The largest part of the Central Bank of Bosnia and Herzegovina's foreign exchange reserves is in euros

In addition to the primary role of central banks to conduct monetary policy and issue money, one of the very important functions in the context of their overall mandate is the management of foreign exchange reserves, reports the bh. news agency Patria.

There are different definitions of foreign exchange reserves (eng. Foreign Exchange Reserves, njem. Devisenreserven), and what they all have in common is that foreign exchange reserves represent foreign assets (funds) that are under the control of monetary authorities (most often the central bank of a particular country, and in rarer cases, the Ministry of Finance). According to the definition of the International Monetary Fund (IMF), foreign exchange reserves represent foreign assets that are under the control of the monetary authority and are available to it for the direct financing of balance of payments imbalances or indirect regulation of imbalances through interventions in the foreign exchange market with the aim of influencing the exchange rate of the domestic currency, and for other purposes. Among other things, foreign exchange reserves serve to ensure the international liquidity of the country, achieve the goals of monetary policy, and facilitate access to international capital markets.

ROLE OF FOREIGN EXCHANGE RESERVES

More specifically, foreign exchange reserves have the following purposes:

- They serve for interventions in the foreign exchange market, thereby influencing the movement of the domestic currency's exchange rate, and indirectly affecting the maintenance of market conditions;
- They are used for the country to pay for goods and services abroad, especially in situations where it has problems securing external financing;
- They can also be used as emergency, liquidity support for certain sectors of the country, most often banks;
- They serve as support for foreign investors, meaning foreign exchange reserves strengthen investors' confidence in the ability of a country's economy to meet its obligations in the event of currency crises;
- They are also used for the country's external debt payments, meaning they can be viewed in the context of the country's external debt management operations;
- They represent support for the country's overall monetary policy as well as the country's liquidity management, etc.

How foreign exchange reserves will be used depends on the monetary policy implemented in a particular country. The choice of monetary policy largely determines the central bank's actions, and thus the system of management, purpose, or use of foreign exchange reserves. In line with the stated purposes, the Central Bank of Bosnia and Herzegovina (CBBH) holds foreign exchange reserves primarily as support for the domestic currency, which stems from the currency board arrangement as the monetary policy model implemented by the CBBH in accordance with the Law on the Central Bank.

Foreign exchange reserves in a broader sense, in addition to foreign exchange under the control of the central bank, also include foreign exchange held by resident commercial banks of that country. When discussing foreign exchange reserves, it generally refers to foreign exchange reserves in a narrower sense, i.e., those managed by the central bank. Holding foreign exchange reserves, i.e., foreign currencies, allows for the maintenance of a stable domestic currency exchange rate and reduces the effects of potential economic shocks. A special case are the central banks of the Eurozone, members of the ECB, which hold part of their foreign exchange reserves in their domestic currency, i.e., in euros. Historically, foreign exchange reserves gained importance after the abandonment of the gold standard in the mid-20th century.

MANAGEMENT OF FOREIGN EXCHANGE RESERVES IN BIH

The IMF states that the objectives of managing foreign exchange reserves are to ensure that the adequacy of foreign exchange reserves contributes to the achievement of other objectives, that liquidity risk, market risks, and credit risks are under appropriate control, and that, while respecting the limitations of liquidity and other risks, reasonable income is generated on invested funds in the medium and long term.

In line with the stated objectives and principles, the Law on the Central Bank of Bosnia and Herzegovina stipulates that one of the basic tasks of the CBBH, performed under the supervision of its Governing Board, is to hold and manage official foreign exchange reserves in a safe and profitable manner.

The process of managing foreign exchange reserves in the CBBH takes place at three levels: (1) strategic – Governing Board/Committee, (2) tactical – Investment Committee, and (3) operational – organizational units of the CBBH responsible for risk management, banking, and monitoring and analysis. The Governing Board approves the CBBH Guidelines on Foreign Exchange Reserve Management, which define the type and level of risk the CBBH is willing to take and the discretionary space for the tactical and operational levels. The Investment Committee directs the foreign exchange reserve management process within the Guidelines and adopts the Operational Rules on Investment. The organizational units of the Central Office of the Central Bank responsible for foreign exchange reserve investment, risk management, monitoring, and analysis must act in accordance with the guidelines adopted by the Governing Board and the operational rules adopted by the Investment Committee. Within these parameters, the responsible department decides which financial institutions and instruments will be operationally selected for foreign exchange reserve investment and regularly reports on this and explains the reasons for its decisions to the Investment Committee.

The CBBH invests foreign exchange reserves primarily in securities of Eurozone countries with the highest credit rating and deposits in selected central banks in the Eurozone, the BIS bank, as well as selected commercial banks with high credit ratings, taking into account investment limits in each individual country and each individual commercial bank, which implies that the dominant principles are security and liquidity, but also profitability. In addition to the above, monetary gold is also represented in the CBBH's foreign exchange reserve portfolio, albeit to a lesser extent.

Regarding the adequacy of the structure and volume of foreign exchange reserves, there are various theories, and the IMF website states that there is no universally applicable measure for assessing the adequacy of foreign exchange reserves. The size of the required foreign exchange reserves depends on several factors, the most important being the level of expected payments in trade of goods and services with foreign countries and short-term capital movements.

It is very important for every country to have an appropriate, i.e., adequate, level of foreign exchange reserves. Although there is no single view in theory and practice on how large foreign exchange reserves should be, certain indicators have emerged to date that indicate the necessary, i.e., adequate, level of foreign exchange reserves. According to these indicators, the optimal level of foreign exchange reserves is one that allows for the following:

Three months of import coverage – which provides insurance against potential current account shocks;
5% to 20% coverage of the monetary aggregate M2 (cash in circulation and demand deposits), as this maintains public confidence in the domestic currency
Coverage of all the country's debt obligations due in the next twelve months, thereby ensuring the settlement of the country's external obligations in the event of a cessation of capital inflows from abroad.

Given that the CBBH operates on the principle of a currency board, and that the domestic currency KM is pegged to the euro, it is understandable that the largest part of the CBBH's foreign exchange reserves is held in euros. On the other hand, most central banks in the world have a more significant currency diversification of their foreign exchange reserves.

In addition to payments abroad, the size of the CBBH's foreign exchange reserves is affected by the purchase and sale of the convertible mark. According to the Law on the Central Bank, the CBBH must be prepared to buy and sell the convertible mark for euros without restriction at the official exchange rate, which is also defined by the Law on the Central Bank of BiH, according to which one euro equals 1.955830 convertible marks, or one convertible mark equals 0.511292 euros, at the request of a commercial bank and other authorized financial institutions in Bosnia and Herzegovina.

When talking about the purchase and sale of KM, it means looking from the perspective of the CBBH. Thus, the sale of KM means that the CBBH sells KM to a certain domestic commercial bank and receives EUR or another foreign currency in return, which means that the value of foreign currency increases in the CBBH's balance sheet, i.e., foreign exchange reserves directly increase. On the other hand, the purchase of KM means that the CBBH buys KM from a certain commercial bank and gives euros or another foreign currency to it in return, which leads to a decrease in the CBBH's foreign exchange reserves.