Memoire Online - Foreign exchange reserve management in Algeria

Prepared by :
Abdelhamid MERGHIT
Lecturer of economics at Mohamed Seddik Benyahia University, jijel ,Algeria
E-mail: merghit @ hotmail.com.

Abstract

Algeria's foreign exchange reserves vigorous growth has been driven by higher hydrocarbon production, and record-high oil prices, especially since2000,which by the end of 2010 were around US$162 billion (103 percent of GDP). By contrast, the global economic crisis of 2008-09 has underscored the importance of holding an adequate level of reserves, under which countries can strengthen the ability to absorb external shocks.This paper analyzes Algeria's foreign reserves management policy in recent years, especially in light of the global economic crisis. It reviews some of the major stands of the recent debate about whether part of the reserves should be infected by the implications of this crisis.Hence, Traditional Measures for Assessing Reserve Adequacy are utilized to show whether Algeria's reserve holding are still in an adequate level from a precautionary perspective.An important finding of the paper is that Algeria current levels of foreign reserves are still comfortable and safe, as it exceeds all international norms and standards. However,the paper emphasized that sound reserve management policy,is essential for helping Algeria to promote policies and practices that contribute to stability and transparency and to reduce external vulnerabilities.

1. introduction

The oil sector has been a dominant feature of Algeria's economy for decades making it vulnerable to changes in world oil markets .hydrocarbons in Algeria accounted for 95percent of exports, 60percentof government revenues, and 30percent of GDP.

The first decade of the 21st century was very positive for the Algerian economy. During the past10 years, the economy recovered from the deep socioeconomic crisis of the1990s. Between 2000 and 2010, real GDP and nonhydrocarbon GDP grew respectively at an annual average of 3.7 and5.6 percent, whereas real GDP per head increased by 22 percent, and unemployment fell from 29.5 percent to 10.2 percent.The recent economic growth has been driven by higher hydrocarbon production and accelerating activity in services, construction, and public works. The reasons for this success were prudent fiscal and monetary policies, combined with a period of high oil prices,contributed to build a comfortable financial position, with large external reserves, substantial savings in an oil stabilization fund, and very low public and external debt.

However, Algeria's foreign exchange reserves vigorous growth has been driven by higher hydrocarbon production, and record-high oil prices, especially since2000,which by the end of 2010 were around US$162 billion (103 percent of GDP). The Algerian reserve management policy has been in focus since the onset of the credit crisis in the US financial markets and its contagion effect on the other economies leading to global financial crisis during the second half of 2008 and during 2009.Indeed, an important debate has begun as to whether part of the reserves should be infected by the implications of the global financial crisis. Furthermore, the global economic crisis has underscored the importance of holding an adequate level of reserves, under which countries can strengthen the ability to absorb external shocks.

The ambition of this paper is to shed light on the issue of reserve management policy in Algeria, itsopportunities and challenges. It also,analyzes Algeria's foreign reserves management policy in recent years, especially in light of the global economic crisis.Hence, traditional measures forassessing reserve adequacy are utilized to show whether Algeria's reserve holding are still in an adequate level from a precautionary perspective. In order to discuss these issues the present article is divided in to four sections:Section1: present abrief exposition of the conceptual framework of reserves management. Section 2 provides ananalysis of reserve adequacy in the Algerian economy. Section 3 describes the framework ofreserve management and practice followed by bank of Algeria, and reviews some of the major stands of the recent debate about the Implications of the 2008finacial crisis. And section4concludes.

This section presents a brief exposition include some basic concepts of foreign exchange reserves, and the risks associated with reserves management.

2.1. The definition of Official foreign exchange reserves

According to the international monetary fund, the Official foreign exchange reserves«are those external assets that are readily available to and controlled by monetary authorities for

direct financing of payments imbalances, for indirectly regulating the magnitudes of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes» [1].

It is worth noting that the official foreign exchange reserves include foreign currency assets and gold, this later must be held by the monetary authorities as monetary gold to be recognized as part of official reserves.

Furthermore, these reserves are held to exercise the basic function as shocks absorber in order to support and maintain confidence in the monetary and exchange rate policies, including the capacity to intervene in support of the national currency [2]

Moreover, Reserve management policy can defined as«the process by which public sector assets are managed in a manner that provides for the ready availability of funds, the prudent management of risks, and the generation of reasonable return on the funds invested» [1].

Usually, the central banks laws defined the investment policy of these reserves, and permits the following investment categories:

-deposits with other central banks and the Bank for International Settlements; -deposits with foreign commercial banks;

- Investments in bonds/treasury bills, which represent debt obligations of highly rated sovereigns and supranational entities;

In the majority of countries, the preservation of the long- term value of the reserves in terms of purchasing power and the need to minimize risk and volatility in returns, are the main principles governing the foreign reserves management.

2.2. The most important risks associated with managing foreign exchange reserves

The word Risk means the possibility of financial or other losses arising from an entity's financial exposures and/or the failure of its internal control systems. So, There should be a framework that identifies and assesses the risks of reserve management operations and that allows the management of risks within acceptable parameters and levels.

The risk management functions are aimed at ensuring development of sound governance structure in line with the best international practices, improved accountability, a culture of risk awareness across all operations and efficient allocation of resources for development of in-house skills and expertise.Typically, official foreign exchange reserves are faced to a range of risk, including [3] :

a. Credit risk

Credit risk is defined as the potential that a borrower or counterparty will fail to meet its obligation (loans or other financial assets) in accordance with agreed terms. the investment of

foreign exchange reserves in bonds/treasury bills or Placement of deposit with Bank for International Settlements is also considered credit risk-free.

Credit risk has been in focus since the onset of the credit crisis in the US financial markets and its contagion effect on other economies leading to global financial crisis during the second half of 2008 and during 2009.

b. Market risk

Market risk arises on account of exchange rate and interest rate movements. b.1.Currency Risk: Currency risk arises due to uncertainty in exchange rates.

It also arises with an appreciation of the domestic currency reduce the domestic currency value of international reserves.

b.2.Interest Rate Risk: The crucial aspect of the management of interest rate risk is to protect the value of the investments as much as possible from the adverse impact of the interest rate movements. This risk involves the adverse effects of increases in market yields that reduce the present value of fixed interest investments in the reserve portfolio.

C/ Liquidity Risk

Liquidity risk involves the risk of not being able to sell an instrument or close a position

In other words it refers to the possible difficulties in selling large amounts of assets quickly, in a situation where market conditions are also unfavorable, resulting in adverse price movements. A highly liquid portfolio is a necessary constraint in the investment strategy because reserves need to maintain a high level of liquidity at all times in order to be able to meet any unforeseen and emergency needs.

D/ Operational Risk

A range of different types of risks, arising from inadequacies, failures, or nonobservance of internal controls and procedures that threaten the integrity and operation of business systems[1]. This risk includes: the risk of the collapse of the internal control systems, risk of financial mistakes....

Algeria's foreign exchange reserves have grown (as Figure 1 indicates ) significantly since 1993. The reserves, which stood at US$ 1.5 billion at 1993 increased gradually to US$ 8 billion by 1997. Thereafter, the reserves declined to US$ 4.4 billion by 1999.The growth continued in the first half of the 2000s with the reserves touching the level of US$ 18 billion by 2001. Subsequently, the reserves increased to US $ 162.2 billion by 2010.

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Algeria's foreign exchange reserves vigorous growth has been driven by higher hydrocarbon production, and record-high oil prices, especially since2000 (see figure2). The Algerian crude oil export unit value which was 22.6 US$/barrel in 1990, increased to 27.6 US$/barrel in2000, Thereafter the oil price touching the level of100 US$/barrel in 2008.

3.2. Adequacy of Reserves in Algeria

To make sure that the current levels of international reserves are still comfortable and safe, there are four applicable measures for assessing the adequacy of reserves [4] : - The traditional measure of import covers of reserves. The optimal level is about three

months at least.
- The ratio of money supply to the foreign exchange reserves. The optimal level is at least 20%.

- The ratio of short-term debt to the foreign exchange reserves. The optimal level is at least 150%.

- Foreign exchange reserves should exceed at least the non-resident deposits in foreign currencies, in the banking system.

This section provides a complete assessment of these measures in the context of the Algerian economy.

Years	Foreign Reserves (US $ billion)	Months of Imports
1993	1.5	1.9
1994	2.6	2.9
1995	2.1	2.1
1996	4.2	4.5
1997	8	9.4
1998	6.8	7.6
1999	4.4	4.6
2000	11.9	12
2001	18	14.9
2002	23.1	17
2003	32.9	18.1
2004	43.1	19
2005	56.2	26.5
2006	77.8	28
2007	110.2	27.4
2008	143.1	35.2
2009	148.9	36.4

The table 1 show that the import cover of reserves indicator, which fell to a low of three months of imports at 1993, rose to 12 months of imports at 2000, and increased further to 36.4 months of imports (or about three years) at 2009.

It is clear that record-high oil prices have translated into huge foreign reserves especially since 2000 .So , Algeria foreign exchange reserves are in a very comfortable level in comparison to the optimal limit (three months at least).

Years	Foreign Reserves (US $ billion) (1)	M2 (DZD billion) (2)	The exchange rate (DZD/USD) (3)	M2 (US $ billion) (4)	The ratio (1/4)
1993	1.5	625.2	23.36	26.76	0.05
1994	2.6	723.5	35.09	20.61	0.12
1995	2.1	799.5	47.68	16.76	0.12
1996	4.2	915.1	54.77	16.76	0.25
1997	8	1081.5	57.73	18.73	0.42
1998	6.8	1287.9	58.74	21.92	0.31
1999	4.4	1789.4	66.5	26.9	0.16
2000	11.9	2025.1	75.3	26.89	0.44
2001	18	2475.2	77.2	32.06	0.56
2002	23.1	2905.8	79.7	36.45	0.63
2003	32.9	3357.9	77.4	43.38	0.75
2004	43.1	3742.5	72.1	51.9	0.83
2005	56.2	4142.4	73.4	56.43	0.99
2006	77.8	4933.7	73.7	66.94	1.16
2007	110.2	5994.6	69.2	86.62	1.27
2008	143.1	6955.9	64.6	107.67	1.32
2009	148.9	7173.1	72.5	98.93	1.50

Source: author's calculations using data available from bank of Algeria statistics.

The Data from the table above Indicate that the ratio of money supply to the foreign exchange reserves increased slightly from 5 per cent at 1993 to 99 per cent as at 2005, the

ratio further increased to 150 per cent at the end of 2009.This results show clearly that the current foreign reserves level exceed the international standards for this indicator (at least 20%).

3.2..3. The Ratio of Short-Term Debt to the Foreign Exchange Reserves Table 3

Years	Foreign Reserves (US $ billion) (1)	Short-Term Debt (US $ billion) (2)	The Ratio (1/2)
1996	4.2	0.328	12.8
1997	8	0.162	49.38
1998	6.8	0.186	36.55
1999	4.4	0.195	22.56
2000	11.9	0.222	53.60
2001	18	0.199	90.45
2002	23.1	0.108	213.88
2003	32.9	0.146	225.34
2004	43.1	0.410	105.12
2005	56.2	0.707	79.49
2006	77.8	0.550	141.45
2007	110.2	0.717	153.7
2008	143.1	1.304	109.73
2009	148.9	1.492	99.8

Source: author's calculations using data available from bank of Algeria statistics.

The table 3 show that t the ratio of short-term debt to the foreign exchange reserves increased from 1280 per cent at 1996 to 22534 per cent at 2003.later, the ratio decline to 9980 per cent as at 2009.

The table above indicates that this indicator has exceeded the optimal level in accordance with international standards which is 150%.This means that foreign exchange reserves in Algeria allow enough cover to its short external debt and insure its safety and financial solvency.

3.2.4 . Non-Resident Deposits Cover of Reserves

It is important to note here, that the lack and incomplete information on non- resident foreign currency deposits in the Algerian banking system, pushed us to used the foreign currency deposits as a proxy in order to calculate this indicator for the period 2000-2009.the results are presented in the table4.

Years	Forgein Currency Deposits (DZD billion) (1)	The exchange rate (USD/DZD) (2)	Forgein Currency Deposits (US $ billion) (3)	Foreign Reserves (US $ bllion) (4)	The Ratio (4/3)
2000	116.9	75.3	1.55	11.9	7.67
2001	154.4	77.2	2	18	9
2002	168.8	79.7	2.11	23.1	10.94
2003	170.8	77.4	2.2	32.9	14.95
2004	218.8	72.1	3.3	43.1	14.22
2005	231.7	73.4	3.15	56.2	17.84
2006	240.8	73.7	3.28	77.8	23.71
2007	229.5	69.2	3.31	110.2	33.29
2008	251.2	64.6	3.88	143.1	36.88
2009	265.7	72.5	3.66	148.9	40.68

Source: author's calculations using data available from bank of Algeria statistics.

The table 4 shows that this indicator has marked strong development. After it was covers more than seven times the deposits in hard currency in 2000, it rose significantly in 2009 to reach more than 40 examples of these deposits.

At the end of this section ,our analysis shows that Algeria current levels of foreign reserves are still comfortable and safe, as it exceeds all international norms and standards. So, this adequacy also allow for Algeria to strengthen their ability to absorb external shocks.

4. Reserve Management In Algeria, and The Implications of The 2008Finacial Crisis.

This section exposes first some available information related to Algeria policy frameworks for reserve management. Secondly, it studies the Impact of the global financial crisis of 2008 on Algeria foreign reserves, and third it offer an evaluation to Algeria reserve management practices.

4.1. The Framework for Reserves Management in Algeria

Given the absence of publications and official reports undertaken by the bank of Algeria to inform the public yearly about the management of foreign exchange reserves ,and its dealing with this issue confidentially with the lack of transparency and disclosure.However,the main aspects of the policy and operational matters relating to the management of the reserves in Algeria, were presented in speech delivered by The Governor of the Central Bank,Mr. Mohammed Laksaci in2011including the following areas[5] :

A/ Algeria has managed its official foreign exchange reserves soundly and prudently, by adopting the following primary objectives:

- The preservation of the reserves capital value: in terms of reducing the risk of loss in assets market value, and maintain a diversified assets portfolio with high quality (i.e. the credit rating), and application of appropriate practices to mitigate risks; - Maintaining a high level of liquidity: through investments of these reserves in assets close to maturity or that can re-sell quickly without loss of value; - Return optimization, with a respect to safety and liquidity, which constitute the twin objectives of reserve management in Algeria.

deposits with other central banks and the Bank for International Settlements (BIS),and deposits with high rating quality foreign commercial banks .

C/ The demands placed : in this regard, 98 percent of investment operations of foreign reserves in the US and Europe were proceeded in the form of sovereign bonds portfolio, which Algeria has bought between 2004 and 2007 when the international interest rates were high.

D/The interest rate of the aforementioned bonds hit 3 percent in 2010, a bit lower than the rate recorded in 2008 and 2009.

E/ Algeria has invested only 1.75 percent of its foreign exchange reserve in deposits with foreign commercial banks, contrary to previous years when it used to invest up to 20 percent . This investment framwork reflect the diversification strategy undertaken by Algerian authorities since2004 in order to secure the reserves from external shocks. While safety and liquidity constitute the twin objectives of reserve management in Algeria, return optimization becomes an embedded strategy within this framework.

F/ the reserves investment policy include the selling of Foreign Currency Assets that are maintained as a multi-currency portfolio comprising major currencies, such as, US dollar, Euro. In 2010 for example: the dollar represent 47.96%,and 41.38% for the euro. This diversification of currencies, countries and institutions is part of the policy of securing these assets

G/ The Bank of Algeria has established an institutional framework for managing foreign reserves, in order to face world interest rates historical decline, especially after the global financial crisis of 2008.in this context Algeria has adopted a prudent approach in the

management of its reserves since the global financial crisis 2008 and, this policy has proven its effectiveness because of the investments non-affected during the period of crisis.

H/ according to the bank of Algeria 2010 report, Algeria has collected $4.60 billion in 2010 from investing exchange reserves abroad, comparing to $4.74 billion in 2009 and $5.13billion in 2008, $3.8billion in 2007 and $2.42billion in 2006 [6] .

4.2. Algeria's Foreign Reserves and the Implications of The 2008 Global Financial Crisis

Many observers to Algeria economic situation said that Algeria, may not be affected by the2008 financial crisis, because of several external and internal factors.According to the International Monetary Fund, Algeria's prudent fiscal and monetary policies contributed to maintaining inflation low, and, combined with a period of increasing oil prices, allowed Algeria to build a solid financial position, with large external reserves, sizable budgetary savings in an oil stabilization fund, and low public and external debts. The support to economic growth, which helped to weather the impact of the global crisis in2009, should not be withdrawn too quickly. The prudent macroeconomic management of the past decade has given Algeria an important margin to face external shocks and absorb sharp falls in hydrocarbon prices. However, the global crisis also showed Algeria's financial vulnerability to prolonged periods of low oil prices. At the same time, the authorities should remain vigilant about risks of potential inflationary pressures [7].

Other Algerian economists like the former Ministers of Economy Mr.Hocine Benissad and Mr.abdellatif Benachenhou , found that Algeria is currently far from the international turmoil because of the following reasons[8 ,9] :

remain in their infancy because of highly opaque financial information, banks' inability to provide investors with information, and small institutional investors[10].

Unlike the various emerging economies opened to international financial markets, Algeria restrictions and controls are maintained on many capital account payments and transfers. So , the Algerian financial system remain disconnected from the international financial center and as result insulated from the global financial crisis contagion effects, which spread rapidly to various international banks through the mechanism of "securitization".

In this regard the Revenue Regulation Fund (oil stabilization funds) that the government had the wisdom to create in 2000 play an important role in dealing with the economic consequences of natural resource booms, to ensure that government savings are accumulated at the fund in periods of strong oil revenues, would be essential, to balance the state budget in period of oil price decline.

Algeria s2008 budget stand with oil at $ 37 ,and the balance of the budget of 2009 was provided with a barrel to 60 dollars, but if the price drops to $ 37( the reference price of the2009 Budget Law), the 2009 budget envisages the use of Revenue Regulation Fund , estimated in 2008 at 4,200 billion dinars to balance the state budget and cover investment projects underway. The Revenue Regulation Fund will hold for three years, so there is no fiscal risk until 2012.

(v). The non Setting Up of sovereign wealth funds Many oil-producing countries has accumulated enormous reserves thanks to the record-high oil prices.but these countries don't have the ability to absorb this soaring foreign reserves at the level of their economies, because to the lack of diversified production system on a competitive basis and the absence of any industrial policy. However, the best way to prepare the post-oil stage is the Setting Up of sovereign wealth funds .

Sovereign wealth funds for these purposes are separate pools of international assets owned and managed (directly or indirectly) by government to achieve various economic objectives, such as stabilization of the macro economy or contributing to a process of saving and intergenerational wealth transfer. Sovereign Wealth Funds are special purpose investment vehicles to generate higher returns[11].

Although security is never absolute, under the global financial crisis of 2008, the sovereign wealth funds suffered heavy losses when, for example, companies - which they held shares - experienced a severe market value devaluation. Some of them continue to count their losses while others have scaled back their investment plans. In the case of Algeria, it was far from these consequences because it doesn't create such sovereign funds.

The main potential issues and shortcomings raised by Algeria's management of its

international assets can consider the following points:
-The Lack of transparency and disclosure in the reserves management policy ,due to the absence of data and annual reports an operational matters relating to the management of the reserves ,especially: currencies, instruments, issuers and counterparties , earnings ,losses.Its appear that Algeria deals with reserve management file as state secrets, despite, the Money and credit Act gives the Bank of Algeria Governor the responsibility for the conduct of exchange reserves.

- The absence of legal framework for the management of the country's Gold reserves notably:gold holdings, the purchase and sales operations, the deposits custody, the rate of

earnings on gold...
- The diversification strategy in the deployment of foreign exchange reserves include only the portfolio currency composition, but the investment policy focus on The safest reserve asset i.e. treasury bills, which pays the lowest rates of return.

- Despite that Sovereign Wealth Funds have become important forms of external assets and its role in generate higher returns and developing the national industrial policy through the acquisition of the high technology. The Algerian authorities still reject the idea of Setting Up of sovereign wealth.

-The management of foreign reserves by the Algerian government focuses on the short-term vision, animated by a desire to provide liquidity to cover the years of importation,which

means the lack of strategic vision (the new trends: from liquidity to return) in the management of these reserves.

- The framework for the risk management practices followed by the Bank of Algeria and the strategy for managing and controlling the exposure to financial and operational risks associated with deployment of reserves are absent.

- It seems that Algeria's Foreign reserves suffer from the phenomenon of depletion because of the imports bill, which increased dramatically to $ 40 billion over two years (2009/2010) . given that the most indicators of the Algerian economy such as economic growth, demographic growth, inflation, consumption, unemployment, productivity and the limited absorptive capacity of the Algerian economy( $ 15 billion annually) did not change significantly during the period (2004/2009) and therefore, cannot explain this excessive increase in imports, which grew during the same period by 300%.

5.Conclusion

At the end of this paper, some recommendations are presented as conclusion, intended to strengthening Algeria policy frameworks for reserve management so as to help increase its resilience to shocks that may originate from global financial markets .these recommendations includes the following areas:

-Algeria reserve management policy should ensure the development of sound governance structure in line with the best international practices, improved accountability, a culture of risk awareness across all operations and efficient allocation of resources.

-The bank of Algeria must apply stringent credit criteria for selection of counterparties. And the financial strength of counterparties must constantly under watch in order to assess whether counterparty's credit quality is under potential threat.

-The bank of Algeria should make available in the public domain data relating to foreign exchange reserves, its operations in foreign exchange market, position of the country's external assets and liabilities and earnings from deployment of foreign currency assets and gold through periodic press releases of its weekly statistical supplements, monthly bulletins, annual reports, etc...

- In order to encourage transparency and disclosure in the reserves management policy it will be necessary the setting up of an entity at the bank of Algeria responsible for reserve management ,named for example " the department of external investments and operations " . This entity may also have a range of policy responsibilities and functions that focus on design of appropriate reserve management policy in accordance with best international practices .

- The Bank of Algeria must closely monitors the portion of the reserves which could be converted into cash at a very short notice in order to meet any unforeseen or emergent needs. -To insure the following of international best practices on transparency in monetary and financial policies, the bank of Algeria should adopted the Special Data Dissemination Standards (SDDS) template of the IMF [12] ,in order to provide detailed data on foreign

exchange reserves to the public. Such data should be available on monthly basis on the central Bank's website.

- Thinking about the the best way to prepare the post-oil stage, to transform the Nonrenewable oil wealth to other forms of renewable wealth on the ground, through the using of these huge foreign reserves to diversify the production system on a competitive basis (in price and quality), this diversification is also the guarantee of greater economic and

political independence.
- Given that the foreign reserves are a public savings, our believe is that the framework for its deployment must be in accordance with the Algerian people religion (which is Islam) However, it should respect the Islamic finance principle, where the interest rate is prohibited.

[3].Reserve Bank of India.(2009). Half Yearly Report on Management of Foreign Exchange Reserves April - September. Department of External Investments and Operations, Central Office , Mumbai.

[7]International Monetary Fund.(2011, February). Algeria: 2010 Article IV Consultation-- Staff Report, IMF Country Report No. 11/39. Washington, DC.

[8]Benissad, H .(2008,december 5). Les avoires exterieurs officiels ne sont exposés qu'aux pertes de change .ELWATTAN, p.5.

[9]Benissad, H. & Benachenhou A.(2008,december 6). l'impact de la crise financière mondiale sur l'Algérie. La Tribune, p.4.

[10]World Bank. (2004, July). Algeria Financial Sector Assessment. Retrieved from: http://www.world bank.org/

[11]Udaibir, S. D., Mazarei, A., & Hoorn, H.V. (Eds.).(2010). Economics of sovereign wealth funds: issues for policymakers., Washington, D.C: International Monetary Fund.

[12] Kester,A.Y.(2000,june) .Improving the Framework for Reporting on International Reserves. Finance and development , 37 (2).