IMFSurvey Magazine: Countries & Regions
IMF TECHNICAL ASSISTANCE
Assessing Chile's Reserve Management
By Kristian Flyvholm
IMF Monetary and Capital Markets Department
November 26, 2007
- Government appoints central bank as agent to manage sovereign wealth funds
- Central bank requests IMF to assess bank's reserve management capacity
- IMF determines that Chile's central bank is well placed to manage country's wealth
Recent years have witnessed spectacular growth in central bank reserves across the world.
In Chile, the government's coffers are brimming as a result of a tripling in the price of copper—the country's main export commodity—from an average $0.8 a pound in 2003 to almost $4 earlier this year. To manage these windfall revenues prudently, the government created two "sovereign wealth funds" in 2006 and put the central bank in charge of managing them.
These two new funds, set up with the promulgation of the Fiscal Responsibility Law, are the Economic and Social Stabilization Fund (ESSF), which is to provide funding for public education, health, and housing initiatives; and the Pension Reserve Fund (PRF), which is to provide funding for the government's pension obligations and help pay for the projected increase in the minimum pension benefit and takeup rate.
The ESSF was constituted with an initial deposit of $6 billion, and the PRF was established with a $600 million initial deposit. At the end of July 2007, the ESSF had a total of $9.83 billion in assets under management, while the PRF had a total of $1.37 billion. Chile's central bank requested the IMF to independently assess how well positioned the bank was to take on the day-to-day investment management of these funds in accordance with the government's investment guidelines.
Managing wealth differently
The assessment, carried out in April 2007, was important because the way in which central bankers invest their resources is quite different from the approach taken by sovereign wealth managers. Central banks have traditionally kept their reserves in highly liquid government securities, agency debt, money-market instruments, and bank deposits. In contrast, sovereign wealth funds tend to hold portfolios with very different risk profiles, time horizons, and a broader set of asset classes.
The IMF staff assessment concluded that the central bank is generally in observance of the IMF's Guidelines for Foreign Exchange Reserve Management which are exemplified in 20 illustrative country cases. These guidelines are a useful tool for countries to devise sound institutional arrangements focused on risk management, transparency, and accountability in foreign exchange reserve management.
The IMF assessment found that Chile's central bank considers reserve adequacy appropriately, based on a cost/benefit approach of holding reserves. In addition, the operational framework is well developed and ensures that liquidity, market risk, and credit risk are controlled in a prudent manner.
Operational compliance is monitored against investment guidelines on a continuous basis, and processes followed are sound and professional, both in terms of the internal investment activities, and in relations with external managers, which are selected under a well documented external manager program.
Furthermore, the central bank's internal governance structure, based on a strong control framework with clear allocation of authority and an appropriate level of management reporting, is sound. It also has a well developed risk management framework, backed by adequate systems and human resources, and an adequate level of reporting to its board. Overall, this ensures that the board is well aware of risk exposures and apprised of the scope for potential gains and losses arising from foreign exchange reserve management.
Model for others
The IMF assessment came as a natural continuation of regular informal engagement between the Chilean authorities and Fund staff on operational and policy aspects related to reserve management. In 2006, for example, the central bank worked with Fund staff to implement best practices with respect to transparent and accountable management of Chile's foreign exchange reserves.
A tangible result of this collaboration was the publication, on the part of the authorities, of a detailed description of how foreign exchange reserves are managed in Chile. This publication is a useful source of information that allows for greater public scrutiny and understanding of the central bank's activities, and serves as a useful model for other countries to adopt.
The favorable outcome of the 2007 review serves not only to bolster the central bank's overall credibility, but also to underscore the bank's fiduciary capacity in managing the government's wealth funds. The process helped identify strengths and weaknesses within the existing institutional framework, and areas for further improvement (for example, the use of electronic bond trading systems, bond futures, and risk-adjusted performance measures), which now form part of the central bank's internal annual work program.
Because other countries setting up sovereign wealth funds also often consider central banks among the potential candidates to manage the day-to-day investments of these funds, they may benefit from similar independent assessments of central bank capacities—an area where Fund staff have developed significant expertise from country work over the years.