Executive summary

The first chapter reports the findings of a survey of 80 reserve managers. A US/China trade war is the most significant risk facing reserve managers in 2019. Overwhelmingly, reserve managers see geopolitics as affecting the choice and amount of currencies invested in by central banks. To this end, the dollar remains undisputed in reserve managers’ eyes as the safe haven currency, and it is interesting to note that reserve managers expect central bank holdings of gold to continue to grow.

Reserve managers remain largely unmoved in terms of their holdings of dollars and euros despite recent policy shifts from the Federal Reserve and European Central Bank respectively. It is clear however that Brexit will reduce the attractiveness of sterling for reserve managers and is also having significant impact on back-office operations and counterparty relations. Reserve managers see the renminbi rising steadily over the next decade, with a majority of respondents envisaging China’s currency accounting for 10–20% of global reserves by 2030. Broadly speaking reserve managers are expanding their currency holdings. They increasingly invest in currencies that until recently would not have been thought to merit discussion, and often acquire small exposures to a range of currencies.

Turning to broader portfolio questions, reserves are typically shorter duration, although this is an area of change and many reserve managers expect to lengthen duration over 2019. Reserve managers typically use a suite of risk indicators, with modified duration and value-at-risk (VaR) the most popular, and it is clear that stress testing is an important part of today’s reserve management, especially for large reserve holders.

There is considerable momentum building for integrating environmental, social and governance (ESG) principles into reserve management, a trend first noted in last year’s survey. Yet the framework and processes for doing this remain underdeveloped. This is a topic this series will continue to track.

External managers are a key part of modern reserve management. And their role is set to grow. Overwhelmingly, reserve managers see potential for external managers to provide services over the next 2–3 years. Active management is an area where external managers can add value, as well as providing access to new markets for the purpose of diversification.

The first contributed chapter, by Juliusz Jabłecki and Magdalena Zielińska, of the Polish central bank, picks up the theme of diversification. Specifically, it describes the experience, or rather experiences, of introducing a corporate bond portfolio into the reserves. The motivations for diversification are well known and corporate bonds, which allow the investor to take a bit more risk, should seemingly offer more rewards in the form of returns. This should especially be the case for a long-term investor like a central bank. Yet, as the authors show, corporate bonds are not as straightforward as could be thought.

Three issues stand out. The first is which bonds to invest in: from a governance point of view there is credit that the central bank thought it should not be exposed to (ie banks). This means an initial deviation from the market benchmark. There is then the challenge of replicating and following the benchmark (it turns out you don’t need all the papers to do this to a reasonable degree of accuracy). And then third there are the practical elements of buying and selling, and getting a feel for the market.

Yet still unseen risks lurk. “Callability” a quality unknown to habitual investors in sovereign paper is commonplace in the corporate market. That corporates would be less liquid than Treasuries was known, but there is more to it than this, as the authors explain: “A more serious problem relates to the fact that the liquidity of individual corporate bonds is hard to predict and much less stable than that of the corresponding Treasury securities. Indeed, it is not uncommon for liquidity scores of bonds in our portfolio to change by 20%, something that never happens for Treasuries.”

The chapter details five key lessons that can be drawn from the exercise of implementing the corporate bond benchmark index, including the credit risk involved, liquidity issues, whether they are a spread product, index replication and the role of corporate credit in their overall strategic asset allocation, and also the expectations of how big the corporate bond portfolio will eventually become.

In forming a judgement on whether corporate credit is worth investing in, the authors pose the dilemma to the reader thus:

They conclude by returning to the question from an overall portfolio perspective.

Their conclusion is both fascinating and unexpected.

In Chapter 3, Michael Ridley and Peter Barnshaw of HSBC examine the environmental, social and governance (ESG) approach to investment for sovereigns. Including ESG in their reserve management framework is an area of increasing interest among central banks, as the survey reported in chapter 1 shows. It is also a challenging area as no clear methodology exists for them to do this. In this chapter the authors describes the evolution of ESG investment analysis from an ethical and sustainable basis to the increasing expectation that it can offer superior returns through longer-term and better valuations than a traditional analysis framework.

The chapter details the use of ESG analysis to cover sovereigns, assessing its impact based on a framework where countries are assigned their own ESG score, which helps to explain a large proportion of the variability of sovereign credit default swaps (CDS). The model of sovereign ESG scores developed, which is based on scoring 77 countries by their main ESG attributes, and the inputs and different individual metrics used to create these scores, are discussed, as is how the scores have improved over the years, breaking the results down into developing market and emerging market countries. The five components of the model are examined in a panel: climate change resilience, the Human Development Index, social readiness, corruption perception and governmental effectiveness.

The authors demonstrate how the sovereign ESG scores can help to assess long-term value in sovereign credit and the correlation of CDS spreads to their ESG measures. The explanatory powers of the ESG scores are shown, as is their residual forecasting power, while the relationship between ESG scores and credit ratings is analysed, as well the transition risk involved in climate change and the impact this has on environmental aspects.

They conclude: “we were able to produce a simple yet powerful sovereign ESG model that we applied to 77 sovereigns. The model shows a strong correlation between the sovereigns’ ESG scores and the sovereigns’ 5 year CDS. Moreover, the model appears to have predictive powers: those sovereigns whose CDS appeared cheap in 2010 appeared to outperform those that appears rich in 2010, in the period 2010 to 2018.”

In the following chapter, authors Andrés Cabrales, Cristiam Rincón and Diana Fernández explores liquidity risk, a key objective of reserve management, and provide a methodology that can measure liquidity in terms of the time required to liquidate and also the cost of liquidation itself. The methodology shows its usefulness by being practical for decision-makers as it is based on units taken from market information and data gathered from key market participants, and can be viewed from different levels and also aggregated. The chapter details how the methodology can measure portfolio liquidity under different stress scenarios.

The motivation, as the authors, note is clear: “Liquidity has always been important for foreign reserves portfolios because central banks must be able to sell their holdings at any given moment. These moments might not be easy to predict, and could occur during periods when markets are not calm, and a central bank might then have to liquidate assets under extreme conditions. Due to such issues, and the fact that market liquidity conditions have changed, the idea that portfolio liquidity should be monitored on an ongoing basis is reaching consensus.” Yet, as they also note there is no formal definition of what constitutes a liquid asset in a reserves context.

As a case study, the chapter examines the investment portfolio of the Colombian central bank, Banco de la República, which is mostly comprised of fixed income instruments, and how both short-term and long-term tranches are defined within reserve objectives and the risks set. It shows how the indicators were defined, and how stress scenarios can be taken into consideration. The chapter also demonstrates how to identify the best indicator, one that captures characteristics such as tightness, immediacy, depth, breadth and resiliency. For Banco de la República’s portfolio, it was important to look at a range of indicators – in their case, 30 were initially looked at – to see which best suits its type of mandate, and also to monitor their reserves portfolio and to be easily relatable to the possible utilisation of the foreign reserves.

And yet it should be borne in mind that liquidity costs and is, at all times, a moving target: “Liquidity evolves, and as a result indicators should be updated regularly. For example, the matrices presented in this chapter are updated on an annual basis so that the indicator reflects market conditions. Information might not vary from one year to the next, but it is important to be up to date when new regulation or market tendencies change the level of liquidity in key markets.”

Chapter 5, by Federico Sturzenegger, provides important lessons and intriguing insights into from the point of view of a central bank governor. He begins by describing the economic situation when he took over in Argentina in late 2015. A weak balance sheet, with negative net reserves, was just the start, as he explains. “To make things worse, the previous government had sold off US dollar futures for about the equivalent of a third of the monetary base at off-market prices.” In addition, the government had committed to end exchange controls and the market was expecting a big depreciation in the official exchange rate. “The situation”, he says called for swift action.”

The exchange rate unification was a success he notes in no small part due to all the foreign currency assets the private sector had built up over the previous decade. There was in fact an excess of these assets, not a shortage. Exports returned and firms ran down their inventories of imports. As a result, the peso strengthened. Next the administration sought to normalize relations with creditors, when a dispute with creditors was settled. The central bank could now build reserves and, crucially invest them without fear that they would be attached by the hold outs.

Sturzenegger then turns to the questions of how much reserves to hold and what to invest them in. On the first question, he notes: “Over time reserves were transformed from a financial exchange rate tool to a creditworthiness confidence-building tool, performing a key role in the policy toolkit of most economies as they reduce the likelihood of balance sheet pressures.” As regards benchmarks he says the central bank looked both to formulas from the International Monetary Fund (IMF) and to its neighbours’ holdings, as a percentage of GDP, to settle on 15% of GDP.

A need to add reserves to reach this target combined with a government funding itself overseas in dollars created a “natural agreement” where the central bank would buy the dollars from the government and then sterilize the pesos created. These “silent intervention”, as Sturzenegger calls them were understood by the market. But the policy of reserve accumulation “turned into a bit of a PR nightmare” as the central bank faced the cost of carry.

In terms of reserves composition, Sturzenegger explores the question of the risk/return trade-off. What risks are the reserves hedging? What risks should the central bank take? How much return is acceptable – or rather what should a schedule of returns look like? For a central bank, in the view of the author, it can be put thus: “We needed to invest in assets that yielded the highest returns at the time when we most needed them.” This proves controversial and he describes the development of a framework where the allocation means risk is not limited to the volatility of financial assets, but expanded to include the volatility in the reserves’ portfolio in relation to external shocks. This is a challenge for the central bank, as he observes: “Central banks prefer to focus on their own balance sheet, probably because they want to avoid any headline or reputational risks. However, once you start to consider hedge properties, your asset allocation decision might drastically change.”

The 6^th chapter is by Ravi Menon, the managing director of the Monetary Authority of Singapore (MAS). He describes the range of techniques that Singapore uses to manage its reserves in terms of the role the official foreign reserves play, how they are accumulated and managed by the three entities involved with the reserves, and their investment objectives within the overall framework. Reserve management in Singapore is multi-objective, multi-agency and multi-generational, and the chapter delves into the structure of the country’s national and foreign reserves as a basis for macroeconomic stability, as well as their objective as a buffer against shocks and potential crises.

The role of the reserves as a rainy day fund, an endowment and as a stability find is considered. As an endowment, for instance, the reserves stand ready as a key source of revenue for funding government expenditure. This, as Menon notes, is set to grow for demographic reasons: “The role of the reserves as an endowment from which to draw a steady stream of income to finance the government budget will become even more important in the years ahead. An ageing population will mean higher expenditures, especially for healthcare, and slower economic growth will mean lower tax revenues.” When the reserves serve as a stability fund, this helps to maintain confidence in the exchange rate-centred monetary policy framework of Singapore, where inflation and demand are more influenced by the exchange rate than interest rates.

Importantly, the chapter also explains how the official foreign reserves are managed by way of its risk management framework for its liquidity and risk tolerance levels relating to how the portfolio is able to meet liquidity needs under stress conditions, and the maximum loss of the portfolio under tail risk scenarios. Stress-testing plays a key role: “MAS employs a comprehensive range of stress tests to assess the risks to the portfolio on a continual basis, and to establish whether the portfolio remains resilient to potential tail risk events over the medium term.” In addition, the central bank has shown itself a pioneer when it comes to currencies, notably the renminbi (RMB), as Menon explains: “The MAS started investing in RMB assets in 2012, fully expecting market indices to catch up at some point. Indeed, recent announcements by major index providers to include or accelerate the schedule of inclusion for RMB assets in their indices reflect this trend.” The MAS is now eyeing factor-based investing, he notes.

Menon shows how this all helps the objective of achieving good long-term returns on reserves based on balanced asset allocation and a well-diversified portfolio, and the chapter describes the use of an efficient investment process from its benchmark selection and customisation, as well as the adoption of specialised external investment expertise.

Central Banking would like thank the contributors to this year’s book and the reserve managers who took part in the survey and who contributed ideas for the survey questions in the preparatory stages. We welcome comments on the content of this year’s edition of HSBC Reserve Management Trends and suggestions for topics and themes for future chapters and survey questions.

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