding them

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The Mexican Experience

• FOC
• Logistic function for ?
• Specification for f

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The Mexican Experience
Optimal Reserves to Actual Reserves
Ratio (Different Levels for Cost of Crises as
Percentage of GDP)
The opportunity cost of reserves (r) was
assumed at 5.
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The Mexican Experience

• Challenges Ahead
• Capitalization and adequate management of the
  oil-stabilization fund.
• Reduce the cost of holding reserves.
• Increase asset returns.
• Riskier assets market risk (higher duration) vs.
  credit risk (alternative asset types).
• Improve risk management capabilities internal
  vs. outsourcing.
• Limit the growth of reserves.

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The Mexican Experience
Local Interest Rates and Selected Yields (Percent)
Cost of Holding Reserves
The average duration of the AAA-rated U.S.
Treasuries and Agencies Portfolio is 2 years. The
average duration of the A-rated Corporate
Portfolio is 5.7 years.
Source Banco de México.
21
The Mexican Experience

• The Government will prepay more than 12.4 billion
  dollars of foreign exchange denominated debt
  (IADB and World Bank mostly). To finance this
  transaction, the Government purchased 12.4
  billion dollars from the Central Banks reserves
  with funds obtained from the issuance of domestic
  debt.

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The Mexican Experience Final Remarks

• The criteria to measure the optimal level of
  reserves has changed over time, reflecting both
  the changes in the global economy and the
  particular features of each country. Capital
  account considerations and external vulnerability
  issues seem more relevant in light of recent
  international experience.
• After the financial crisis of 1994-95, Mexico
  started to build up international reserves in
  order to improve investor confidence, strengthen
  the access to external capital markets, and
  reduce the countrys external vulnerability.
• During the last years, the increase in
  international reserves is explained by the higher
  oil revenues.

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The Mexican Experience Final Remarks

• Several factors explain the reduced need for
  accumulating international reserves in Mexico.
  Macroeconomic stability, the development of
  domestic financial markets, and the substitution
  of external debt for domestic debt have made the
  economy less vulnerable to financial shocks. The
  floating exchange rate regime implies that there
  is no need to hold reserves to manage the
  exchange rate.
• The net benefits of continuing to accumulate
  international reserves at a rapid pace are
  considered to be limited. In order to reduce the
  cost of holding large international reserves,
  Mexico decided to reduce their growth rate.