On April 7, 2017, I posted a tweet on myofficial twitter account, celebrating the good news regarding our level ofinternational reserves– “Historical: net international reserves reach USD8,000 million. Solid external position of Paraguay #Paraguay @BCP_PY #RIN”.
Thenews was widely celebrated and that tweet is perhaps one my most successfulones, but why?An adequate level of foreign reserves providesconfidence within a nation. Foreign Reserves have a central role in the economyand serve a wide variety of purposes including: intervening in the FX market tomitigate irrational volatility, backing the domestic currency, safeguardingliquidity of financial markets, enabling international trade, and providingtrust that the country is capable of repaying its foreign debt. Paraguay´sforeign reserves have grown at an annual rate of 18.
4% since 2008, whilstaverage GDP grew 4.9%. Reserves represent 8.5 months of imports, X% of GDP, X%of M0, and X% of Foreign Debt. These indicators, not only help measure adequatelevels of reserves, but have also outlined the traditional asset managementapproach defined by the following investment priorities: Safety, Liquidity, andReturn. Safety, liquidity and returnas an investment guideline has led many central banks to allocate a largeportion of reserves to the short end of the soverieign yield curve, primarilyin US dollars (64% of global reserves). An overweight position in U.S.
dollars hasbeen a profitable strategy in the last thirty years, whilst rates have beendeclining, but this becomes a less attractive strategy in a rising rateenvironment and could provide considerable FX and Interest-Rates risk. Diversification is key, in order to reduce riskexposures, but globalization is driving asset class correlations higher, makingit harder to diversify via classical asset class diversification (PIMCO, 2016). Furthermore, correlations increase duringmarket downturns, as many investor see the US as the predominant”flight-to-safety”. As a Central Bank, it is important to understand theobjectives behind foreign reserves and create strategies that can createoptimal risk-adjusted returns. However, creating thesestrategies have been challenging for Central Banks. Instead of having a longinvestment horizon, public accountability of reserves leads to a short-termhorizon mentality where “safety” does not only mean zero tolerance for defaultrisk, but also zero tolerarnce for loss in principal in any interest rateenvironment. Diversification in this universe limits the pool of asset classesand currencies.
Within this limited pool, common approaches to strategic assetallocation such as mean variance optimization (Markowitz), mean VaR optimizion,minimum variance are applied. The returns generated on foreign reserves in thelow interest rate environment has not been able to offset the rising cost ofmonetary policy, driving many Central Banks on a search for yield. The “search for yield” has driven many CentralBanks to re-think Safety and Liquidity. From a risk-based perspective, Safetycan be defined by a comfortable level of volatility that a Central Bank iswilling to absorb, whilst Liquidity can be defined by the liability and crisiscoverage needed.
Taking this into consideration, acceptable asset classes andrisk exposure are redefined. An analysis recently done by the BIS shows thatinvestors from 36 countries have increased their credit risk exposure on theirsearch for yield (Ammer, 2018). An allocation framework looking to maximizereturns subject to constraints on liquidity, volatility budget, credit qualityand currency allocation can bring clarity in risk-based diversification. The success of diversification through theapplication of investment models does not hinge on the ability to select the”best” model, but by combining several models that truly providediversification of risk factors. Furthermore, diversification can be improvedby not relying on a single style or manager.
For this reason, the Central Bankof Paraguay has decided to join the RAMP program with the World Bank. Bydividing the risk budget into external and internal managers who makeinvestment decision independently, qualitative and quantitative approaches ingenerating alpha can be diversified. In conclusion, wehave seen that diversification strategies based on correlations have becomeless effective due to the increase in capital flows and globalization. Thepossibility of looking for new qualitative and quantitative methods such asdiversification based on risk factors is important, however we must rememberthat Central banks have a fairly limited universe of instruments.
Asadministrators of public funds, the tolerance for losses is practically nil dueto public accountability. We face a continual challenge in effectivelyinvesting our reserves to meet its objectives, whilst adhering to stringentinvestment guidelines.
