Exchange Fund Account Annual Report 2000: 1
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Introduction

This report reviews the operations of the Exchange Fund Account ("EFA") for the 2000 calendar year and the changes in Canada’s international reserve holdings against the background of developments in the foreign exchange market. The accompanying Financial Statements provide additional information on the operations of the EFA.

The Exchange Fund Account is the principal repository of Canada’s official international reserves. The EFA is governed by the provisions of the Currency Act and is held in the name of the Minister of Finance. Foreign currency borrowings by the Government of Canada are the main source of financing of the EFA.

Objectives

The objectives of the EFA are:

• to promote orderly conditions in the foreign exchange market for the Canadian dollar;

• to provide general liquidity for the government; and

• to minimize the cost of carry of the government’s foreign currency liabilities used to fund the EFA’s assets, with due attention to risk management.

Governance

The Minister of Finance approves the general policies related to the management of the EFA and, in particular, establishes the target level of reserves ^[1], and provides an annual report to Parliament on the operations of the Account. Responsibility for the management of the EFA is jointly shared by the Department of Finance and the Bank of Canada. The Bank of Canada, acting as fiscal agent for the Minister of Finance, effects transactions for the Account.

The Director, Financial Markets Division (Department of Finance) and the Chief, Financial Markets Department (Bank of Canada) are responsible for the on-going management of the EFA. A Policy Committee, comprised of senior management of the Department of Finance and the Bank of Canada, meets semi-annually to review developments, approve major policy initiatives and provide guidance and accountability on the management of the Account.

The Risk Management Unit (RMU), established by Bank of Canada to oversee the risk position of the Government of Canada, monitors and advises on the risk position of the EFA, including market, credit and liquidity risks.

Key Principles

In recent years the Government has increased the level of foreign exchange reserves in light of large flows in foreign exchange markets, to provide liquidity for the government’s operating needs, and bring Canada more in line with other comparable sovereigns. The foreign currency reserve assets and the liabilities financing those assets are managed on a portfolio basis, based on many of the same principles used by private sector financial institutions, including prudent risk management principles.

In this regard, interest rate and currency risks are immunized to the extent possible. On the asset side, attention is paid to asset liquidity and quality, diversification and credit limits with counterparties. On the liability side, the same attention is paid to diversified means of raising funds and a diversified investor base, as well as the cost of different sources of funds and the maturity profile of the liabilities.

• There should be a sufficient amount of high-quality, highly-liquid foreign exchange reserve assets available for intervention and general liquidity purposes;

• The difference between the interest paid on the government’s foreign currency liabilities used to fund EFA assets and the interest earned on those assets should be minimized (to the extent that the former is higher);

• Foreign reserves should be managed to ensure, as much as possible, that the assets match the liabilities in currency and duration;

• A prudent maturity structure and maturity profile should be maintained to limit refinancing needs;

• Best practices with regards to risk management should be applied in the overall management of the EFA;

• Credit risk should be managed prudently through diversification of the EFA asset portfolio, with appropriate use of credit ratings and counterparty limits; and,

• Foreign currency borrowing activities to fund EFA assets should be conducted so as to maintain Canada’s reputation as a successful borrower in international capital markets.

• The EFA portfolio is structured into a Liquidity Tier and an Investment Tier;

• At least 50% of the EFA’s assets are denominated in U.S. dollars. The remainder of the portfolio is split among euro and yen-denominated assets;

• The EFA holds debt in the designated currencies of highly rated sovereign governments, their agencies and by supranational organizations having a AA-rating or better.

The Gap between Foreign Currency Assets and Liabilities

In recent years foreign currency liabilities came to exceed liquid foreign currency assets in the Exchange Fund Account, largely as a result of foreign exchange intervention and important commitments to the International Monetary Fund in 1998. At its widest point, the excess liability amounted to some US$13 billion. Consistent with the Government’s policy of immunizing currency and interest rate risk in Canada’s reserve program, the Government is taking steps to bring foreign currency liabilities in line with foreign currency assets.

In December 1998 the Department of Finance, in collaboration with the Bank of Canada, implemented a program of purchases of U.S. dollars in foreign exchange markets. These U.S. dollars are used to reduce U.S.-dollar denominated liabilities. Purchases of U.S. dollars are small in relation to the large daily flows in foreign exchange markets and are undertaken with sensitivity to market conditions. This program has reduced the gap between foreign currency assets and liabilities to some US$6.5 billion, based on the market value of the assets, as of the end of December 2000, and the plan is to close it over the next few years.

Recent Developments

Collective Action Clauses

In April 2000, Canada announced that it was adopting collective action clauses in its future foreign currency bond and note issues. Collective action clauses in bond contracts facilitate debt restructuring by providing an orderly framework for debtors and creditors.

By bringing in collective action clauses, Canada indicated that it was helping to lead the process of having collective action clauses adopted by all countries. These clauses are an important part of Canada’s effort to promote international financial stability and reduce the risk and severity of global financial crises. In recent years, there has been a growing consensus that the wider use of collective action clauses in international bond contracts could contribute to a more orderly resolution of financial crises.

The specific collective action clauses that Canada adopted include collective representation, majority action and non-acceleration clauses.

• Collective representation clauses facilitate restructuring discussions between issuers and bondholders.

• Majority action clauses are intended to prevent restructuring proposals from being blocked by minority bondholders.

• Non-acceleration (without majority agreement) clauses help restructuring discussions by discouraging individual bondholder action to accelerate the terms of repayment.

The documentation governing Canada’s two foreign currency note programs (the Euro Medium-Term Note and Canada Note programs) has been modified to ensure that all future issuance under these programs includes collective action clauses. Future global bond issues by Canada will also include these clauses.

Risk Management

In June 2000, the Minister of Finance approved a new framework and limits governing credit exposure to commercial financial institution (FI) counterparties with respect to the government’s foreign currency reserve portfolio. The framework is consistent with best practices in credit risk management, including a rigorous, comprehensive credit risk system and credit exposure limits on counterparties.

The key elements of the new framework include:

• Aggregating the government’s credit exposure across all lines of EFA business (deposits, gold loans, FX forward contracts and cross-currency swaps) for each counterparty and for all FI counterparties as a group;

• Limiting the government’s actual credit^[2] exposure across all lines of EFA business and potential credit exposure^[3] on longer-term swap (and FX forward) business per counterparty and for all FI counterparties.

The Risk Management Unit monitors actual and potential credit exposures to each of the government’s FI counterparties on a daily basis and reports regularly to senior management of the Department of Finance and the Bank of Canada.

The government is also proceeding with the development of a collateral management framework to better manage the government’s credit risk to FI counterparties associated with cross- currency swaps and forward contracts. Collateral management systems are increasingly the norm in capital markets as a way of managing credit risk associated with swaps. The effect of collateralization is to substitute the credit risk of the issuer of the collateral for that of the counterparty to the transaction. The government expects to have the new collateral management framework in place in 2001.

Foreign Exchange Market Developments

The Canadian dollar weakened over the year, losing almost three U.S cents (or 3.8 per cent) against the U.S. dollar, finishing the year at US$0.6669. The dollar’s high for the year was US$0.6984 recorded on January 27 while the low for the year was US$0.6397 recorded on November 17. On a trade weighted basis against the C6^[4] currencies the Canadian dollar depreciated by 2.6 per cent, slightly less than it declined against the U.S. dollar alone. This is explained by the fact that the Canadian dollar appreciated by over 4.8 per cent against the C5 currencies (i.e. the non-U.S. dollar C6 currencies).

International Financial Developments during 2000

The global economic climate continued to be strong in 2000. Interest rate increases by the major central banks in the first part of 2000 lowered the risk of higher inflation rates in the major industrial countries. In the second half of the year, prospects for more significant than expected economic slowdown in the United States halted the increases in interest rates seen in the first part of the year.

(1) First Half of 2000 - Stronger growth raises concerns about inflation

In Europe, economic activity improved. The euro area real GDP growth was over 3.5 per cent for the first half of the year. Among the reasons for the economic strength was firm domestic demand, coupled with the depreciation of the euro, exerting a stimulative effect on exports.

In Japan, the Bank of Japan moved away from its "zero-interest-rate policy" in August by raising its target overnight interest rate to 0.25 per cent. The reduction in monetary stimulus was motivated by a surge in output growth in the first half of 2000 led by strong business investment and buoyant demand for Japanese exports.

The U.S. economy continued to grow vigorously leading to pre-emptive interest rate increases by the Federal Reserve. The federal funds target rate increased from 5.50 per cent in January to 6.50 per cent in May.

The Canadian economy started 2000 on a strong note due to sustained U.S. demand. In the context of the stronger-than-expected pace of economic expansion and potential inflationary pressures, the Bank of Canada increased the Bank Rate by 25 basis points in February, 25 basis points in March and 50 basis points in May bringing the Bank’s target for the overnight rate to 5.75 per cent.

(2) Second Half of 2000 - Economic conditions begin to show signs of weakness

The global economy, particularly the U.S. economy, started to show signs that growth had begun to slow more significantly and sooner than anticipated in the second part of the year. In all, past increases in interest rates, declines in personal wealth associated with weakening stock prices, and higher energy prices weakened the global economic outlook for the major industrial countries, particularly those with strong linkages to the U.S.

Prices for crude oil and natural gas increased in the later part of the year, driven by low inventories of petroleum products such as heating oil, by cold winter weather and by short-term concerns over tensions in the Middle East.

In the euro area, the pace of expansion slowed in the second half of 2000, partly owing to past increases in official rates by the European Central Bank. In addition, surveys suggested some declines in both business and household confidence.

The still fragile Japanese economy grew only marginally in the second half of the year. Household spending remained flat, reflecting weak income growth and concerns about employment prospects.

In the U.S., GDP growth slowed in response to the earlier increases in official interest rates and higher energy prices. In response, the Federal Reserve left the federal funds target rate unchanged at 6.50 per cent from May to December. At the same time, tighter credit conditions and lending standards and reduced profit margins contributed to restraining business investment.

Despite a slowing world economy and a deceleration in export growth, the pace of economic expansion in Canada remained solid in the second half of 2000, bolstered by strong domestic demand. Business investment increased considerably, reflecting further gains in profits, residential construction rose considerably, while overall consumer expenditures were supported by further increases in employment. Export volumes edged down, mainly owing to a marked slowing in the growth of U.S. demand. The Canadian economy slowed late in 2000, reflecting the further slowing in the U.S.

Financial Review

1. Foreign Exchange Market Intervention

The objectives of the Exchange Fund Account are to provide general liquidity for the government and to promote orderly conditions in the foreign exchange market for the Canadian dollar. In September 1998, the Department of Finance and the Bank of Canada decided to move away from intervening in the foreign exchange market in a predictable or automatic fashion (selling foreign exchange / buying Canadian dollars when there was downward pressure on the exchange rate, or buying foreign exchange / selling Canadian dollars when there was upward pressure on the value of the Canadian dollar). Instead, the current policy is for the Bank of Canada to intervene on a discretionary basis.

Since September 1998 the Bank of Canada, acting as agent for the Department of Finance, has not undertaken any foreign exchange market intervention in the form of either purchases or sales of U.S. dollars versus the Canadian dollar (see Table 1)^[5]. On September 22, 2000 the Bank of Canada participated in a concerted intervention by the G7 and European central banks in support of the euro by purchasing euros by an amount equivalent to US$97 million.

Table 1
Foreign Exchange Market Intervention

2. Amount and Composition of Canada’s Official International Reserves

The Exchange Fund Account is the principal repository of Canada’s official international reserves; Canada’s foreign assets at the Bank of Canada and the International Monetary Fund are also included in the total of reserves. The composition of Canada’s official international reserves and their distribution by holder at year end are shown below:

Table 2
Canada’s Official International Reserves Holdings 
As at December 31
(market value)

Canada’s official reserves ended the year at US$32.4 billion on a market value basis. The increase in the level of reserves over this period was funded primarily through swapped domestic issues and spot foreign exchange purchases. These financing activities are set out in greater detail in Table 7.

With regards to the Official International Reserves press release and as noted in the last Annual Report, the Government of Canada became one of the first countries in 1999 to provide enhanced reserves disclosure in a manner consistent with the standards established by the International Monetary Fund and the G-10 central banks. Initiatives to enhance international standards for reserves disclosure reflect the broad international consensus that more comprehensive and timely reserves data would help reduce the possibility of financial crises. An important feature of the enhanced reserve reporting is to provide more extensive, disaggregated data - for example, Canada reports its reserve position weekly and data related to foreign currency liabilities and off-balance sheet transactions are disclosed on a monthly basis.

Table 3 below outlines the main factors affecting the level of reserves:

Table 3
Sources of Changes in Canada's Official International Reserves
(market value)

More detailed information on monthly levels and changes in Canada’s reserves is presented in Table 8.

3. Term Structure of EFA Investments and Liabilities

Table 4
Term Structure of Foreign Currency Investments and Liabilities
As at December 31, 2000
(par values¹ in millions of U.S. dollars)

As noted earlier, foreign exchange liabilities have grown significantly in recent years, particularly in 1998 due to extensive foreign exchange intervention and important commitments to the International Monetary Fund. As a result, foreign currency liabilities grew to exceed foreign currency assets in the EFA and purchases of U.S. dollars in the foreign exchange markets are being used to reduce the mismatch between foreign currency liabilities and assets. Graph 1 presents the EFA’s liquid foreign reserve assets and the foreign currency liabilities since 1986.

4. The Exchange Fund Account’s Revenues

The Exchange Fund Account’s revenues include income from its investments, net gains on sales of gold, and foreign exchange gains or losses on its assets and liabilities. In 2000, the EFA’s income totalled C$2,529 million, compared with C$1,935 million in 1999. Income earned by other reserve holders is added to official reserves, but is reported directly by those other entities.

The main categories of income earned by the EFA are summarized below:

Table 5
Exchange Fund Account Income Summary

At year end, the EFA’s portfolio of marketable securities consisted entirely of discount and fixed-rate securities; there were no floating rate investments held.

The EFA’s securities lending programs enhance the yield earned on its securities portfolio by lending out to counterparties securities which are highly sought after in the market. At year end, $2,825 million (par value) in U.S. Government securities were held by financial institutions that act as agents for on-lending these securities in the market. Income from securities lending was US$2.6 million in 2000.

The EFA lends gold in the market on a short term basis, periodically using forward rate agreements in order to benefit from occasional upward fluctuations in rates offered on gold loans and to establish rollover rates on these loans prior to their maturity. Income from this activity is reported as investment income on gold.

5. The Exchange Fund Account’s Costs

The Exchange Fund Account’s cost is represented by the interest paid on Canada’s foreign currency borrowings. In 2000, this cost totalled US$2,028 million. The running cost of carry of the EFA is estimated by subtracting the interest paid on Canada’s foreign currency liabilities from interest earned on the EFA’s assets and totalled US$28.4 in 2000. Table 6 provides an estimate of the running cost of carry for the EFA portfolio as a whole and for the euro, yen, and U.S. dollar segments of the portfolio. The cost of carry of the EFA portfolio is estimated at 8 basis points per year. The running cost of carry for the euro and the yen portfolios is lower than that of the US dollar portfolio, reflecting the comparative cost advantages which Canada has enjoyed recently in the euro and yen markets.

The Running Cost of Carry For the EFA, Year 2000^[6]:

Table 6
Running Cost of Carry For the EFA

The main strategies used to reduce the cost of the EFA have been, on the liability side, to achieve cost-effective funding of the reserves and, on the asset side, to modify the composition of the Account by shifting a portion of the government’s investments in sovereign issues to other higher- yielding but still liquid high quality, fixed-income securities. These securities bear returns near the rate of interest Canada pays on its foreign liabilities. To further reduce carrying costs, a more aggressive use of the government’s euro-currency portfolio has been undertaken, when a comparative carrying cost advantage relative to the US-dollar assets exists. Finally, the cost of holding securities has been further reduced by proceeds derived from the government’s active securities lending program.

6. Financing of EFA Assets

EFA foreign currency reserves are financed by foreign currency borrowings by the government (see Table 7). Currently, all foreign currency marketable assets are matched by foreign currency borrowings. In addition, as we noted, because of heavy intervention in support of the Canadian dollar in 1998, there are currently more foreign currency liabilities than foreign currency assets (i.e. a portion of foreign currency liabilities is not matched by foreign currency assets).

Table 7
Foreign Currency Issues
as at December 31
(par values)

7. Risk Management

The government has in place a comprehensive risk management framework for identifying and managing treasury risk, including market, credit, operational and legal risks, related to the financing and investment of the foreign exchange reserves. The government’s risk management policies call for prudent management of treasury risks based on best practices. Standards for risk tolerance are very prudent, with market risks generally immunized and high credit quality and diversification standards followed.

The governance framework separates risk management from treasury operations. The Risk Management Unit (RMU) established by the Department of Finance and the Bank of Canada monitors and advises on the risk position of the EFA. The RMU measures the EFA’s major treasury risks on a daily basis and reports regularly to both treasury and senior management at the Department of Finance and the Bank of Canada.

The Risk Management Committee (RMC), meets regularly to review risk reports and to provide guidance and accountability on the government’s treasury risk policies. The Committee is comprised of senior treasury management from the Department of Finance and the Bank of Canada and also includes members from the Department of Finance and the Bank of Canada outside treasury operations.

Table 8
Canada’s Official International Reserves
(market value in millions of U.S. dollars) 

Table 8 (cont'd)
Canada’s Official International Reserves
(market value in millions of U.S. dollars)

Table 8 (cont'd)
Canada’s Official International Reserves
(market value in millions of U.S. dollars)

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