Adam Smith Seminars: 2016 AND BEYOND: WORLD ECONOMIC PROSPECTS (III) Foreign Exchange Interventions and the Growth of FX Reserves: Diversification Potential? Lubomír Lízal, Ph.D. Budapest, November 9, 2016
The exchange rate commitment CNB introduced one-sided exchange rate commitment at 27 CZK/EUR in November 2013 to avoid deflation or long-term undershooting of the inflation target. It has been repeatedly prolonged as a result of mainly anti-inflationary cost-push shocks from abroad. The FX interventions to support the commitment are automatic, i.e. without the need for an additional decision of the Bank Board, and without any time or volume limits. CNB succeeded to avert deflation, core inflation returned to positive values in 2014 after five years of decline. But the FX reserves have grown sizably during the last three years! 2
CNB s commitment and FX interventions Since July 2015, the exchange rate has stabilized close to the floor which means more activity on the FX market. The sum of interventions has reached EUR 20.9 bn. by July 2016. But client operations also significant: EUR 10.9 bn. since Nov 2013. 3
The latest (November) forecast Headline inflation forecast Headline inflation will increase and slightly exceed the 2% target at the monetary policy horizon (year on year in %) 6 5 4 3 2 1 0-1 Inflation target IV/14 I/15 II III IV I/16 II III IV I/17 II III IV I/18 II 90% 70% 50% 30% confidence interval Monetary policy horizon Interest rate forecast The forecast expects market interest rates to be flat at their current very low level until mid-2017; consistent with the forecast is an increase in rates thereafter (3M PRIBOR in %) 3 Monetary policy-relevant inflation forecast (year on year in %) 6 5 4 3 2 1 0-1 Inflation target IV/14 I/15 II III IV I/16 II III IV I/17 II III IV I/18 II GDP growth forecast 90% 70% 50% 30% confidence interval (annual percentage changes; seasonally adjusted) 10 Monetary policy horizon 8 2 6 4 1 2 0 0 IV/14 I/15 II III IV I/16 II III IV I/17 II III IV I/18 II -2 IV/14I/15 II III IV I/16 II III IV I/17 II III IV I/18 II 90% 70% 50% 30% confidence interval 90% 70% 50% 30% confidence interval 4
The latest CNB s monetary policy decision The Bank Board decided to continue using the exchange rate as an additional instrument for easing the monetary conditions. It confirmed the CNB s commitment to intervene on the foreign exchange market if needed to weaken the koruna against the euro so that the exchange rate of the koruna is kept close to CZK 27 to the euro. In line with this, the CNB still stands ready to intervene automatically without any time or volume limits. The asymmetric nature of this exchange rate commitment is unchanged. According to the new forecast, sustainable fulfilment of the 2% inflation target, which is a condition for a return to conventional monetary policy, will occur from mid-2017 onwards. The Bank Board therefore states again that the CNB will not discontinue the use of the exchange rate as a monetary policy instrument before 2017 Q2. The Bank Board still considers it likely that the commitment will be discontinued in mid-2017. 5
The challenge: FX reserves growth CNB's FX reserves in EUR bn. 80 70 60 50 40 30 20 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Reserves grow mainly due to FX interventions and client operations. Now clearly large enough to cover the basic functions. Space for further reserves diversification. Which path to take? Has to fulfill the requirements. 6
FX reserves requirements Functions & mandates: monetary policy (interventions), financial stability (liquidity), clients servicing, foreign reserves investments Internal capacities: market & legal know-how, human & system capacities, master agreements in place, infrastructure live Objectives, targets, needs of reserve management: safety, liquidity, return; diversification, reputation Market opportunities: size/capitalization, proved liquidity, existing derivatives market, lifted administrative barriers, tested law/master agreement enforceability, functioning infrastructure 7
Current structure: currencies 100% 90% 80% 70% 60% 50% 4.2 3.0 3.5 4.4 4.5 3.4 26.4 32.9 31.4 3.7 3.5 3.6 2.9 3.6 2.8 3.9 7.4 5.2 5.7 6.9 7.6 5.7 2.9 7.1 2.0 3.2 7.5 2.6 1.8 12.6 13.8 2.6 2.7 2.3 15.6 1.9 1.6 1.7 1.7 23.5 20.8 20.1 16.0 13.4 others SEK AUD CAD 40% GBP 30% 57.5 59.7 65.1 57.1 55.0 55.2 65.9 55.3 57.9 JPY 20% USD 10% EUR 0% 2007 2008 2009 2010 2011 2012 2013 2014 2015 Currency diversification started in 2010 by adding SEK, AUD, and CAD portfolios. 8
Current structure: instruments Debt securities issued by selected governments of advanced countries, selected government-guaranteed bonds and bond issued by top-rated multilateral institutions constitute the largest part. 9
Other currencies: requirements view There is space for further diversification: Renminbi? Monetary policy, financial stability, clients don t need CNY. Export Import Germany * 29.9% 26.4% EU 81.8% 69.7% China 1.1% 8.6% rest of the world 17.0% 21.7% Bank assets towards Chinese resident (CZK mil.) Bank liabilities towards Chinese resident (CZK mil.) Interbank 160.3 Interbank 13.8 Clients 51.1 Clients 359.8 Securities 0 Issued securities 34.9 * Foreign trade as a whole 10
Other currencies: requirements view Central Bank Survey of Foreign Exchange and Derivatives Market Activity FOREIGN EXCHANGE CONTRACTS 1 Turnover in nominal or notional principal amounts in April 2016 (in millions of USD) Negative values and non-numeric entries are not allowed Instruments Domestic currency against AUD CAD CHF EUR GBP JPY SEK USD Other 2 TOT TOTAL FX CONTRACTS 17 11 35 18,343 179 126 8 36,579 438 55,738 o/w prime brokered 450 4 222 676 o/w retail-driven 3 2 8 1,296 17 1 1 298 23 1,648 USD against AUD BRL CAD CHF CNY EUR GBP HKD INR JPY KRW MXN NOK NZD PLN RUB SEK SGD TRY TWD ZAR Other 2 TOT 288 438 246 11 14,656 1,601 15 384 114 1 948 414 85 87 0 209 19,497 9 36 3 48 1 0 0 0 74 6 0 0 1 1 0 83 Almost no flows and no trading observed in CNY. 11
Currency diversification: return 12
Currency diversification: credit measured by rating Fitch Moody s S&P China A+ Aa3 AA- Australia AAA Aaa AAA EUR (portfolio benchmark) AA+ Aa1 AA+ - France AA Aa2 AA - Germany AAA Aaa AAA - Netherlands AAA Aaa AAA Canada AAA Aaa AAA Sweden AAA Aaa AAA USA AAA Aaa AA+ 13
Currency diversification: credit measured by investors CDS spreads bp 180 160 140 120 100 80 60 40 20 0 3/2015 6/2015 9/2015 12/2015 15/2015 18/2015 21/2015 24/2015 27/2015 30/2015 33/2015 36/2015 39/2015 42/2015 45/2015 48/2015 51/2015 4/2016 7/2016 10/2016 13/2016 16/2016 20/2016 23/2016 26/2016 29/2016 32/2016 35/2016 Australia Germany Sweden USA China EU periphery 14
Risk management principles and RMB CNB s criteria regarding currency allocation: Full convertibility Free float Best credit quality Liquid market with large market cap RMB doesn t meet most of it Two markets, one currency (CNY and CNH) problematic for the status of reserve currency. Still many administrative measures in place, many of them changed recently and expected to keep changing in the near future. Reference peers other central banks invest in RMB rather for testing purposes. Quality of data for internal credit models challenged even by IMF. Higher but natural legal risk compared to traditional reserve currency jurisdictions due to language and cultural differences. 15
Instruments diversification: equities Steady increase in FX reserves since 1998 started an informal discussion at CNB about whether and how to invest them. As reserves grow, liquidity not a priority for an increasing portion of them. Aim of diversification: increase return and reduce non-market risk. Since 2008 gradual build-up of equity portfolio, target level 10% of FX reserves reached in 2011; allowed deviation 2 p.p. Equity portfolio loss-making in only two years: 2008 and 2011. Total cumulative return of equity portfolio from June 2008 to September 2014 was 61.4%, total cumulative return of fixed income portfolio 15%. Further build-up of FX reserves, also due to the use of FX interventions at the zero lower bound, will probably lead to increase in equity reserves in the near future. 16
Current structure: equities By the end of 2015, equities accounted for 8.1% of FX reserves. Equity portfolios managed by BlackRock and State Street Global Advisors and invested using benchmark indices: European (MSCI Euro), US (S&P 500), UK (FTSE 100), Japanese (Nikkei 225), Canadian (S&P TSX), Australian (S&P ASX 200). 17
Investing in equities According to the Official Monetary and Financial Institutions Forum (OMFIF), central banks have foregone USD 200 billion to USD 250 billion in interest income due to the fall in bond yields in recent years. To compensate, they started to buy equities: e.g. China s State Administration of Foreign Exchange, Swiss National Bank (20% of reserves), Bank of Japan, Bank of Korea, National Bank of Denmark, National Bank of Italy, Bank of Israel (all approx. 10% of reserves). ECB running out of bonds to buy. Will it start investing in equities, too? Central banks are usually passive investors who do not exercise their voting rights. 18
How to find the right share of equities Market risk (equities) vs. credit risk (bonds): CNB prefers increased market risk which can be offset by lengthening the investment horizon. 1. Stress-testing the whole equities + fixed-income portfolio building on the worst scenarios observed since 1971: How much equities to reach non-negative return over 36 months? 2. Mean-variance optimization: Portfolio which minimizes variance for a given expected return. 3. Value at risk: Even though equities are riskier assets than bonds, a mixed portfolio of both can have better risk characteristics due to diversification. All methods show that the choice to invest 10% of FX reserves into equities is a very conservative approach. 19
Conclusions The use of the exchange rate as an additional instrument for easing the monetary conditions will probably continue until mid-2017. FX interventions contribute to the growth of reserves which creates potential for their further diversification. RMB so far not the preferred choice because the CNB doesn t need it for its monetary policy and financial stability goals, nor for its clients. A more suitable path is assets diversification, mainly into equities. Gradual build-up of equity portfolio since 2008, target level 10% reached in 2011. By the end of 2015, equities accounted for 8.1% of FX reserves. 20
Thank you for your attention www.cnb.cz Lubomír Lízal, Ph.D. member of the CNB Board lubomir.lizal@cnb.cz 21