Interview: Solomon Kavuma

How would you characterise market conditions in early April 2018 from a reserve manager’s perspective?

There are three main forces dominating the market environment at the moment. The first is rebounding global economic growth, which is expected to continue both in the advanced and emerging-market economies with continued resilience to geopolitical uncertainties. The second, which is longer term, is demographic concerns, again in both advanced and emerging-market economies. The third factor is the emergence of so-called cryptocurrencies, which again, may be for the longer term, but which create challenges for us as reserve managers and indeed central bankers broadly. These are dominating market conditions and therefore investment decisions need to be based on a cautious and disciplined approach.

Please could you briefly explain the governance for managing reserves at the Bank of Uganda?

The governance of reserves is both the manner and the process of overseeing the reserves. At the Bank of Uganda this is characterised by a cautious and disciplined approach. The bank employs a top down approach, where the central bank Board owns the decision. Under the Board there are two key committees with respect to reserve management: the Reserve Management Policy Committee and the Investment Sub-Committee. The former oversees the implementation of Board’s decisions by the operating unit, ie the Financial Markets Department, and is chaired by the governor. The latter oversees the coordination and implementation of the decisions of the Reserve Management Policy Committee across the relevant departments and is chaired by the executive director for finance. In addition, there is an independent risk management department and an independent audit function that team to provide assurance to senior management.

So we think of it as a highly “restricted and disciplined” approach where the technical team provides input which is exhaustively discussed by all the relevant committees and the Board. Membership of the committee is limited and selected across the universe of relevant departments who discuss proposals at length.

Do you make use of a strategic asset allocation (SAA) process?

Yes we do: SAA is a critical component of reserve management. It is the framework that explicitly guides the allocation of the assets in line with the approved institutional risk appetite and expected portfolio return. The process involves decisions related to liquidity, and of course as a small growing central bank this is paramount, the kind of asset classes to engage, and considerations for reasonable consistent return, given that it is a cost to hold reserves. Consideration of return is important, but not achieved at the expense of compromising safety and capital preservation. Liquidity in this sense means that funds should be available at all times when needed, at minimum cost. This obviously has a big impact on the types of assets and markets we can invest in.

What about currency exposure?

The decision regarding currency exposure is mainly driven by the structure of the currency of the liabilities that go through the central bank, eg, both the micro and macro institutional obligations. Our base currency is the US dollar, and this forms a significant portion of our reserves. We make considerable use of the principle of currency representation and correlation to reduce the burden of currency exposure.

How often do you review the SAA?

We review it once a year and it is expected to stay for at least two to three years. Review in this instance does not mean changing! It is a process which allows us to look at what has recently happened in the global markets and then look at our allocation to see if it is still relevant. And if there are major, major changes that we think will last over two to three years and have great impact on the global financial markets, then we revisit the decision. But we try to minimise the disruption to what has been decided for the SAA in the past.

Do you ‘tranche’ your reserves?

Yes, we do. Tranching helps to allocate and manage the reserves efficiently. There are three tranches: transaction, liquidity and investment. The transaction tranche is for the day-to-day operating needs. It is highly liquid. The liquidity tranche serves as a cushion for the transaction tranche. This is again in highly liquid assets and is calculated based on needs of meeting liabilities. Then, after simulation, anything beyond that – “excess” if you like – falls into the investment tranche. This is less liquid, but, as I mentioned earlier, liquidity is paramount for us so I would not want anyone to think the assets here are “illiquid”.

It is in the investment tranche where return is optimised in line with the approved risk threshold. This is where we exercise our disciplined and restricted approach, which I talked about earlier, in deciding which asset class, and for what period and which market. We are very optimistic that with the growth in reserves, which at present is about 5.4 months of import cover, other things being equal, this investment tranche will grow.

How important is the yield on the reserve portfolio to the Bank’s overall income?

It’s very, very important. Reserves are now the main source of income for the Bank. The return on the central bank reserves has been generally low, but with the pick-up in global market bond yields, we have high hopes that this will greatly improve.

Do you make use of external managers?

Yes. External fund managers are important as they bring on board reserve management skills which are not available in-house. The first is skills and knowledge transfer, the second, is they have the IT and market infrastructure to support engagement with otherwise non-traditional central bank instruments, hence diversifying the portfolio. And the third one is they add value that enhances return without compromising safety and liquidity.

Are they assigned a specific role or project in the portfolio?

Yes. As I mentioned, they tend to be more experienced, especially in what can be thought of as “non-traditional” central bank assets where we as a small central bank do not have the skills. For example, the exposure to mortgage-backed securities (MBS) and asset-backed securities (ABS). Usually the allocation in such new classes is not so big, to give internal skills a chance to learn from them and as well as to manage the associated risk well.

Have you considered emerging-market bonds?

We have allowed a small exposure. These are new areas for reserves managers. A number of emerging markets are very attractive of late and have made significant progress in terms of governance, the reserve environment and the state of the economy. So it is worthwhile to cautiously move in and tap these select markets, where the risk-adjusted return is high. This is the key measure: the risk-adjusted return.

Where else have you looked for return: do you engage in securities lending, for example?

Yes, we do engage in securities lending through our custodian. It has been worthwhile for the central bank. It pays to make use of these idle assets to add value to your portfolio. The key is being able to understand the custodian’s operations, to regularly receive reports from them and to also be able to monitor these well. The additional income can help subsidise the fees payable to the manager or offset the custody fees at least!

How has the rise in Fed rates impacted your reserve management?

Rising interest rates in the global markets is not a new phenomenon. That’s important to remember. The key concern however should be moving from very low interest rates – in fact negative in some markets – to positive territory. The global financial market is changing very fast and moving towards synchronised monetary policy by the major central banks. Essentially, we are looking to manage this by shortening the duration of our portfolio.

You mention negative rates. Have these impacted your reserve management at all?

Yes, of course. Negative interest rates are not desirable for any central bank, from the straightforward standpoint of capital preservation. So you have to make arrangements to minimise the impact of that: you don’t want to give away your money. With the euro, which we held due to the nature of our liabilities, we had to find a way, through the SAA process, to make sure we got the most possible return. So we readjusted our allocation to make sure we minimise negative returns going forward. However the Eurozone outlook now is much more promising and markets (and rates) will pick up going forward, I am sure. I hope, personally speaking, it will be a big area for investment for us in the future.

The renminbi joined the special drawing right (SDR) in late 2016. Do you have exposure to this currency?

When the renminbi joined the SDR the central bank, by default, was exposed to the currency. So, yes we do, but it is not so significant. Going forward, we will need to review and see how much we should allocate. The renminbi is becoming an important part of global markets and we at the Bank of Uganda don’t want to be caught late.

The key principle in the management of reserves is matching the assets with the currency of the liabilities. So allocation in this currency will require a thorough assessment of the extent of the liabilities held. This is the discipline of our approach. If we do take a larger exposure, our preferred option would be the onshore market, though either onshore or offshore would work well. But this is really one for the future.

Do you see a role for equities or exchange-traded funds (ETFs) in reserves?

From a personal perspective, I believe equities and ETFs are going to be very important instruments. They are going to be the latest non-traditional instruments for small central banks. And the reason is that there has been a lot of improvement here. Earlier, as a central bank, our fear with respect to equities was volatility and credit risk. On the first aspect, global markets have changed a great deal and the regulatory environment has improved significantly. On the second aspect, risk management in central banks is much more at the forefront than before. We look at assets in combinations, for instance: here, equities for instance can complement traditional central bank assets, from a risk perspective. To be sure, if you move into equities, there are lots of important decisions to take: which markets, sectors and so on. So reserve managers will have to do a lot of thinking in this area. But as you know, central bankers are increasingly asking “What kind of risks am I taking here and how can I manage these?” And as long as they understand the risk component of the asset, they will be able to go ahead. Investment is understanding the risks. When you do that, there is no fear. But understanding requires skills and experience, and this is what we need, as central banks, to focus on and build.

You mentioned a change in understanding of risk. Does this extend up the Board? As you said earlier, the reserve management decision are owned by the Board at the central bank.

Yes. Central bank boards have changed so much. They are very dynamic and mission oriented. You can’t push through anything, as they are very keen and understand the reserve management process very well. They are more detailed than before.

At the start you referred to cryptocurrencies. Will these impact reserve management?

This is an area in which central banks have to be extremely careful. They and their risks need to be understood very well before a central bank gets involved. The developments are exciting, but the risks need to be understood.