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Exchange Equalisation Account: Accounts 1998-99

Account for the year ended 31 March 1999


CONTENTS

Foreword

Introduction
Origin and Purpose
Audit and Publication
Statement of the Accounting Officers Responsibilities
Administration and control
Links to the National Loans Fund
Investment Policy
Credit Risk
Evaluation of the Bank's Management of the Reserves
Review of Activities during 1998-99

FOREWORD

Introduction

• to secure the conservation or disposition in the national interest of the means of making payments abroad; and
  
  
• for certain purposes arising from the United Kingdom's membership of the IMF, including the holding, purchase and sale of SDRs.

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Audit and Publication

Statement of the Accounting Officer's Responsibilities

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Administration and control

• any change in the level of the reserves for the year;
  
  
• benchmarks for investing the reserves, with limits to the Bank's discretion to take currency or interest rate positions relative to these benchmarks,



• the framework for controlling credit and market risks,
  
  
• it also specifies the National Loans Fund (NLF) foreign currency borrowing programme which is partly used to finance the reserves.
  

 The Remit can be reviewed during the year at the Bank's or Treasury's request.

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Links to the National Loans Fund

Table 1: Combined EEA and NLF Foreign Currency Assets and Liabilities (,mns)

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Investment Policy

12.         Given the uses for which it was set up, the EEA's foreign currency reserves need to be carefully managed to ensure their liquidity and to avoid exposing the public purse to unnecessary risk.   Market risk (exposure to movements in either exchange rates or interest rates) is carefully controlled both in financing the EEA's reserves and in limiting the Bank's discretion to manage them actively.  While the EEA was not set up to make a profit, achieving value for money means that the Treasury and the Bank seek to maximise returns on the foreign currency balance sheet, taking assets and liabilities together, subject to controlling risk and ensuring liquidity.


13.               Where it finances the foreign currency reserves through borrowing in foreign currency the Treasury limits its exposure to fluctuations in sterling.  When sterling appreciates the value of the EEA's foreign currency assets falls in sterling terms but the value of the NLF's foreign currency liabilities also falls.  As Table 1 illustrates, while assets of foreign currency and gold totalled ,22,791million at the end of 1998-99,  exposure to currency movements (and the gold price) was largely limited to the net assets valued at , 8,479 million as a substantial proportion of the currency exposure on the assets is hedged by the foreign currency liabilities valued at ,14,312 million.  There is, however, a net currency exposure and this needs to be controlled.  Taking account of past patterns of risk and return the benchmark for net currency exposures in 1998-99 was 40% US Dollar, 40% deutsche mark (euro after 1 January 1999) and 20% Yen. ^[5]   This is reflected in the composition of the net reserves (i.e. the differences between the level of foreign currency assets and liabilities) between the US dollar bloc, European bloc and in yen at the balance sheet dates.  The overall currency composition is determined by the A40:40:20" benchmark for the net reserves combined with the composition of the NLF's foreign currency liabilities.


14.               Interest rate risk is controlled by matching the risk characteristics, for example the maturity, of the EEA's assets to the NLF's foreign currency liabilities.   The net currency assets are invested in short term money market instruments to control the residual interest rate risk.


15.         The “benchmark” for investing the reserves during 1998-99, against which the actual return can be measured, was the return to keeping currency exposures split 40:40:20 between US dollar, deutsche mark/euro and yen and limiting interest rate exposure to 1 month on the net currency reserves.   The composition of the currency risk can vary from the benchmark, or the Treasury can take on interest rate risk, as a result of decisions taken by the Treasury or the Bank.  Any intervention to influence the level of sterling would change the level and possibly the composition of the currency risk.


16.         The Treasury may decide, on advice from the Bank, to set deviations from the 40:40:20 currency benchmark or the one month interest rate benchmark (which are denoted “strategy positions”).    No such “strategy positions” were in place at the start of 1998-99 but the net reserves were held in the proportion of 44:42:14 at the end of the period.  No further positions were run during the year.


17.         As part of its active management, the Bank can run currency or interest rate risk on the reserves within the following limits.  On currencies, deviations from the 40:40:20 benchmark must be limited to the equivalent of $300 million for each currency.   In 1998-99 the maximum currency divergences were long $141 million of dollar, long $139 million of euro and short $280 million of yen.  On interest rates, deviations from a neutral position must be limited to the 4 year equivalent of $600 million for each of the dollar, deutschemark/euro and yen currency blocks.  The maximum month-end interest rate divergences from the benchmark were the 4 year equivalent of $112 million for the dollar yield curve at the end of August 1998; $107 million for the deutsche mark/euro curve in July 1998; and $175 million for the yen yield curve in November 1998.  At the end of March, exposures to parallel shifts in the yield curve were the 4 year equivalent of $1 million for the dollar curve, $26 million for the euro curve and $47 million for the yen yield curve.

18.         Limits and measuring exposures to parallel shifts in yield curves does not tell the whole picture on interest rate exposures.  During 1998-99 the Bank made significant progress in introducing a new management information system to enable value at risk (VAR) limits to be implemented (a system which is now fully in place).  Value at Risk measures the aggregate market risk on a portfolio, specifically, the maximum potential change in the value of a portfolio with a given probability over a given time horizon.  For example, A95% of the time gains/losses will not exceed $10million over a two week period.  These value-at-risk estimates are based on the past volatility of returns on different asset classes and on how the returns on each asset class are correlated with others held in the portfolio.   In addition, regular stress tests are conducted to explore the vulnerability of the portfolio to hypothetical market developments.


19.              Investments need to be highly liquid so they can be made available quickly for intervention purposes if necessary and carry minimal credit risk.  Essentially this means that the bulk of the assets are securities issued by the national governments of the United States, France, Germany and Japan and currency deposits with highly rated banks.  During 1998-99 the EEA also made use of other financial instruments including:

• bonds issued by supra-national organisations and selected official sector agencies,
  
  
• foreign currency spot, forward and swap transactions,
  
  
• interest rate and currency swaps,
  
  
• bond and interest rate futures,
  
  
• sale and repurchase agreements,
  
  
• forward rate agreements,
  
  
• gold deposits, gold loco and gold quality swaps,
  
  
• special drawing rights (SDRs),
  
  
• and corporate commercial paper.
  

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Credit Risk

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Evaluation of the Bank's Management of the Reserves

Returns in 1998-99

Gold

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Review of Activities during 1998-99

Intervention

Redenomination

Provision of foreign currency services to Departments.

Loans to the IMF

31.         At various times during the year the IMF called on the UK's Quota at the Fund to finance its lending programmes.   In addition, the UK's IMF Quota was increased as part of the General Quota Increase in February 1999.  These transactions resulted in an increase in the UK's reserve tranche position at the Fund from the SDR equivalent of ,1,752million at end-March 1998 to the SDR equivalent of ,3,222million by end-March 1999.  Other things being equal, lending by the Fund in sterling or an increase in the Quota, would lead to a rise in the UK's SDR assets.   To avoid the UK’s foreign currency exposures increasing as a result of this activity the EEA used foreign currency to buy back the sterling lent by the Fund and funded the reserve tranche portion of the Quota increase from its foreign currency holdings.

32.         The UK also participated in IMF lending made under the General Arrangements to Borrow (GAB) and the New Arrangements to Borrow (NAB) during the year, by making advances totalling the SDR equivalent of £318 million in July and November 1998 which were repaid before the financial year end in March 1999.   The temporary increase in the UK’s foreign currency exposures which this would have produced was also offset by purchases of sterling using some of the foreign currency reserves.

Foreign currency borrowing programme

33.         The foreign currency borrowing programme comprises NLF foreign currency liabilities.  The foreign currency receipts are sold to the EEA for sterling and partly finance the reserves.  The Treasury continued with its regular auction programme in ECU bills (Euro Bills for those bills maturing after 1 January 1999) and maintained the total outstanding at €3.5bn (excluding bills issued to the EEA for use in sale and repurchase transactions). However, in January 1999 the Government announced its intention to replace this part of the financing of the Government's foreign exchange reserves through the issue of sterling debt swapped into foreign currency.  At the same time, the Bank of England announced that it would take over as issuer of Euro Bills.   The proceeds of the Bank of England Euro Bills will be available to the Bank to finance the provision of intra-day liquidity, on a secured basis, to participants in CHAPS Euro, as part of the arrangements for TARGET.  This process started in April 1999 and all Euro Bills maturing after September 1999 have been Bank of England bills.  

34.      A rolling Euro Note issuance programme was continued and it was announced in January 1999 that regular tranches of €500 million would be auctioned each quarter in calendar 1999.   The outstanding ECU 2 billion 1999 Note was repaid in January and ECU 2 billion of 2000 Notes were redenominated as €2 billion of 2000 Notes in January 1999.   These changes meant that at the financial year end the total of Euro Notes outstanding stood at  €4.5 billion. The proceeds from these Euro Note issues were swapped into fixed rate instruments giving the highest yield from a range of options, within set cost limits.

Level of the Reserves

Financial Statements

36.         The financial statements of the EEA comprise a Receipts and Payments Account, a Statement of Assets and Liabilities and supporting notes.   The  Receipts and Payments Account is a cash account which measures the level of the EEA's turnover for the year.   The Statement of Assets and Liabilities records the EEA's (but not the NLF's) assets and liabilities including its sterling balance at the Paymaster General.   Assets are valued at their weighted average historic cost in their original currency of issue but for balance sheet purposes this historic cost is converted to a sterling equivalent using year end exchange rates.

37.               Before drawing any inferences from the attached financial statements the reader should remember that they only cover the EEA's assets and liabilities.  As explained above the EEA's exposures are managed together with the NLF's.  Currency or interest rate movements that generate a gain or loss to the EEA may well therefore have an equal and offsetting impact on the NLF.  The management accounting data presented above combines the EEA and the NLF's foreign currency assets and liabilities.  Furthermore, because the EEA's financial statements are constructed on a cash rather than an accruals basis and assets are valued using a modified historic cost basis rather than at their open market values this means, for example, that these financial statements make no allowance for variations in the prices of bonds the EEA holds until such time as they are sold.  In particular, no allowance is made for any “marked-to-market” gains or losses on uncompleted contracts such as forward commitments to purchase foreign currency. 

38.         The Bank has instituted a new accounting system for the financial year 2000-01 based on UK Generally Accepted Accounting Practice (UK GAAP).    As well as reporting the EEA's returns on a UK GAAP basis the Treasury intends to show in the Financial Accounts the relationship between EEA and the NLF with regard to foreign currency assets and liabilities.  This should generate meaningful profit/loss figures for combined EEA and NLF  foreign currency exposures as a whole, which can be audited by the NAO.  For more information about the NLF see the >Consolidated Fund and National Loans Fund Accounts 1998-99 Supplementary Statements' (HC 55) published January 2000 by The Stationery Office.

39.         The high level of reported turnover on the Receipts and Payments account reflects the accounting methodology.  In the case of a deposit in dollars, for example, the initial placement of a deposit is scored as a sale of dollars (cash) and a purchase of dollars (deposit).  When the deposit matures another sale and receipt is scored.  Each of these transactions is converted into sterling at the market exchange rate ruling at the time of the transaction.  Rolling over short term deposits contributes to the level of turnover.  For example an overnight deposit of $100million rolled over throughout the year would contribute $50 billion (plus interest) to the turnover.   The use of swaps for liquidity management and for rolling the forward book is also significant.

40.         As a member of the European Monetary System the UK swapped 20 per cent of its gold holdings and 20 per cent of its gross dollar reserves with the European Monetary Institute (later the European Central Bank) during 1998-99 in return for an equivalent value of official ECUs.  Each swap was for three months, at the end of which the swap was unwound and a new swap entered into.  The swaps reduced the level of gold and dollars on the EEA's statement of assets and liabilities and increased the holdings of ECUs.   This arrangement was unwound just ahead of the start of Stage 3 of Economic and Monetary Union (EMU) on 1 January 1999 and has now ceased.

41.         “Payments” of interest represent the accrued interest element of bonds purchased by the EEA in the year.  Gold lending transactions account for most of the recorded purchases and sales of gold.   The difference between the two figures reflects fluctuations in the sterling price of gold between the dates gold was placed on deposit (sales) and when the deposit matured (purchases) combined with changes to the maturity profile of the EEA's gold deposits.

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