Select Committee on Public Accounts Minutes of Evidence


Supplementary memorandum submitted by HM Treasury (PAC00-01/107)


  Further to the Public Accounts Committee hearing on the sale of part of the UK gold reserves on 5 February 2001, please find enclosed the notes requested by the PAC Chairman, David Davies.

    1.  Note on the determination of the composition of the UK's net foreign currency reserves.

    2.  Note on the supposed gameplaying in the run up to auctions of part of the UK's gold holdings.

    3.  Value at Risk: A Worked Example.

Gus O'Donnell

HM Treasury

Note on the determination of the composition of the UK's net foreign currency reserves


  At the recent PAC hearing on the sale of part of the UK gold reserves, the PAC Chairman, David Davies, asked for a note on the determination of the 40/40/20 benchmark and an explanation of the impact a slowdown in the US economy might have on the composition of the benchmark. The following addresses these issues.


  The net foreign currency reserves currently stand at US$13.7 billion. The main components of the net reserves are dollars, euros, yen, Gold and SDRs (Special Drawing Rights make up about 13 per cent of the net reserves). The non gold and SDR components of the net reserves (dollar, euro and yen) are held in the proportions 40 per cent, 40 per cent and 20 per cent respectively.

  The primary reasons for holding reserves are for the purpose of intervention or to sustain trade in times of emergency or financial market dislocation. As such the currencies held need to be liquid, usable for intervention and, for the purposes of trade, acceptable as payment by the UK's major trading partners. In broad terms, this dictates that the currencies to be held are those of the larger economic blocs, ie the US$, euro and yen.

Financial markets have changed significantly over the last 10-20 years and, as a result, the methods of managing foreign currency reserves have also changed. In the early 1990s the key determinant of the weights in the benchmark for the currency component of the net reserves was the pattern of UK trade. The rationale being that in times of sustained financial crisis, the UK may not have access to the capital markets and the foreign currency reserves would have to be drawn on to sustain trade.

  UK imports of goods and services (by value) by exporting region, for 1992 and 1999, were:
EMU countries USJapan
199251 per cent13 per cent 5 per cent
199950 per cent14 per cent 4 per cent

In terms of invoicing currency (excluding sterling invoicing) the shares in 1999 were:
EMU country currencies US$Japan
199938 per cent50 per cent <1 per cent

  The International Monetary Fund uses a similar approach in determining the weights of currencies that make up the SDR basket. The weight of each of the currencies broadly reflects the relative importance of each currency in international trade and reserves. If sterling is excluded, the weights are 45 per cent dollar, 36 per cent euro and 19 per cent yen; very similar to those used for the UK net reserves.

  Although trade is still one aspect considered when setting the weights of the currencies in the benchmark, the importance of portfolio management is in the ascendance. This is because it is felt that the probability that the financial markets would be closed to the UK for a sustained period of time has fallen and new financial management techniques now allow portfolios to be run more efficiently (minimising risk for a given return).

  As stated above, the proportions of the net reserves held in each currency were originally determined by the share of UK imports from the US, Europe and Japan. However, the focus now is more on optimal portfolio theory.


  Optimal portfolio theory is based on the trade-off between risk and return. Investors rarely concentrate their entire wealth in a single asset, preferring instead to hold a diversified portfolio of assets. This is because, although investors seek high returns, they generally seek to minimise the high risks (the volatility of returns) usually associated with high returns.

  Therefore, as well as choosing between individual assets of differing returns and risks, investors can also form portfolios containing a number of different assets. The risk and return characteristics of the overall portfolio will depend not only on those of the individual assets contained in it, but also on the correlation between the returns on the different assets. The degree of diversification benefit that can be achieved depends on whether assets are perfectly positively correlated (no diversification benefit possible), perfectly negatively correlated (maximum diversification benefit) or somewhere in between; and also on the number of assets held in the portfolio (the benefits of diversification increase as more assets with uncorrelated returns are included in a portfolio).

  The consequence of this is that, within the universe of all possible portfolios made up of the assets that the manager is willing/able to hold, there is a set of efficient portfolios. This set of efficient portfolios dominate all other portfolios in that they have minimum risk for a given level of return. The efficient set lies on the frontier A to B in figure 1. And it is a portfolio on this frontier that portfolio managers seek to hold. Thus, for the UK net reserves, it is possible to determine the set of portfolios that yield maximum return for a given level of risk from within the universe of portfolios made up of the assets that can be acceptably held, eg the analysis considers the shares to be held in dollar, euro and yen but doesn't include assets, such as equities and property, that are not suitable for the purposes that reserves are held.

Figure 1

  The following section summarises the factors that are considered when the benchmark is set. However, as outlined above, the purposes for holding reserves determine the assets to be held and the benefits of diversification (minimising risk for a given return) that are of prime importance.


  The main determinants of the benchmark are:

(i)   Intervention:

    (a)  One of the purposes of holding reserves is to be able to intervene in the foreign exchange markets. This suggests that the reserves should be invested in relatively liquid assets, which in turn points to holding the currencies of the US, Europe and Japan.

    (b)  Of these currencies, the dollar and euro are the most readily usable for intervention and the most likely currencies to intervene in, which points to holding larger proportions of these currencies.

(ii)   Macroeconomic factors:

    (a)  Reserves may be required to finance outflows of trade and capital account for a sustained period without selling sterling in the event of a period of financial instability in which sterling becomes fundamentally undervalued and liquidity in the currency markets deteriorates.

    (b)  The foreign currency balance sheet is just one component of the government's portfolio of financial assets. And if the government were risk averse, then its optimal strategy would be to structure its entire balance sheet to provide protection against shocks to its macroeconomic policy objectives. This strengthens the case for having a net exposure to the yen, because bad times for the UK economy would be less likely to be correlated with weakness in the yen than with weakness in other currencies.

(iii)   Risk and return:

    (a)  Within the parameters set, portfolio optimisation suggests that (on investment grounds alone) the market risk of holding net reserves is minimised when the proportions of the liquid currencies selected are 30 per cent to 50 per cent in dollars, 40 per cent to 70 per cent euros and 0 per cent to 10 per cent yen. As described above, this is determined by calculating the shares (based on variances and covariances) of each asset to be held in the portfolio to minimise risk.

    (b)  Economic theory suggests that the returns on currencies, net of short-term interest rate differentials, should be zero. In other words, taking on higher risk cannot increase returns. However, analysis of recent data suggests that this has not been the case and that, of these three currencies, the dollar has been the highest yielding. Providing that the past repeats itself this would suggest that the return on holding the net reserves can be increased by increasing the proportion held in dollars.

  Given the number of different factors involved, there is clearly an element of judgement as to the exact proportions of each of these currencies that should be held in the benchmark, but all of the above factors are taken into account when making the judgement.

  The benchmark for the currency holdings of the net reserves is reviewed periodically to ensure that it is still appropriate given changes in macroeconomic conditions and currency volatilities and correlations.


  One issue raised at the PAC hearing related to a slowdown in the US economy and its impact on the net reserves benchmark. As can be seen from the list of determinants above, the benchmark is set on the basis of long run factors and it is unlikely that the benchmark would be adjusted on the basis of a cyclical downturn in one economy. Changes to the benchmark might come about if, for example, structural changes in one of the major economies or in the foreign currency markets led to a currency becoming more volatile. Alternatively, if a currency from a fast growing emerging economy became more liquid, then this could lead to an alteration of the benchmark.

  However, as part of normal portfolio management, as currencies strengthen (weaken) against each other the benchmark portfolio is adjusted by selling (purchasing) currencies to get back to 40/40/20. If, for example, the US dollar were to weaken against the euro and the yen then, in the absence of corrective action, this would lead to less than 40 per cent of the portfolio being held in dollars and more than 40 per cent and 20 per cent being held in euros and yen respectively. To correct this, the benchmark portfolio would be adjusted through the sale of euros and yen, and the purchase of dollars.

Note on supposed gameplaying in the run up to auctions of part of the UK's gold holdings


  At the PAC hearing into the sale of part of the UK gold reserves, the PAC Chairman, David Davies, asked for a note on supposed gameplaying in the run up to UK gold sales. The following note analyses the price movements in the run up to the ten gold auctions held by the UK Government to date.


  Observations of bond prices in the run up to, and following, bond auctions shows that bonds tend to cheapen (prices tend to fall) into auctions and rally out of them. This is entirely consistent with market makers selling at a small discount to the market price and in effect this discount can be thought of as an "underwriting fee" paid to market makers for helping to sell the auction stock. A second reason why a dip in prices into an auction, and a rally in prices following an auction, might be observed is if large market participants are forcing the price down in the run up to the auction in order to purchase the asset at what subsequently looks to be cheap prices.


  Tables 1 and 2 show the price movements (in US$ and percentage terms) into each of the ten auctions at 15, 10, 5 and 1 day(s) before the auction. The average price movements, with and without the September 1999[7] auction, are also shown. Charts 1 to 10 show the price movements around the ten auctions graphically.

  As can be seen from the data there is no consistent pattern in the price movements in the run up to the auctions. Although, on average, prices have tended to fall slightly into the auctions, they have also tended to fall after the auctions. This is not consistent with "gameplaying" by the market; rather it is what would be expected during a period in which prices have tended to trend down over time. Looking behind the averages, we also see that prices have risen into some auctions but fallen into the next auction. For example, prices fell into the first auction but rose into the second. In fact, prices fell before and rose after, only the sixth, eighth and ninth auctions.

  The increases in gold prices following the second, fourth and sixth auction can be explained as follows. The rise following the second auction resulted from the announcement of fifteen European central banks' agreement, which limited the amount of gold to be sold by the central banks signing up to the agreement to 2,000 tonnes until 2004. The price rose following the fourth auction as a result of a number of announcements from gold producers which suggested that the levels of producer hedging would be less than they had been in the past. And finally, the rise in price following the sixth auction was a direct result of the weakening in the US dollar, which boosted non-US demand for gold by lowering the effective price of gold for investors dealing in currencies other than the dollar.


  In conclusion, the analysis shows that there has been no consistent pattern in price movements in the run up to or following auctions and that the overall pattern in price movements is not consistent with gameplaying.

Table 1: Price movements in US$ terms: (-) indicates a price fall

1510 51 1510 15

1-2.40-1.65 -4.40-4.20261.20 -0.50-2.95-4.80 -3.00
24.053.25 2.103.45255.75 4.5542.6566.65 61.40
34.001.35 -2.65-4.60293.50 -0.90-16.15-12.75 -8.00
46.505.75 2.200.80289.50 -2.10-5.008.25 16.25
5-8.50-4.60 -3.60-0.60285.25 2.65-4.50-8.30 -2.65
6-1.40-2.25 -1.950.05275.25 -0.35-1.8010.05 13.10
7-6.10-8.05 -6.90-2.90279.75 0.85-0.75-0.55 -2.35
8-2.15-3.15 -2.80-1.15270.60 -0.453.000.25 -1.35
9-4.75-4.70 1.00-0.20264.30 -1.40-0.550.65 4.45
10-5.00-0.90 1.65-0.05268.00 -1.85-1.15-3.40 -5.35
Average-1.57-1.49 -1.53-0.94274.31 7.25
(ex Sep 99)
-2.20 -2.02-1.94-1.43 276.37-0.45-3.32 -1.181.23

Table 2: Price movements in percentage terms: (-) indicates a price fall

1510 51 1510 15

1-0.9%-0.6% -1.7%-1.6%261.20 -0.2%-1.1%-1.9% -1.2%
21.6%1.3% 0.8%1.3%255.75 1.8%16.5%25.7% 23.7%
31.4%0.5% -0.9%-1.6%293.50 -0.3%-5.5%-4.4% -2.7%
42.3%2.0% 0.8%0.3%289.50 -0.7%-1.7%2.9% 5.6%
5-3.0%-1.6% -1.3%-0.2%285.25 0.9%-1.6%-2.9% -0.9%
6-0.5%-0.8% -0.7%0.0%275.25 -0.1%-0.7%3.7% 4.8%
7-2.2%-2.9% -2.5%-1.0%279.75 0.3%-0.3%-0.2% -0.8%
8-0.8%-1.2% -1.0%-0.4%270.60 -0.2%1.1%0.1% -0.5%
9-1.8%-1.8% 0.4%-0.1%264.30 -0.5%-0.2%0.2% 1.7%
10-1.9%-0.3% 0.6%0.0%268.00 -0.7%-0.4%-1.3% -2.0%
Average-0.6%-0.6% -0.6%-0.3%274.31 0.0%0.6%2.2% 2.8%
(ex Sep 99)
-0.8% -0.8%-0.7%-0.5% 276.37-0.2%-1.2% -0.4%0.4%

7   The average has been shown excluding the September 1999 auction because of the one off sharp rise in prices resulting from the announcement of the European central banks' gold agreement that occurred shortly after the auction took place. Back

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