Interview: Ma. Ramona Santiago

The editor spoke with the head of reserves at the Central Bank of the Philippines (Bangko Sentral ng Pilipinas, BSP) in June 2020.

What has been the impact of the Covid-19 crisis on reserve management at the Central Bank of the Philippines (BSP), from a portfolio point of view but also operationally?

The Covid-19 pandemic has put a sudden stop to the entire global economy as a result of the draconian measures adopted by almost all nations in order to fight the major health risk caused by the virus. The impact of the Covid-19 crisis will be more profound as it affects many industries and different sectors of the economy, and a large swathe of the global population.

This pandemic situation has imposed another important stress test for reserve managers. Whether to remain with the status quo in terms of existing strategies or to recalibrate positions is an important decision that reserve managers have to make in this current environment.

For the BSP, we have not made changes to our strategic investment allocations as a result of the pandemic. We decided on our asset allocation pre-pandemic and, as we are long-term investors, we maintain our portfolio stance. Any adjustments to our portfolio at the moment are tactical in nature and within the allowable risk tolerance. Moreover, we remain invested in high investment grade assets, the majority of which are sovereign bonds, hence our portfolios are well-positioned for these circumstances.

From an operational standpoint, this pandemic period has tested the BSP’s business continuity plans. Despite the change in the work arrangements (a mix of onsite and work-from-home), we make sure that day-to-day business operations run smoothly and efficiently as possible, in line with the mission-critical nature of our functions. So, for the most part, we are doing work from home. However, our present rules do not allow us to trade or settle transactions from our homes. We have to go to the office to do that.

Do you split your team?

We have two groups and we rotate them every two to three days. From June 15, there will be a slight change in the shifting/rotation. The two groups will alternate reporting to the office and working-from-home on a weekly basis. This change allows us to gradually adjust our work patterns as we move towards the gradual normalisation of our operations.

Do you think those rules around trading and settling will stay?

We want to change them. However, our IT limitations mean this is not possible at the moment. We have to put up with that. Fortunately, as with all the mission critical departments, we have a warm back-up site. Even prior to Covid-19, it has been, and continues to be, the practice of our subsector, the Financial Markets Operations Subsector (FMOSS), to operate from its backup site every two weeks, in accordance with BCP.

You mention BCP. It is interesting because with back-up sites there has been an underlying assumption that a group of people can move to a new location. In this crisis, the idea of groups moving to one place is not straightforward.

That is right. We have to have groupings now to make sure that if, for example, someone is infected, and it happened to us, then we have the other team ready to take over while the first team has to quarantine and take all the necessary precautions. We also practise social distancing and we have to wear face masks. We are very lucky because, since the lockdown, public transportation has been limited but the BSP provides daily transport for those who have to report to the office for work.

What aspect have you found most challenging?

There are two main challenges: first, ensuring the safety and welfare of the workforce while carrying out their duties. As there are some functions that cannot be conducted from home, as I said earlier, we need staff to come to the bank despite the health risk. Just to elaborate, I think most crucial are the mental and the psychological aspects. When we go to work at the office, we know we are more at risk compared to other colleagues. In the back of our minds therefore is “I have a higher propensity to catch the virus.” Naturally, this weighs on people. However, the measures we have put in place – social distancing, regular disinfection of the workplace, and the provision of transport for the skeletal team – are mitigating this.

The second challenge is to ensure that we continue to manage the reserves according to policy objectives and, if warranted, to act decisively on any portfolio adjustments so long as they are within the allowable risk limits.

Have lessons been learned from the crises of 1997–98 and 2007? And, if so, do they still hold?

Yes. By the nature of the central bank’s charter, the BSP is a conservative investor. Previous crises led us to strengthen our governance framework and risk management. One of the important lessons learned from the 1997 Asian financial crisis is that having more than enough reserves is the best line of defense against any shock. Another key lesson is to avoid over-reliance on portfolio flows, or so-called “hot money”, and also to reduce our reliance on capital flows.

The 1997 crisis also taught us how to manage external borrowing. If you look at the Philippine picture at that time compared to now, we had much lower reserves then, but we had more borrowed reserves. At the onset of that crisis, there was a bunching of maturities. It was a challenge when we had to repay the loans. That is one lesson we learned.

The 2007 global financial crisis or GFC was centered on the financial services industry. It led to the collapse of Lehman. Luckily for us at the BSP we did not have exposure to Lehman, but one of the key lessons from the GFC was the need for better risk management, and in particular to take a different approach to identifying, understanding and managing counterparty risk.

The global economy is now facing another crisis, driven by the Covid-19 outbreak. It is unique in the sense that it is characterised by global economic shutdown first due to health risk. The stabilisation of the health issue will be critical. It will drive economic actions and policymaker actions.

Lessons learned from the past crises has made us more resilient and a better prepared nation. Look at our credit rating: in 1997, we were rated Ba1 by Moody’s. In 2008, we were rated B1, and, in 2014, Baa2. We are investment grade now. On the other hand, if you look at our reserves, they have also grown significantly. In 1997, we had about $8.8 billion. In 2008, $37.6 billion, and the latest figure for gross international reserves, as of April 2020, now is $91 billion. When this crisis started, we had around $87 billion.

Your reserves have increased.

Yes. There are three factors at work here. First, remember that during the Fed’s quantitative easing, or QE, many investors started to search for yield. They found their way to emerging markets. We have been a beneficiary of this. Second, another thing going for the Philippines is the flow of remittances from our overseas workers. We thought the past crisis would put a dent in remittance flows, but the opposite happened because we sent more skilled, and “professional” workers overseas. The third factor is the business process outsourcing industry or BPO.

Looking ahead, do you have a view on what the longer-term impact will be, on reserve management but also central banking broadly?

The pandemic situation is said to be ushering in another new normal environment for both reserve management and the central banking operations of monetary authorities. Extreme policy accommodation will be the key feature of the new normal, and the boundaries between fiscal and monetary policies will be more blurred.

Depending on the speed of the recovery, central banks and governments will continue to push policies to their limits, and expand the tools to fight economic recession. In this current environment, central banks are deploying an array of monetary tools, from lowering of policy rates, traditional open market operations, conventional asset purchase programmes and lending facilities, in order to alleviate the liquidity concerns and to fill the hole in the economy caused by prolonged economic lockdown.

However, given the scope and extent of policy accommodation, central banks may face pressure as their actions may be construed as direct monetary financing, which in the long run would have significant implications for independence and credibility. Moreover, as the path to recovery will be slow, low inflation and the low interest rate environment are expected to linger.

And for reserve managers?

For reserve managers, this scenario will provide pockets of opportunities in different markets. But nothing is free. More sophisticated central banks with higher risk tolerances will capitalise on this dislocation, given their experience and the internal support available to them. Talking about dislocations, these are evidenced by the widening of spreads and the liquidity premium on credit products, from the sovereigns, supranationals and agencies (SSAs) up to the non-traditional credits during this volatile environment.

On the other hand, more conservative central banks may shelve their plans to expand exposures to non-traditional investments. Prospectively, environmental, social and governance (ESG) themes will gain greater importance in this new environment. A growing trend for responsible investing and incorporating sustainability goals in the investment process is set to continue with the increasing dominance of the S (social) component. Investors, while expecting lower returns down the road, will allocate capital to specific strategies which focus more on sustainable investments.

The past decade – in fact just over – has been characterised by historically low yields. Has this changed the way you manage reserves?

Yes. It has definitely fostered a trend for “search for yield” given the low and sometimes negative interest-rate environment. Along with other central bank investors, we are considering the risks involved. We have been able to get out of the euro market, but for the yen, notably the Japanese government bond or JGB market, we continue to keep our exposure because of economic reasons. It is always a case of do we go for the negative or zero yield, or do we go for longer duration, in which case we take on another risk. In answer to your question, though, yes we have changed a bit. We are taking on more risk, but still within the appetite allowed. In a nutshell, the BSP has reduced its exposure to negative yielding assets and has expanded its universe of eligible investments to include non-traditional assets for yield and diversification.

You mentioned the euro. I wonder if you could just say a bit more about that? One of reserve management’s traditional aims is capital preservation, and a negative yield is a very direct threat to that.

Sure. I was at a meeting of reserve managers in Paris last year and most of the delegates were part of the European Union, so they had no choice but to hold on to the euro. In their case, in order to manage it, they took on more risk, either by buying longer tenured instruments or going down the credit curve. In our case, we are lucky because our economic exposure to the euro, whether in terms of debt or trade flows, is very limited. What we did internally was to move so we did not hold any euro, but for our externally managed funds, we still have some exposure to the euro. We cannot do the same thing for the yen, however, so we had to get specific Monetary Board approval to allow us to continue holding yen assets. On the euro and the yen, both currencies will still be mostly driven by the (current) negative interest rate policies. However, the yen also enjoys safe haven status.

You also mentioned a move to non-traditional assets. What have you added?

Over time, we have expanded the universe of eligible asset classes for our reserves, so non-traditional investments, but still within the investment grid. Recently, the BSP invested in the green bond portfolio of the Bank for International Settlements (BIS), and the Monetary Board has also approved other investments in other high-grade spread assets.

With this latter group, have you decided how you are going to approach that market? Will you be looking at a fund, or will you be buying bonds directly?

We are looking at investment grade US corporates, and to start with it will be a tactical approach. We are changing the guidelines for our external fund managers to allow them to go into corporate bonds. This will be adding to existing mandates, not new mandates though.

We also expanded the number of currencies that we hold in our emerging market portfolio to include the Thai baht and the Indonesian rupiah. Before this, it was just investment grade currencies. Of course, we have the renminbi, but we do not really lump it with the other emerging market Asian currencies.

It is part of the special drawing right (SDR) now of course, but the renminbi has for many made a shift, if you like, from an emerging market currency to a reserve currency. Would you agree with that?

Yes. But I’m still concerned about the full internationalisation of the renminbi. I believe that the central bank has to stop fixing the rate, and the country itself has to liberalise more before you can really say that the renminbi is a fully fledged reserve currency.

You mentioned the Thai baht and the Indonesian rupiah. Could you say why you are looking for exposure to those currencies? Is it for return purposes, or diversification, or is it to match country liabilities?

It is more for diversification and also for yield pickup. If you remember, we are part of the EMEAP group.¹¹ Executives’ Meeting of Asia-Pacific Central Banks. Founded in 1991, it has 11 members. We formed the Asian Bond Fund (ABF), but we cannot put more money into that now. So we thought it would be good to hire external fund managers to manage a similar fund. This allows us to compare the performance of the externally managed portfolio with the ABF.

Can you give an indication of how much of the portfolio would be in those currencies?

We continue to hold more than 70% in the US dollar, 10% is in gold, and for the other developed markets it is around 10%. The remaining 10% is in SDR holdings and Asian currencies, which includes the baht, rupiah and renminbi.

If I look back at previous surveys in the Reserve Management Trends series, 10, even five, years ago, a central bank holding Indonesian rupiah in reserves would have been unusual. It is a real indication of how things have changed.

Well, Indonesia, like us, is now investment grade, and Thailand, like us, has repaid all its loans to the International Monetary Fund (IMF).

How do you determine your currency and asset allocation?

This is fundamentally determined by taking into account the country’s external foreign exchange requirements. Meanwhile, we employ optimisation techniques to determine the strategic asset allocation of the reserves.

Has your use of external managers changed in recent years?

In terms of assets under management, we have increased the amount. We have also increased the number of mandates and the number of managers because, as I mentioned earlier, reserves have almost tripled over the past ten years.

Here I can also mention tranching. Aside from keeping our internal and external division of the portfolio, we have also gone into tranching because of the size of the reserves now. The tranches have their own objective. We have the working capital tranche, the liquidity tranche, the investment management tranche, and the long-term tranche. Some of these are managed internally, some are managed externally, but for those where we look for diversification and better return, we look to external fund managers. For one thing, they have better access to new markets, they also have better systems, and they have specialised skills. Given all this, it continues to be a learning process for us to work with external fund managers. So, perhaps it is fair to say that the basic elements have not changed, but mandates and skillsets have progressed.

Do you carry out securities lending, and if so what has been your experience here?

We have engaged in securities lending programmes since the 1990s. We have had a positive experience, although there was a year due in which, due to our own guidelines, which are very restrictive, we did not generate enough to cover the custody fees. But, bottom line, the amount of income that comes from securities lending is enough to cover our custody fees, and the only thing we make sure of is that the lending programme should in no way interfere with the management of the respective portfolios and always conducted according to guidelines and parameters set by the BSP.

There are some counterparties offering to becoming third-party securities lenders. We also tried that. It’s not really efficient. It’s more costly. The best way to approach this, we have found, is to have custodians do the securities lending.

The past five years have seen an increasing number of central banks invest in equities. I don’t think you do that, but could I ask if you’ve considered it, or what your view of that is?

Yes, even though the BSP charter was recently amended, section 128 of the amended charter continues to prohibit us from acquiring shares of any kind, or accepting them as collateral, or participating in the ownership or management of any enterprise, either directly or indirectly. We’ve been monitoring the movement of the equities market over the years, and we know that a small exposure to the equities market for a long-term investor will really add value, however we cannot do it directly, or indirectly. Given the legal limitation, the BSP is not likely to invest in equities in the foreseeable future.

You mentioned a drive to include ESG in reserve management earlier. Can I ask what the stance of the BSP towards this is?

We’re taking small steps. We started by putting some money with the BIS in their green bond portfolios. While sustainability goals are not explicitly considered as one of the investment objectives for reserve management, the bank is taking an active role in incorporating ESG in its investment process. In terms of external management, fund managers on our current roster are all signatories to the United Nation’s “Principles for Responsible Investment”. Furthermore, the BSP has also started to use ESG ratings as one of the eligibility factors for corporate bond investments.

In general, the way we approach new asset classes is to team up, either with the BIS or the World Bank. Now that we’re getting to know how the BIS manages, we are exploring the possibility of going into ESG bonds with our external fund managers. It could be an entire portfolio, or it could be a diversification. We’re also thinking of creating a new Asian Bond Fund that would be invested in ESG bonds.

Do you see any conflict with this move to include ESG with the traditional demands of reserve management?

Actually my concern is that I don’t know if countries like the Philippines can really force our companies to follow ESG principles. But we can set an example by investing, and there’s a complementary move from our colleagues in supervision, who are encouraging banks, and financial institutions under them, to observe them.

Internally, what have these changes meant to the size and structure of the reserve function?

As the reserves have grown and the environment continues to evolve, we have to ensure that we have capabilities to meet our objectives in managing the reserves. We have undergone organisational restructuring to make sure that we have the proper staffing and the necessary skillsets of the people from the front-, middle-, and back-offices. We have, likewise, strengthened our governance framework, thus, establishing clear delineation of work and accountabilities in the reserve management function.

From a technical or operational point of view, do you manage your gold holdings as a part of the portfolio or separately?

We have always managed it separately. For one thing, after the Asian financial crisis, which I mentioned earlier, we built up our reserves because we could purchase gold produced domestically with local currency. The source of the gold reserves is actually local, and that’s one reason why we want to manage it separately. A second point is that we cannot find a benchmark that incorporates gold reserves. Ultimately, however, the real reason why it is managed separately is because it is viewed as the ultimate insurance. Indeed, to this end, over the past two years, we shifted to managing it passively.

When you look at the reserves as a whole, though, you include gold in the valuation.

Yes. Gold is always counted as part of the assets of the bank, and part of the reserves, but since we started the passive management, it is no longer marked to market.

One reason some central banks hold gold is because of the diversification benefits it can bring in a mixed portfolio. Do you, with that approach and that treatment, not see those benefits?

We stopped marking to market two years ago, but before that, when we did mark to market we were getting the full diversification benefit. As you correctly point out, now, because of the accounting change it will not show in our books that we are benefiting fully from gold. For what it is worth, I prefer this treatment as it is more conservative.

The main benefit with gold is insurance and then diversification. There’s also a third benefit: liquidity. You can liquefy gold into cash when needed, either by selling it outright, or going into gold financial swaps, or gold backed loans. There are many ways that it can be turned into cash, which is important for the reserve manager.

In a paper published by BIS last year in a series on intervention, you mention as shift in composition of reserves in response to markets and to further diversify “with focus not merely on returns but on better risk management.” Could you say in more detail what you meant by this?”

The shifts in the composition of reserves as described in the paper were primarily aimed at maximising the use of the country’s reserves to generate better risk-adjusted returns. We recognised the external challenges posed by the divergent monetary policies among the developed economies during the past decade. With depressed yield levels in traditional reserve currency markets, the challenge to generate returns was magnified. Our pursuit of yields has led us to expand the eligible investment universe, lower the credit threshold spectrum and reduce exposures to negative yielding markets. Meanwhile, the other measure that we implemented was the strategic adjustment to the benchmark. This was done in order to minimise the cost of periodic rebalancing and to enhance the investability of the benchmark as it provides greater leeway for portfolio strategies. Lastly, the creation of a held-to-maturity (HTM) portfolio helped augment the income on the reserves and simultaneously reduced the volatility of the balance sheet amidst the normalisation of the US policy rates. This is what I meant by saying, “with focused not merely on return, but on better risk management,” or putting it differently, focusing on risk–return and not just on return.

Where do you see opportunities in markets for yield pick-up now?

Investment grade credits and US MBS may be good assets to consider. Spreads have widened significantly, although they have retraced somewhat. The Fed’s asset purchase programme may help contain any further widening of spreads. Given all this, there are tactical opportunities to have exposures to the assets that major central banks are taking in at the moment.