Management of Canada’s Foreign Exchange Reserves

Abstract

Canada’s foreign exchange reserves are owned by the federal government, but jointly managed under a relatively unique framework that is based on a partnership between the government and the central bank. This partnership is supported by a well-defined governance structure that ensures that the reserve portfolio is appropriately structured to meet its strategic objectives, that the government’s risk tolerances are respected, and that associated costs and risks are carefully managed. Canada’s reserves are primarily held to help meet the government’s prudential liquidity objectives. The foreign currency holdings also support the market’s general confidence in Canada. Given these objectives, Canada’s focus is on liquidity and safety of principal. Return, while important, is a secondary focus. To help manage risks in the portfolio, the asset structure is guided by a number of strategic portfolio parameters. These parameters ensure that the reserve assets support the strategic priorities of liquidity and safety of principal while also striving to minimize the cost of holding reserves. To better manage interest rate and foreign exchange risks, Canada manages its reserves using an asset and liability matching framework. Under this approach, every foreign currency asset is funded by a liability of the identical currency and term-to-maturity. This effectively hedges the portfolio’s foreign exchange and interest rate exposures, although significant basis risk can remain. The asset and liability matching framework has served Canada extremely well, effectively eliminating foreign exchange and interest rate risk at relatively low cost. There are a number of factors that explain this. First, Canada has a floating exchange rate with very infrequent intervention. As a result, the reserve portfolio stays hedged. Second, Canada’s high credit quality and well-developed capital markets mean that it can fund the foreign exchange reserves relatively cheaply, both directly and synthetically. This allows the portfolio to meet its liquidity and capital preservation goals and, typically, earn a positive net return.