Executive summary

The first chapter reports the findings of a survey of 74 reserve managers, which was sent in February, and two supplemental questions sent in April as the crisis unfolded, which were answered by 40 of these reserve managers. A main finding is that the Covid-19 crisis will have a significant impact on reserve management over the next 12 months across central banks’ asset allocation and risk management. Twenty-nine reserve managers (73% of 40 responses) see the crisis impacting their tactical asset allocation, 63% their risk appetite, 58% their risk framework and 55% their strategic asset allocation. Reduced market liquidity has been the most challenging aspect for reserve managers, along with a reduction in reserves among smaller holders.

Last year saw the 20^th anniversary of the euro and, in the main, reserve managers view the single currency as having underperformed as a reserve currency in its first 20 years. A lack of policy coordination and negative rates are the main reasons, and a return to higher, positive yields would have the biggest impact on its attractiveness. More broadly, the low-yield environment has had significant and far reaching effects on reserve management. More than 80% of respondents said low yields had led to changes in the number of assets classes, geographies and currencies invested in. Indeed, change in asset classes has been a common feature of portfolios over the past 12–18 months, with addition being most prevalent. There was less of a trend with respect to change in currencies, however.

Reserve managers use a range of custodians with, broadly speaking, more custodians associated with higher national income. The most popular single category is five or more, but over half of respondents said they use three or fewer. Safety of assets is paramount when choosing custodians, and securities lending is an important element especially among central banks from higher income countries and with larger reserves. Tranching is a common means of managing reserves in 2020. The most popular arrangement is to have two tranches but more reserves are managed by those employing three.

There is considerable growing and active interest in incorporating socially responsible investing (SRI) into reserve management, a topic this series has tracked for three years now. Almost half of the survey respondents said that they were considering this and just over a quarter said they already did. For those considering integrating SRI, the main obstacles are concerns over liquidity and returns, and difficulties in reconciling SRI with the central bank’s mandate.

Chapter 2 presents an interview Maria Ramona Santiago of the Central Bank of the Philippines (BSP) which was carried out in the first week of June 2020. The impact of the Covid-19 pandemic has affected work at the central bank and, at the time of the interview, reserve managers were split into two groups, rotating every two to three days for going into the central bank. The experience has shone a light on business continuity practices: current rules do not allow reserve managers to trade and settle from home. This is clearly a source of frustration as Mrs Santiago makes clear: “We want to change them.” The most crucial aspect for her is mental and psychological wellbeing of staff, she says. Concerns naturally weigh on people.

An experienced reserve manager, she is able to draw on lessons of previous crises, which have been well learned. The crisis of 1997 taught the central bank the value of more reserves and also the need to manage external borrowing. From 2007, a key lesson was the need for better risk management. In 2020, reserves under management at the BSP have increased, she notes.

The years since the global financial crisis of 2007 have been characterised by low yields which have impacted reserve management at the BSP, as Mrs Santiago explains: “…the BSP has reduced its exposure to negative yielding assets and has expanded its universe of eligible investments to include nontraditional assets for yield and diversification.” The main area of change on the first count has been to leave the euro market (though not the yen) and, on the second, to move into new credit markets and to add exposure to emerging markets.

The latter includes the addition of the Thai baht and Indonesian rupiah, and the rationale here is clear: diversification and yield pick-up. An expression of surprise at their inclusion elicits a crisp rejoinder: “Well, Indonesia, like us, is investment grade, and Thailand, like us, has repaid all its loans to the International Monetary Fund (IMF).” She is cautious on the renminbi, and while the case for equities is clear in her mind, the central bank law does not allow share ownership.

The central bank is embracing socially responsible investing and environmental, social and governance (ESG) issues. “We’re taking small steps,” says Mrs Santiago. “While sustainability goals are not explicitly considered as one of the investment objectives for reserve management,” she adds, “the bank is taking an active role in incorporating ESG in its investment process.” The BSP has started to use ESG ratings as one of the eligibility factors for corporate bond investments, she notes.

Chapter 3, by Ashim Paun, presents the results of an analysis of 67 countries that were ranked from the most resilient to the most vulnerable in terms of the risks they face from climate change. The survey, which uses 35 indicators based on 54 data points for each country, looks at how much countries have achieved in terms of a suitable response to climate change, as well as their actions on ESG. Reserve managers will, increasingly, have need of this type of information as the author notes: “However, whether reserve managers are managing foreign exchange reserves, own funds or their pension assets, climate change risks are inherent.”

While every country now has to manage increasing climate risks, there is great variation in how well this is being achieved. To gain a better understanding, they take the following approach: “The challenge has been distilled here into a single question: ‘Which countries are most resilient in the face of rising climate risks?’” Analysis of a country’s resilience and vulnerability is structured around four sections based on key questions: how embedded carbon is in their national economy; which countries face greater risk from physical impacts associated with global warming; which have put in place the policies, institutional changes, financial backing and public education to meet these challenges; and how they are placed to gain economically from clean technology as the world decarbonises.

The chapter shows that the countries that have best achieved resilience are in Northern Europe, with Finland in first place, followed by Germany and then Sweden, while the most vulnerable countries are Nigeria, Bangladesh and Oman. It also describes the variations in carbon intensity by country, finding that Switzerland and France are best placed, and points out: “It should be noted that the analysis ranks Middle East and North Africa (MENA) countries as the most vulnerable.”

After analysing how effective countries have been in mitigating emissions and the impact of climate change, the author assesses the increasing investment prospects for taking advantage of green opportunities, and how climate revenues – from products and services that enable the low carbon transition – can offer greater resilience. These include from diversification in non-hydrocarbon sectors, particularly for those economies dependent on fossil fuels, the use of clean technology production, and also climate-themed products and services.

The chapter concludes with examples of initiatives taken by central banks, including the Network for Greening the Financial System (NGFS), ESG corporate bond and green bond funds, and responsible investment charters. The author notes progress made: “The integration of ESG criteria into central bank portfolios is clearly gaining pace, although taxonomy and the availability and consistency of data are still evolving, making this a challenging task for reserve managers.”

The 4^th chapter addresses benchmarking: the “cornerstone”, as authors Juliusz Jabłecki and Jacek Próchniak describe it, of a reserve manager’s strategic asset allocation. The focus of their investigation is understanding and explaining what they term the “uncompensated transaction costs” of benchmark replication. These are mostly incurred when rebalancing a portfolio so that its holdings match those of the benchmark. They are, importantly, borne by the portfolio manager, but not reflected in the benchmark.

The problem is not a trivial one, as the authors show. The cumulative effects of periodic turning over to rebalance a portfolio, differences in prices paid vs the benchmark and reinvesting coupons all stack up for any asset manager. In a central bank context, inflows to a portfolio and a fixed currency structure can contribute further headaches. Finally, for the reserve manager, who is subject to more constraints and greater risk aversion than her commercial cousins, the scope to offset these costs with active bets is reduced. The effect will vary with market, but the authors show straightforwardly how such costs can erode a reserve manager’s excess returns “causing them to underperform their benchmarks despite taking little or no risk.”

It is no little irony, the authors observe, that while the practical work of determining a benchmark will contribute the lion’s share of a portfolio’s risk, relatively little time and resource is spent on this. In contrast, positioning against the benchmark adds little risk, but is where the focus tends to lie. This real world observation is neatly mirrored in academic and professional literature, they add.

Having set out the problem, the authors take a methodical approach to engineering a portfolio that can replicate a benchmark (or its qualities) but avoid – as far as is practicable – these uncompensated costs. They take as a starting point the risk profile of the benchmark. Targeting this can lead to a “leaner” portfolio, ie one with fewer bonds than the benchmark, but one which still mirrors its risk characteristics. A leaner approach yields better results, but also creates problems in terms of availability of popular issues and portfolio concentration. It also means more turnover.

Enter derivatives. These allow a reserve manager to avoid the costs of selling short-dated bonds that a benchmark drops solely to maintain its duration. This effect, which the authors term “forced selling”, turns out to be a big driver of uncompensated costs. The authors show how a reserve manager can write futures so that a portfolio’s duration continues to match that of the benchmark, yet, all the while, continue to hold those short-dated securities to maturity.

As redemption is cheaper than liquidation, the reserve manager sidesteps the “forced selling” costs. This approach – more one of ‘having your cake and eating it’, than skinning a cat – works well with positive results in backtesting as excess returns remain positive after transaction costs. Their finding has implications not just for conservative portfolio managers who may feel “prisoners of their benchmarks”, but also for those setting benchmarks who should not feel they are required to select indices that are perfectly replicable.

From a technical portfolio focus, chapter 5, by Streevarsen Narrainen, switches to a macro view. Indeed, looking beyond reserve management, he examines how Mauritius is developing a sovereign asset liability management (SALM) framework by moving from a silo strategy to a broader portfolio approach for the management of sovereign risks. The aim is to improve coordination between all the institutions that hold and manage sovereign assets and liabilities, a move that also requires the development of the country’s balance sheet. It is, as he makes clear, a work in progress, and notes that “Mauritius has not yet decided on which model to adopt.”

What is the motivation for this change? The author identifies two main ones. First, is that the balance sheet of Mauritius has changed a great deal. This has been “both quantitatively with an increase in assets and liabilities and qualitatively in terms of diversity and sophistication,” the author notes. This, in turn, has made the need to manage the balance sheet from a risk mitigation perspective “evident and urgent” he adds. A second motivation is an asymmetry, which the author says leads to a bias in assessing and interpreting risks:

Narrainen identifies four key steps in the process: selecting a framework, constructing the balance sheet, the integration of risk management into the framework and finally institutional coordination. Interestingly he notes that the country has, along the way, taken a number of steps towards an ALM approach “unwittingly”. The first of these was the creation of a balance sheet, which was first published in 2008. There is still work to do here and there are challenges around data provision, and governance arrangements to name but two. The situation is not helped as the government has begun a move to accrual accounting from cash, he adds. A second step was the coordination that has grown out of inter-agency or inter-ministry committees. These have worked through issues which have a direct impact on the sovereign balance sheet, he observes. A third step was the transfer of realised gains from reserves revaluation to pay off foreign currency debt. The rationale for this, he says “was very much in line with SALM principles.”

Institutionally, the country is making changes in this direction too. The creation of a new Mauritian National Investment Agency will bring together public funds. Together with the State Investment Corporation, it will create “a sovereign investment fund of some $5.4 billion, which could be the largest portfolio of assets in the country.” The MNIA could, the author notes, take on a role managing the country’s excess reserves.

In Chapter 6, Jesus Alberto Zapata, Guillermo Alarcon and Omar Santivañez break new ground for this series with a discussion of the development of a new integrated information system for reserve management. The background to this is perhaps not uncommon in reserve management and central banking, more broadly, in recent years. Substantial reserve growth over the past ten years, in particular, has placed new sets of demands on the reserves and by extension reserve management at the Central Reserve Bank of Peru (CRBP). As a result, the central bank revisited their investment objectives and guidelines. For the reserve management department, this meant they needed “more personnel and systems adapted to decision-making at all the levels of the institution.”

The chapter focuses on the system and tracks the development from a world of non-integrated spreadsheets and sources to a custom-built datamart and business intelligence architecture. It is clear that a key element in the success of this large-scale project – which took almost three years to implement – was the data-driven and user-focused approach from the start. As the authors explain:

And here users are considered in a broad sense:

The resulting product has five main characteristics: a complete set of reports, dashboards, on-demand reports, alerts (and the possibility to create these) and business analytics capabilities. The authors are clear in their assessment of what the benefit is: the new systems enable reserve managers “to make better decisions based on objective indicators (updated and with a deep level of detail) while identifying opportunities and risks for the management of the international reserves.”

They conclude with a list of what they see as key success factors, a checklist that will no doubt be of use to reserve managers considering system builds at a time when they continue to move into new markets, manage new risks and face increasing operational challenges.

Central Banking would like to thank all who contributed to this year’s book in what have been (and continue to be) the exceptional circumstances of the Covid-19 pandemic. As ever, the editors welcome comments on this year’s book and suggestions for the future.

We would also like to thank HSBC for their continued sponsorship of this title.