FOREIGN EXCHANGE RESERVE MANAGEMENT IN THE EUROZONE AND THE GLOBAL INTEREST RATES

Abstract

Global interest rates and their term structure depend on the relation of the time structure of demand and supply of capital. With the monetary integration in Europe one can observe substantial realignments in the mentioned variables. The scientific problem of this paper is the change in the term structure of the global interest rate over the period of the last 25 years – 1987 – 2011. The aim is to recognize any actual anomalies in the yield curve of the global interest rate that may be associated with the creation of the Eurozone and its further expansion. The first step in this quest is presentation of the theoretical background for the foreign exchange reserve management at a central bank. Then, the institutional solutions are presented to give insights into the actual operating procedures that have potential of affecting the term structure of  demand and supply of liquid funds in foreign exchange markets. In the next step, a rationale for a substantial realignment of large foreign assets’ portfolios in a monetary union is presented in detail. One may list here several cost-related arguments and efficiency in maximizing rate of return, without endangering the international liquidity of a country and a monetary union as a whole. It is argued that the institutional solutions together with the rational behavior of central banks result in permanent departure from the once well-established balance in the global economy. It could be also argued that monetary integration in Europe is responsible for moving toward a new equilibrium at the global financial market. These claims are later supported in the empirical part by the time series analysis of the term structure of global interest rates. Differentiating between interest rates of different maturities delivers three years over the period 1987-2011 when the yield curve inverted. These years were 1998, 2001 and 2007. All three cases of unusual yield curve behavior may be associated with: onset, expansion and further expansion of the Eurozone. In each case, adding to the common pool of the foreign exchange reserves created an impulse for demand-supply interplay, concerning the term structure of capital offered and demanded at the global financial market. Another supporting argument flows from the recognized strong and significant relationship between foreign exchange reserves management and the term structure of global interest rates. Correlation exercise delivered interesting results, showing not only uniqueness of the mentioned years (1998, 2001, and 2007) but also some differences between these years in the manner of the yield curve shape and form of adjustment. In some cases changes leading to the inverted yield curve were only in long-term interest rates (down), but sometimes interest rates of all maturities were changing (short term up& long-term down). Also the form of latter adjustment, when yield curve returned to the normal shape differed for the studied anomalies.

DOI: http://dx.doi.org/10.5755/j01.eis.0.5.1090