F OREIGN R ESERVE A CCUMULATION October 20, 2006 Manuel Ramos Francia T HE M EXICAN E XPERIENCE

2 As a result of the currency crisis on December 1994, Banco de México was forced to abandon the predetermined exchange rate regime and float the peso, thus changing the nominal anchor of the economy. Banco de México withdrew from actively intervening in the foreign exchange market and gradually converged towards an inflation targeting regime.  Fixed exchange rate  Monetary policy subordinated to the exchange rate regime  Flexible Exchange Rate  Inflation Targeting The Mexican Experience

3 The free floating regime has simplified monetary policy management, since the exchange rate can adjust more rapidly to domestic and external shocks. Overnight Interest Rate and Exchange Rate (Percent and Pesos per Dollar) The Mexican Experience Source: Banco de México.

4 Banco de México’s operations in the foreign exchange market are divided in two categories: a)Operations with the Federal Government and PEMEX. b)Operations for international reserve management. FX OPERATIONS OF BANCO DE MÉXICO FOREIGN EXCHANGE MARKET Rule Based Operations ( , 2003 onward) Discretional Interventions (last intervention in Sep. 1998) Federal Government: external debt service PEMEX: export revenues and external debt proceeds FEDERAL GOVERNMENT AND PEMEX The Mexican Experience

5 1.Operations with the Federal Government and PEMEX. Both are required to undertake all their foreign currency operations with the Central Bank. Although these operations are not carried out in the foreign exchange market, they are settled at market prices. Banco de México sterilizes completely the monetary effect of its foreign exchange operations. Flows of Net Foreign Assets: Decomposition by Source ( ) 1/ 1/ Million dollars. * Include net income generated by investing Banco de México’s international assets. ** As of September, The Mexican Experience

6 2.Operations for international reserve management. Since the crisis, several mechanisms have been adopted for the management of international reserves: 1.Initial Stage ( ): Low level of international reserves and highly volatile foreign exchange market. Restore orderly market conditions. 2.Intermediate Stage ( ): Increase the level of international reserves and provide liquidity to the foreign exchange market in face of shocks (high volatility episodes). 3.Current Stage (2001 to date): Promote a cleaner float and prevent excess accumulation of foreign reserves. The Mexican Experience

7 International Reserves and Foreign Exchange Rate * * As defined in the Banco de Mexico Law of : Initial Stage. 2: Intermediate Stage. 3: Current Stage. The mechanisms adopted allowed for a fast buildup of international reserves and promoted orderly conditions in the foreign exchange market in face of different shocks. This contributed to the development of a deep foreign exchange market. The Mexican Experience

8 Rule Based Operations: Between August 1996 and July 2001, the Foreign Exchange Commission (FEC) developed well defined mechanisms for the accumulation of international reserves and to limit the volatility of the exchange rate. 1.Monthly auction of options to sell dollars to Banco de México (August 1996 to June 2001). 2.Daily dollar auction to financial intermediaries (February 1997 to July 2001). Once the FEC concluded that the benefits from continuing the accumulation of international reserves were less significant, a mechanism to reduce Banco de México’s rate of accumulation was put in place (since May, 2003). Discretional Interventions: Banco de Mexico’s last intervention in the foreign exchange market took place on September 10 th, 1998 for 278 million dollars. The Mexican Experience

9 Net International Reserves (Billion Dollars) Red lines represent dates when Moodys improved Mexico’s credit ratings. Source: Banco de México.

10 The Mexican Experience International Reserve Accumulation through Automatic Mechanisms (Billion Dollars) Source: Banco de México.

11 Daily Dollar Auctions (Million Dollars) Exchange Market Volume* (Million Dollars; Monthly Average) *Includes operations in the spot, swap and forward markets. Source: Banco de México. The Mexican Experience

12 The Mexican Experience Sterilization of International Reserves. International reserves have grown more than the monetary base. Reserve Accumulation and Monetary Base Growth (Cumulative Flows, Billion Dollars) Monetary Base (Percent of GDP) Source: Banco de México.

13 The Mexican Experience Monetary Regulation Bonds (BREMS) and Compulsory Deposits (Amounts Outstanding; Billions of Mexican Pesos) *Since August 17th, Banco de México uses BONDES “D” for monetary purposes instead of BREMS. Source: Banco de México.

14 Sources and Uses of Financial Resources (Effective Flows as Percent of GDP) The Mexican Experience 1/ Refers to non-sectorized assets, capital and results accounts, technical reserves accounts, capital reserves, physical assets of financial intermediaries, preemptive reserves, investment in stocks, commercial banks external resources, financing to non-residents, INFONAVIT liabilities other than those submitted by workers, financial intermediaries liabilities other than bank credits, net position of trusts (fideicomisos) with the banking sector, the difference between development banking domestic financing to the private sector and to financial intermediation, and non-monetary liabilities of IPAB, among others. 2/ Corresponds to dollar sales according to the mechanism for reducing the rate of foreign reserve accumulation (see Foreign Exchange Commission press release of March 20, 2003). Source: Banco de México.

15 The Mexican Experience Benefits and costs of holding reserves in Mexico. Benefits The economy is insured against sudden stops: the exposure to external shocks is much lower. The country’s credit worthiness improves: the country has Investment Grade since March 2000 and has already developed a market for long-term instruments in domestic currency. Costs Carry cost of reserves. At the margin, increasing reserves holdings is progressively yielding lower net benefits.

16 The Mexican Experience Optimal Reserves in Mexico: Methodology of Ben-Bassat and Gottlieb. The Central Bank chooses the level of reserves to minimize expected costs of holding them:

17 FOC: Logistic function for  : Specification for f: The Mexican Experience

18 The Mexican Experience Optimal Reserves to Actual Reserves Ratio* (Different Levels for Cost of Crises as Percentage of GDP) * The opportunity cost of reserves (r) was assumed at 5%.

19 The Mexican Experience Challenges Ahead Capitalization and adequate management of the oil- stabilization fund. Reduce the cost of holding reserves. Increase asset returns. a)Riskier assets: market risk (higher duration) vs. credit risk (alternative asset types). b)Improve risk management capabilities: internal vs. outsourcing. Limit the growth of reserves.

20 The Mexican Experience Source: Banco de México. 5.2% 7.0% 5.8% 5.0% 3% 4% 5% 6% 7% 8% 9% 10% 11% % Break even yield from FX reserves Overnight Mexican Peso Rate Broad Corporate Yield US Treasuries and Agencies Yield Cost of Holding Reserves Local Interest Rates and Selected Yields (Percent) The average duration of the AAA-rated U.S. Treasuries and Agencies Portfolio is 2 years. The average duration of the A- rated Corporate Portfolio is 5.7 years.

21 The Government will prepay more than 12.4 billion dollars of foreign exchange denominated debt (IADB and World Bank mostly). To finance this transaction, the Government purchased 12.4 billion dollars from the Central Bank’s reserves with funds obtained from the issuance of domestic debt. The Mexican Experience BREMS BONDES D Dollars BONDES D External Debt Cancellation Foreign Creditors Dollars Government Local Market Central Bank

22 The Mexican Experience: Final Remarks The criteria to measure the optimal level of reserves has changed over time, reflecting both the changes in the global economy and the particular features of each country. Capital account considerations and external vulnerability issues seem more relevant in light of recent international experience. After the financial crisis of , Mexico started to build up international reserves in order to improve investor confidence, strengthen the access to external capital markets, and reduce the country’s external vulnerability. During the last years, the increase in international reserves is explained by the higher oil revenues.

23 Several factors explain the reduced need for accumulating international reserves in Mexico. Macroeconomic stability, the development of domestic financial markets, and the substitution of external debt for domestic debt have made the economy less vulnerable to financial shocks. The floating exchange rate regime implies that there is no need to hold reserves to manage the exchange rate. The net benefits of continuing to accumulate international reserves at a rapid pace are considered to be limited. In order to reduce the cost of holding large international reserves, Mexico decided to reduce their growth rate. The Mexican Experience: Final Remarks