Reserve Bank of Australia Annual Report – 1997 Operations in Financial Markets

The Bank operates in financial markets to implement monetary policy, to manage its own portfolio of assets and to carry out transactions on behalf of its customers. By far the largest and most important operations are those related to monetary policy. These have been used to give effect to five easings since June 1996.

Operations for Monetary Policy Purposes

Domestic market operations

Domestic market operations became the main mechanism for implementing monetary policy in Australia in the mid 1980s, replacing the previous reliance on various administrative controls on banks.

These operations are used to influence the ‘cash’ rate – the overnight interest rate in the money market. The Bank's high degree of control over the cash rate (see following box) gives it the ability to influence the short end of the yield curve and interest rates charged by intermediaries. This model of monetary policy implementation, which uses the cash rate as the main instrument, is common to most central banks, the best known being the US Federal Reserve.

Since 1990, the practice has been to announce all changes in the cash rate by media release on the morning the changes take effect. Such announcements sometimes occur in the days following the Bank's Board meeting early in the month, or they may be later if, for example, the Board's decision is contingent on the release of further data or if there is a need to wait for more settled market conditions. The announcement states the new target level for the cash rate together with the reasons why the Board has decided to make the change.

Monetary policy has been eased in five steps since July 1996, the cash rate target being cut by 0.5 of a percentage point in each step. The easings took the cash rate from its opening level of 7.5 per cent to 5.0 per cent by late July 1997.

Monetary policy changes: 1996/97

(Per cent)

	Change	New cash rate target
31 July 1996	−0.5	7.0
6 November 1996	−0.5	6.5
11 December 1996	−0.5	6.0
23 May 1997	−0.5	5.5
30 July 1997	−0.5	5.0

These days, the market tends to move to the new cash rate as soon as the Bank makes its announcement – that is, before it undertakes its market operations. As discussed in the accompanying box, market participants now work on the assumption that the Bank will enforce the new cash rate and therefore move there in anticipation. Nonetheless, the adjustment in rates is underpinned through market operations: on each of the five days when policy was eased during the past year, the Bank used its market operations to leave surplus funds in the market. The size of operations undertaken to achieve a given cash rate target takes into account not only the money market opening cash position (the amount of funds that would otherwise be available to the market on the day), but also other factors which affect market behaviour, such as the outlook for the availability of funds in the days ahead.

Market operations are undertaken almost every day, not just on days on which policy is changed. In intervening periods, they are used to maintain the cash rate close to the target. This ‘liquidity management’, as it is termed, involves the use of market operations to adjust the supply of funds in the face of the various factors which affect funds availability (e.g. Commonwealth Government transactions, the Bank's foreign exchange operations and currency flows).

The Bank's operations include both outright purchases and sales of short-dated Commonwealth Government securities (CGS) and repurchase agreements (also known as repos). The latter involve a purchase or a sale of securities with a simultaneous undertaking to reverse the transaction at an agreed date and price in the future. Repos have become the main instrument used in market operations, accounting for about 90 per cent of transactions. This is due to the flexibility they offer in managing liquidity flows because their maturity can be tailored to market needs and because they give access to a wide range of securities (securities used in repos can be of any maturity). The repo market in Australia is large, with daily turnover of about $6 billion, permitting sizeable volumes of sales or purchases when necessary.

The total value of the Bank's domestic market operations in 1996/97 was much larger than in previous years, with repo turnover more than doubling to almost $200 billion. This growth reflected the fact that, with interest rates generally falling over the year, financial institutions held on to longer-dated paper to maximise their chances of making capital gains and hence shortened the maturity of assets they were prepared to sell to the Bank. This was most evident in the shortening of the term of repos, the majority being of overnight maturity. As a consequence, the Bank was required to roll over its repo position at a higher frequency than in the past.

The size of daily market operations varies a good deal but on average was about $800 million a day in 1996/97. Generally, transactions on any one day are undertaken with around four or five counterparties.

Outright transactions in short-term CGS were around the same volume as last year, at about $25 billion. Most of these involved purchases of Treasury notes though about $8 billion in near-maturing bonds were purchased during the year.

The total value of bids or offers received by the Bank each day almost always exceeds the volume needed for its operations, on average by about three to one. There were several episodes during 1996/97, however, when the total value of deals presented by the market was insufficient to satisfy liquidity management objectives through transactions in CGS. They occurred at times when the Bank was looking to inject a substantial amount of liquidity into the market – such as in the peak company tax periods of early December 1996 and March and June 1997. During these episodes, transactions in CGS were supplemented by foreign currency swaps. Foreign currency swaps work in much the same way as repurchase agreements in securities, the difference being that the underlying asset exchanged for cash is foreign exchange rather than securities. (Foreign exchange swaps do not change the foreign exchange exposures of the parties and therefore have no effect on the exchange rate.) Over the year, the Bank undertook around $10 billion in swaps to manage cash market conditions. These were unwound by the end of the year.

Until the past year, the Bank's operating procedures had been broadly unchanged for over a decade. Apart from the occasional use of foreign exchange swaps, operations were confined to CGS and were carried out with a group of counterparties known as the authorised money market dealers. In the past year, however, a number of changes were made in preparation for the introduction of a real-time gross settlement (RTGS) system in Australia (described in ‘Surveillance of the Financial System’). In mid 1996, the Bank:

• broadened the range of counterparties with which it was prepared to undertake market operations to include all members of the Reserve Bank Information and Transfer System (RITS), which is the settlement system for Commonwealth Government securities;
• withdrew the facilities it had provided to the authorised money market dealers; and
• began to pay interest on balances in banks' Exchange Settlement Accounts at the Bank. This provided banks with an alternative to their previous practice of holding transactions balances with the authorised money market dealers. Accordingly, the interest rate on these balances was set at 10 basis points below the cash rate target, similar to the margin which had applied on average to funds placed with the authorised dealers.

One consequence of these changes in arrangements was that the balances in banks' Exchange Settlement Accounts grew quickly. Whereas banks had typically placed funds of about $3½ billion with the authorised dealers, over the course of the past year balances in Exchange Settlement Accounts built up to an average of around $7 billion, and often higher. By the end of 1996/97, for example, these balances had reached a level of almost $10 billion. Instead of using the Accounts simply as a transactions facility, some banks viewed them as an attractive investment avenue in their own right, offering a rate competitive with short-term government paper from an institution of absolute creditworthiness, and with considerably less market risk.

This build-up of balances caused some difficulty on occasions, in that funds injected through purchases of securities were simply held by banks in their Accounts rather than lent into the market more generally. As a result, there were times when the cash rate remained above the target even though the Bank had supplied adequate liquidity to the market overall. Essentially, banks' behaviour suggested that a margin of 10 basis points between the rate paid on their Accounts and the rate available in the market was not sufficient to induce banks to undertake market loans.

This issue was addressed in June this year when, as part of a further package of measures to prepare for the introduction of the RTGS system, the Bank announced it would reduce the interest rate on Exchange Settlement Account balances to a margin of 25 basis points below the cash rate target. This change will take effect from October 1997. Other changes announced at the same time included:

• the introduction of an end-of-day credit facility to holders of Exchange Settlement Accounts, again effective October 1997. This facility, which will take the form of overnight repos, will permit these institutions to generate liquidity to cope with any end-of-day pressures under RTGS. Use of the facility will be at the discretion of the account-holder, though the interest rate applying will be at a margin of 25 basis points above the cash rate target;
• the broadening of repo operations to include Australian dollar-denominated securities issued by the central borrowing authorities of State and Territory Governments. This change became effective in late June 1997, when such securities were also made eligible for inclusion in banks' Prime Assets Requirement (PAR) holdings; and
• the reduction in the minimum PAR ratio from 6 per cent of banks' liabilities (excluding capital) to 3 per cent (see ‘Surveillance of the Financial System’).

Foreign exchange operations

In Australia's exchange rate system, the exchange rate for the Australian dollar is determined among buyers and sellers of Australian dollars in the market. Nonetheless, the Bank takes a close interest in movements in the exchange rate, as do all central banks. Exchange rates play too important a role in the transmission of monetary policy for central banks to be completely indifferent to their movements.

The Bank has been prepared to accept fairly wide variations in the exchange rate over the economic cycle, recognising that these movements can play a benevolent role in helping to insulate the domestic economy from various shocks. After the sharp fall in the exchange rate in the latter part of 1984 and early 1985, the trade-weighted index of the Australian dollar has varied around a fairly flat trend, ranging between a high of 68 and a low of 47, with an average of about 57. The variability of the Australian dollar, in trade-weighted terms, is similar to that of other major countries with floating exchange rates. Variability was above average in the 1980s but has declined in the 1990s.

There have been episodes since the float in which the Bank has taken action to influence the exchange rate, either because market overshooting had pushed the exchange rate to levels which could have compounded problems of economic management, or because market conditions had become unsettled in reaction to economic news or other events. The most powerful, and only certain, way for a central bank to influence the exchange rate is through monetary policy. But there can be circumstances in which the use of monetary policy for this purpose may have other, undesirable, consequences for the economy more generally. For this reason, almost all central banks with floating exchange rates engage from time to time in intervention – i.e. buying or selling currency in the open market – with the aim of influencing market expectations about the exchange rate.

The Bank's foreign exchange market intervention typically involves purchases or sales of Australian dollars in exchange for US dollars, as the US dollar is the main currency against which the Australian dollar trades. Intervention does not involve ‘spending’ the Bank's assets; it is simply the exchange of one type of asset for another. The Bank maintains a capacity to intervene on a 24-hour basis, through its main foreign exchange dealing room in Sydney, which operates from 6.00 am to 6.30 pm local time, or through its offices in London and New York.

Foreign exchange market intervention is not intended to target any particular level of the exchange rate. For one thing, it is difficult to judge when the exchange rate has overshot, until it has done so by a large margin, since understanding about how economic forces affect exchange rates is far from precise. The Bank's intervention objectives are fairly modest: to slow movements in the exchange rate when the market is moving quickly to a position which appears to be out of line with fundamental economic conditions, or to calm market conditions when there is a short-term overreaction to news. Though history provides examples of both, episodes which require intervention are not very common. The most recent bout of intervention aimed at influencing the exchange rate was between late 1991 and September 1993, when the Bank supported the exchange rate with market purchases of $18 billion of Australian dollars in exchange for US dollars. Some of these transactions were funded by sales of foreign exchange assets (i.e. by a rundown in official reserves) and some through the swap market; at the end of that period, swaps outstanding were around $11 billion. The Bank also met the Commonwealth Government's net foreign exchange needs of over $3 billion during this period directly from official reserve assets.

From late 1993 until the first half of 1995, as the Australian dollar gradually appreciated, the Bank did not undertake transactions in the market and continued to meet the Commonwealth's foreign exchange needs out of reserves. Since mid 1995, however, it has begun to buy back foreign exchange to cover net sales to the Commonwealth and to rebuild official reserves. Its net spot purchases were $3.8 billion in 1995/96 and $5.6 billion in 1996/97. Purchases were used, in part, to reduce the outstanding swaps position. In addition to these market transactions, interest received on foreign currency investments has also added to official reserves.

Market purchases of foreign exchange during the past year were concentrated at times when the exchange rate was rising, particularly the December quarter. The Bank was not targeting any particular exchange rate level, but its purchases would have acted to slow the appreciation of the exchange rate.

The average exchange rate at which the Bank's purchases of US dollars have been made since mid 1995 is about US78.3 cents. This compares with an average rate of US71.4 cents for sales during the intervention of the early 1990s, a difference which resulted in considerable profit for the Bank.

Profits from intervention can be measured meaningfully only over a long period of time, taking into account a complete cycle in the exchange rate. The Bank, of course, is not motivated by profits in deciding on intervention strategy, but it does monitor profitability over time. This is because profitability can be one indication of whether the intervention has contributed towards stabilising the exchange rate, as profits will result when intervention involves buying when the exchange rate is low and selling when it is high. This is explained more fully in an earlier study of intervention, reported in a Research Discussion Paper, Reserve Bank Operations in the Foreign Exchange Market: Effectiveness and Profitability (1994).

Operations Undertaken for Balance Sheet Management

The second type of operation undertaken is that directed at managing the Bank's portfolio of assets. These assets underpin monetary policy operations. They consist of domestic securities and foreign currency assets, the latter being held mostly in securities issued by overseas governments and deposits with highly rated foreign commercial banks. These holdings of foreign assets comprise the bulk of Australia's official reserves.

In 1996/97, the Bank's balance sheet grew by about $14 billion. This was an unusually large increase, due mainly to the strong rise in balances in Exchange Settlement Accounts, noted earlier. The latter rise has already been largely reversed in the new financial year as banks have anticipated the effect of the recently announced reduction in interest rates on these balances and have sought alternative outlets for these funds. There was also a temporary run-up in Commonwealth Government deposits of $2.6 billion in 1996/97, due mainly to the year-end receipt of funds from the Telstra ‘special’ dividend.

The expansion in liabilities was absorbed between official reserve assets (an increase of $4.5 billion) and holdings of domestic securities (an increase of $9.3 billion); the latter included $4.4 billion of Commonwealth Government and State Government securities bought under repo. This allocation between foreign and domestic assets was the outcome of market operations for monetary and exchange rate reasons, and was not an objective in its own right.

The Bank's assets carry very little credit exposure because of the high quality of the issuers, but they are subject to a large amount of ‘market’ risk, i.e. the risk of capital losses due to a rise in market yields or a rise in the exchange rate of the Australian dollar. While asset revaluation reserves (which reflect unrealised gains made on assets since they were purchased) can provide some buffer to falls in asset values, the losses could potentially be large enough to negate the Bank's underlying earnings (which have averaged around $1.6/$1.7 billion a year in recent years). The Bank therefore seeks to manage its exposure to market risk, within the constraints imposed by its monetary policy responsibilities.

Management of the domestic securities portfolio

The Bank has very little scope for active management of its domestic securities portfolio. For one thing, the overall size of this portfolio is essentially determined by its monetary policy operations and cannot be managed independently of them. In addition, the large size of the portfolio – about $20 billion or almost 20 per cent of all Commonwealth Government securities on issue – would mean that any attempt to engage in active trading could disrupt market conditions more generally.

At the margin, there is some scope, however, to manage the composition of assets. Over the past year, there was a shift in the portfolio to short-term assets such as repos, Treasury notes and Treasury adjustable bonds. This was done to limit the maturity mismatch between the additional liabilities the Bank took on (which were mainly of overnight maturity) and the corresponding assets; otherwise, the expansion in the balance sheet would have resulted in a significant increase in interest rate risk carried by the Bank. There was also some shortening of the bond portfolio.

The overall result of the above operations was that the duration of the domestic securities portfolio declined to 1.4 years, from 2.5 years twelve months earlier. Thus, even though the balance sheet grew strongly over the year, the overall risk of the portfolio, measured in terms of the potential loss for each basis point rise in yields, fell from $3.7 million to $2.7 million.

As well as initiating its own transactions, the Bank also responds to market initiatives, particularly proposals from the market for stock lending. This is done to improve the liquidity and efficiency of the Australian bond market. Stock lending allows market participants to access particular stocks in the Bank's portfolio in exchange for other lines of stock, helping to alleviate temporary shortages in supply. Because of the size and diversity of its bond portfolio, the Bank is a natural counterparty for these transactions, which earn a fee. In 1996/97, a total of $12 billion in stock was lent compared with $17 billion the previous year, the lower turnover mainly reflecting an increase in the term of the loans of stock.

Management of foreign currency assets

Foreign exchange reserves are held mainly to enable the Bank to intervene in the foreign exchange market. They represent, on average, about half the Bank's assets although this proportion tends to vary in response to intervention.

Unlike the domestic bond portfolio, the Bank has greater freedom to manage these foreign currency assets since, in overseas markets where these operations are undertaken, it is simply another participant. Nonetheless, care is always taken to avoid any transactions which could disrupt markets. Within constraints imposed by the need to keep a high degree of liquidity and minimise credit risk, foreign assets are managed to achieve the best possible combination of risk and return.

In line with best market practice, the Bank uses a benchmark as a yardstick against which to assess its performance in reserves management. This is a portfolio of assets which, on average over the long term, satisfies the Bank's investment objectives regarding credit risk, liquidity, market risk and return. For 1996/97, as in earlier years, the benchmark portfolio has been composed of securities issued by the United States, German and Japanese governments, and some deposits with highly rated commercial banks. Weights are decided on the basis of, among other factors, statistical research on past patterns of risk and return in the different markets. The major benchmark characteristics are shown below.

In previous years, the benchmark had specified a shorter duration for US dollar assets as a way of increasing US dollar liquidity. Greater use of repo markets, however, now permits the Bank to raise cash just as easily against assets of longer duration; in October 1996, benchmark duration of the US dollar portfolio was increased to reflect this.

In 1996/97, the return on the benchmark portfolio, in SDR terms, was 4.2 per cent. The actual return on reserves was a little above this, at 4.5 per cent. Most of the difference arose in the second half of the year, when the decision to reduce the proportion of US assets and their duration ensured that the negative effect of rising US interest rates was smaller for the actual portfolio than for the benchmark. Through most of the second half, a currency allocation to the US dollar was maintained above the benchmark 40 per cent; this ‘overweight’ position contributed to earnings as the US dollar rose against both the Japanese yen and the German mark. On the other hand, the decision to reduce the duration of the Japanese bond portfolio worked against performance. The Bank took the view early in the year that yields on longer-term Japanese bonds below around 3 per cent did not represent adequate value for a 10-year investment and carried a heavy risk of large capital losses if yields were to rise. In the event, yields in Japan continued to fall, with the benchmark long bond ending the year at 2.4 per cent; the short duration position therefore reduced the return on Japanese investments relative to that on the benchmark.

Gold

During the past year, the Bank reduced its gold holdings from 247 tonnes to 80 tonnes. This was done through a process of gradual sales over the second half of the year. The sales were undertaken forward, with 125 tonnes being delivered in June and the remainder to be delivered in August and September. In carrying out these sales, the Bank took care not to disrupt market conditions, and there was no discernible impact on the price of gold as the sales were being made. To further minimise the impact on the market, the Bank delayed announcement of the sales until early July when the first deliveries had taken place. By this time all sales had been completed, and the Bank's media release noted that there were no plans for further sales. Nonetheless, on the announcement, the price of gold fell from about US$332 per ounce to a low of US$317 per ounce, before recovering about half this fall in late July.

The fall in price in the days after the announcement was larger than expected, given the relatively small size of the Bank's sales, and elicited strong protests from the gold mining industry. As noted, however, the fall was substantially reversed subsequently and should be seen in a longer perspective. For example, the net fall in the price since the Bank's announcement is small relative to the fall of US$80 per ounce that had taken place over the previous year.

The sales crystallised a large portion of the unrealised gains on gold holdings; details are given in ‘The Bank's Earnings’. Under the Bank's normal arrangements for distributing profits, these gains would have been paid to the Commonwealth Government, which would also have had the effect of reducing official reserve assets. To avoid this, the Treasurer gave his approval for the Bank to retain the proceeds. The Government will, of course, receive an ongoing benefit from the additional profit the Bank will generate from the reinvestment of these proceeds.

The proceeds of the June deliveries were immediately invested in foreign exchange (government securities denominated in US dollars, Japanese yen and German marks). As a result, the gold sales have not resulted in a reduction in official reserve assets. Similar steps will be taken when the final deliveries take place.

The Bank will continue to lend its remaining gold holdings to market participants. During the past year, revenue from gold loans was about $35 million.

Transactions on Behalf of Clients

The Bank also undertakes transactions in financial markets on behalf of clients. By far the most important are foreign exchange transactions on behalf of the Commonwealth Government. In addition, transactions in government securities and foreign exchange are undertaken for other central banks, particularly those seeking to hold Australian-dollar investments as part of their official reserves. These are mainly central banks from the Asian and Pacific regions though some European central banks and international organisations are also involved. Total Australian-dollar investments held by these bodies were $6.3 billion at end June 1997, up $1.7 billion from a year earlier.

The Commonwealth Government has an ongoing need for foreign exchange of around $3–4 billion a year to cover its overseas expenditure. In some years, including the one just ended, the net need is lower because of foreign exchange raised through the swaps program which it undertakes as part of its financing transactions.

All transactions between the Bank and the Commonwealth are carried out at market prices. The Commonwealth advises the Bank of its needs on a daily basis and the Bank quotes an exchange rate at which it is prepared to deal, based on rates in the market at the time. As is the case with any bank transacting with a customer, the Bank then decides whether to carry the position or cover it in the market. For the most part, the Bank covers in the market. In periods such as the early 1990s, however, when the Bank was intervening in the market to support the Australian dollar, such an approach would have offset a significant part of the Bank's intervention. In these circumstances, the Bank meets the Government's needs directly from its foreign reserves for a time, though in due course the transactions are covered in the market as exchange rate conditions allow.

In 1996/97, the Bank's foreign exchange transactions with the Government involved sales of about $4 billion and purchases of about $3 billion. These figures are within the range of other recent years. With the exchange rate well above its early 1990s lows, the Bank covered in the market the net sales of $1 billion that it made to the Government; effectively, it added this amount to the market purchases it was undertaking on its own account to replenish reserves.