A Joint Foreign Currency Risk Management Approach for Sovereign Assets and Liabilities

Abstract

An asset and liability management framework for managing risks arising from sovereign foreign exchange obligations requires a joint analysis of (i) the external financial liabilities resulting from a country's sovereign debt and (ii) the foreign exchange assets of its central bank. Governments often issue sizable amounts of debt denominated in foreign currencies, subjecting their fiscal positions to foreign exchange volatilities. Prudent management of a sovereign’s foreign exchange position under an asset and liability management framework enables governments to mitigate risks at the lowest possible cost, hence increasing resilience to external shocks. Based on the challenges associated with the implementation of an asset and liability management framework, this study recommends a practical approach that includes analysis of the foreign exchange positions of central bank reserves and central government debt portfolios and optimization of the net position. The proposed model is tested, using the foreign exchange reserve and external debt data of seven countries (Albania, Ghana, FYR Macedonia, South Africa, the Republic of Korea, Tunisia, and Uruguay). The paper employs quantitative methods to explore the impact of an overarching asset and liability management strategy and integrated approach on the efficient management of foreign exchange risk. It provides policy recommendations on ways to minimize the risk of foreign exchange mismatches and increase the return on foreign exchange reserves.