Liquidity Tranche and Investment Tranche

The liquidity tranche and investment tranche are the two main portfolios into which many central banks divide their foreign exchange reserves. The liquidity tranche holds money that may be needed soon, for market intervention, government debt payments or import bills, and is kept in very safe, short-dated assets. The investment tranche holds reserves that are unlikely to be needed for some time and is invested over a longer horizon to earn a higher return.

Tranching is a tool of reserve management, the wider job of looking after a country's official foreign assets. It is not a legal category, and the names vary: some institutions add a separate working-capital tranche for daily payments, and others run a third, long-term portfolio. The split should not be confused with the tranches of a structured bond or with the credit tranches through which the International Monetary Fund (IMF) lends to member countries.

Think of how a careful household keeps its savings. Some money sits in a current account because the rent and the grocery bill arrive every month and must be paid on time, whatever happens. The rest goes into a longer-term savings plan, where it can grow, because nobody expects to touch it for years.

A central bank does the same with its foreign currency. The liquidity tranche is the current account: money it can reach at once if the currency comes under pressure or the government has a foreign bill to pay. The investment tranche is the savings plan: money it can afford to leave alone, so it can accept slightly more ups and downs in exchange for better returns over time. Splitting the pot this way stops the bank from being forced to sell long-term holdings at a bad moment.

The starting point is an estimate of how much foreign currency the authorities might need over a set period, often one year. Central banks look at scheduled external debt payments, expected intervention in the foreign exchange market, the needs of a currency peg if there is one, and stress scenarios such as a sudden stop in capital inflows. Reserves above that need, but still within what the bank considers adequate, can be placed in the investment tranche. Measures of reserve adequacy, including the IMF's own metrics, guide how large the total pot should be.

The simplest way to express the split is:

• $R$ is total foreign exchange reserves.
• $L$ is the liquidity tranche, sized to cover estimated outflows plus a safety buffer.
• $I$ is the investment tranche, the amount that can be invested for the longer term.

Suppose a central bank holds $60 billion of reserves. It expects $12 billion of debt service and intervention over the next year and adds a $6 billion buffer for stress, so $L = 18$ billion. The investment tranche is $I = 60 - 18 = 42$ billion dollars, or 70% of reserves. In practice the bank would also set rules for topping up the liquidity tranche when it is drawn down.

The two portfolios differ mainly in the time horizon and risk they accept:

• Liquidity tranche. Deposits at other central banks and the Bank for International Settlements (BIS), Treasury bills, short government notes and repurchase agreements, nearly all in the main reserve currencies. The aim is that it can be turned into cash within days at little or no loss.
• Investment tranche. Longer-dated government and agency bonds, supranational debt, and at some institutions corporate bonds, mortgage-backed securities or equities. It is usually managed against a benchmark with a target duration and risk budget.
• Gold. Central bank gold reserves are often reported outside both tranches and treated as a strategic holding rather than a trading portfolio.

Surveys of reserve managers show that the shares differ widely. An IMF working paper published in 2019 noted that some central banks keep less than 10% of reserves in the liquidity tranche while others keep more than half there. Countries with large reserves relative to their needs, or with a stable floating exchange rate, tend to hold a bigger investment tranche. Countries that defend a peg or face heavy external debt payments keep more in liquid form.

Some reserve holders go further. The Hong Kong Monetary Authority, for example, divides its Exchange Fund into a backing portfolio that supports the currency board and an investment portfolio, alongside a long-term growth portfolio. Others have moved part of their excess reserves out of the central bank altogether, into a separate state-owned investment fund with its own mandate.

Tranching makes the trade-off between safety and return visible. It lets the board approve a clear risk budget for each portfolio, lets managers be judged against a suitable benchmark, and protects the liquidity that matters most in a crisis. It also helps explain to the public why reserves earn what they do, since the low yield on the liquidity tranche has a stated purpose.

The approach has limits. The estimate of liquidity needs can be wrong, and in a severe crisis outflows may exceed the liquidity tranche, forcing sales from the investment portfolio when prices are falling. A large investment tranche can also tempt reserve managers to take more risk than a public institution should. Finally, both tranches are only as available as the custodians and jurisdictions that hold them, a lesson underlined when immobilized reserves became a policy issue in 2022.

• IMF: Revised Guidelines for Foreign Exchange Reserve Management
• IMF Working Paper: Determinants of Currency Composition of Reserves