Choosing instruments in managing dollar foreign exchange reserves

Two years ago, managers of official foreign exchange reserves were pondering the uncertain but serious prospect of a shrinking stock of outstanding US Treasury securities. This concern reflected the fact that some three quarters of global foreign exchange reserves were held in US dollars, and their management traditionally favoured US Treasury securities. Today, with the US economy growing slowly after a shallow recession, and the effects of discretionary tax cuts being felt, the outstanding stock of Treasury securities is once again expanding. Moreover, while the risk of a war of unknown duration and expense attaches more than usual uncertainty to any forecast of future US deficits, there is little doubt that this expansion will continue for some time. The challenge posed by the gradual disappearance of the outstanding stock of the traditional investment vehicle no longer seems so pressing as it was two years ago. Managers of official foreign exchange reserves no longer face the gradual disappearance of the outstanding stock of their traditional investment vehicle as a given. The pressure to achieve returns in an environment of lower interest rates may nevertheless pose other challenges to reserve managers. It puts the spotlight on reserve managers’ choice of instrument. This note analyses the instruments in which central banks have invested their dollar reserves in recent years and poses three questions: How is the official dollar portfolio invested? How has the choice of instrument evolved over time? And how have recent events, including the return of recession and US fiscal deficits, lower Treasury yields and corporate defaults, altered its evolution?