The Swiss Central Bank should Diversify its FX Reserves

Introduction

There is plenty for central banks to worry about right now. Not least rising inflation and a potential recession that could rock almost every country and leave central banks cutting interest rates right back to where they were. Traditionally, central banks have adjusted the level of interest rates to achieve their mandates and support acceptable levels of economic activity. The Swiss central bank like other central banks went further and cut interest rates to negative territory after the 2008 GFC, until recently when it began to raise the levels of interest rates.

Central bankers have an unhealthy but justifiable obsession with inflation. It determines what your money can buy tomorrow, how much your assets are worth, and in layman's terms, how rich you are. In the last decade, central bankers have diversified their foreign exchange holding, in part to prevent the stronger dollar from impacting inflation outcomes. In this article, we look at why central banks keep reserves, the composition of Swiss FX reserves, followed by an outline of its assets. Throughout the article, we provide an overview of what the Swiss Central Bank must do in order to support its currency and prevent the haven properties of the Swiss Franc from impacting or blunting the impact of its monetary policy.

Why do central banks keep FX Reserves and how?

Global foreign exchange reserves are used by countries to pay for goods and services and to hedge against exchange rate risks. It is equally not unusual for central banks to hold FX reserves in different tranches so that policy objectives can evolve as reserve accumulation grows.

A liquidity tranche is dedicated to meeting on-demand requirements, usually by holding the most risk-averse instruments, with liquidity being prized above returns. Conventional thresholds for reserve adequacy encompass measures of import cover, short-term debt service, and broad money supply. This often involves enough funds to cover foreign currency debt for up to 12 months for advanced economies and 3.5 months for Central African countries like Cameroon. The liquidity tranche portfolio typically holds short-duration, ultra-conservative government bonds.

Reserves held in excess of the liquidity tranche but still within the reserve adequacy threshold may be dedicated to an investment tranche. This second tranche provides an additional precautionary buffer, and…