UNCTAD Virtual Institute for Trade and Development
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Sovereign Asset and Liability Management: An E-Learning Training Course
I. Balance Sheet Risks
I.i. Currency Matching
I.ii. Interest Rate Matching
I.iii. Maturity Matching
II. Methodologies
II.i. Initial Methodologies
II.ii. Advanced Methodologies

Currency Matching

“Foreign currency exposure often has two dimensions: (i) liquidity risk–the ease or difficulty of obtaining foreign exchange; and (ii) balance sheet risk–the sensitivity of the borrower or investor’s net wealth or net income to changes in the exchange rate…If a SALM framework is employed, the optimum currency composition of debt is often determined by an optimization that takes into account both the minimization of projected debt servicing costs and maximization of the risk-adjusted return of the country’s assets (in particular, international reserves and projected primary balances) subject to constraints regarding specific-risks and the country’s asset-liability structures.  This approach, in essence, espouses the view that the currency composition of the debt (liabilities) should closely match that of the assets in a sovereign’s balance sheet” (Das et al., 2012).

More specifically, the primary assets that will be matched to liabilities are international reserves and the stream of future tax flows and other revenues. Taxes and other revenues will generally be collected in the domestic currency and will require a match of liabilities in the same currency.  The next best alternative to this would be to match the currency of the liabilities in the currency that is most correlated with the domestic currency.  In commodity rich nations the primary asset, commodity revenues, are likely to be denominated in foreign currency (i.e. oil and the U.S. dollar) and this would indicate that liabilities should be held, to a great extent in U.S. dollars.  In markets where international reserves are used not only for intervention in the currency markets but to also mitigate shocks and pay short-term debt service, the appropriate level of reserves must be held in the same currency as these short-term debt liabilities. 

There is a lack of consensus as to what the appropriate level of reserves should be but the literature does offer guidance.  “The size of the liquidity portfolio [within foreign reserves held by the CB] corresponds in principle to the so-called optimal reserve level.  Before the 1990s, optimal levels of reserves were defined via the ‘three months of imports’ rule.  This simple rule of thumb states that the level of reserves should be enough to cover at least three months of imports.  After the experience of the 1990s, when financial crises were triggered by a sudden drying-up of capital inflows, the ability of economies relying on international borrowing to service the resulting external debt became a central policy issue.  Consequently, the optimal level is commonly defined as the level that is sufficient to cover total short-term external debt in crisis situations.  The Guidotti-Greenspan rule of reserve adequacy states that countries should hold enough reserves to cover at least their external liabilities falling due within one year” (Bloomenstein and Kalkan, 2008).  By having a reserve to short-term debt ratio of 1, theoretically, nations should be able to withstand large outflows of foreign short-term capital.

For further discussion on the appropriate level of reserves, please see the BIS report “Managing Foreign Debt and Liquidity Risks in Emerging Economies: An Overview” (page 29).


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