Central Bank Governor Ajith Nivaard Cabraal urged central banks of the SAARC region to explore the possibilities of cross investment in financial instruments with the region.

"In this way, we would be able to shift and retain capital within the region and applied in the development of the region," he said at a SAARC Finance seminar on Foreign Exchange Reserve Management yesterday in Colombo.

Cabraal said that for developing countries, being those still requiring improvements in their infrastructure and other systems, increasing their foreign exchange reserves had resulted in a huge opportunity cost.

"This is because they have generally been invested in low-risk, low-return securities, mostly in fixed income securities of industrialized countries. This situation has indirectly funded huge fiscal deficits of several western countries or the expansion plans of their large corporations," he said.

Cabraal went on to say that the reserves of developing countries were being used in such a way instead of being used for domestic infrastructure. He said that in many instances the infrastructure of these countries are being funded with high cost loans from industrialized countries.

He suggested that central banks should gently move away from traditional asset classes such as gold and government treasury bills to more sophisticated investment instruments.

"Gold and Treasury bill holdings traditionally held by central banks are now being challenged by investments like derivative products, securities lending and securitized products," he said.

" The experience of the financial market turmoil has led to fresh new challenges as well, which are quite formidable. At one time, mortgage backed and asset backed securities of government owned or government sponsored agencies, were considered good alternatives for the generation of added spreads for central banks. However, today, the market fluctuations and credit concerns arising from the mortgage and housing market crises due to overall market downturns and increased mortgage defaults in developed countries, has exposed new vulnerabilities and risks attached to such investment avenues. As a result, the vital importance of managing risks associated with reserve management has been increasing exponentially in recent times.

" That development will lead us to another important aspect in this discussion. In the past, measuring risk was mostly based on credit ratings. For this purpose, the yardstick for measurement was usually provided by the rating agencies who were supposed to rate countries and institutions in accordance with certain predetermined norms. However, it is now clear that the rating agencies on whom we relied heavily to provide us with independent assessments of the standing of institutions and instruments, have obviously failed to warn of possible weaknesses in the balance sheets of such institutions and investment houses. In fact, perhaps unwittingly, they may have even contributed to the turmoil, by their ratings of pooled assets with large vulnerabilities, as assets of prime class.

"This may have been due to the weaknesses in their approaches, the lack of proper skills or the weaknesses of their governance frameworks. But, whatever may be the reasons behind these failures, the challenge that we now face is as to how to manage risks optimally in this even more challenging environment, knowing that the opinions provided by the rating agencies may not be too accurate, after all," Cabraal said.