Global reserve management (research in progress) SEMINAR Warsaw School of Economics 26 April 2007 Dr Krzysztof Rybiński* National Bank of Poland Deputy Governor Email: [email protected]

Blog: www.rybinski.eu

* Views presented during the seminar are my own and they do not necessarily represent the official position of the National Bank of Poland or the Financial Services Authority

Research motivation • • • • • Huge, unprecedented reserves growth in recent years, well in excess of standard central banks needs in many emerging markets Observed change in central banks’ asset management strategy (new, global approach). Why?

Assessing implications for the global economy and global financial markets The end of US „exorbitant privilege”?

Implications for the NBP asset allocation strategy Rybinski.eu

Growth of Official Reserves Developing and Emerging Economies, USD bln.

3 000 2 500 2 000 1 500 1 000 500 0

Sources: BIS, IMF Rybinski.eu

Growth of Official Reserves – selected countries USD m 3000000 2000 2006 2500000 2000000 1500000 1000000 500000 0 Western Europe CEE Asia Source: IMF Oil exporting countries Latin America Africa Rybinski.eu

Top Five Reserve Holders USD m 1000000 800000 600000 400000 China Russia South Korea Japan Taiwan 200000 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: IMF, RBS Rybinski.eu

Growth of Official Reserves – Oil Exporting Countries 900000 800000 700000 600000 500000 400000 300000 200000 100000 0 Export of oil exporting countries, mln USD Total reserves, mln USD Oil Brent spot price, USD (right axis) 70 60 50 40 30 20 10 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 0 Sources: IMF IFS, IMF DOTS Rybinski.eu

3 2 1 8 7 6 5 4

Reserves Adequacy: Months of Imports Developing and Emerging Economies, Weighted Average

9 0

Sources: BIS, IMF Rybinski.eu

Reserves Adequacy: Months of Imports – Selected Countries 14 12 10 8 6 4 2 0 Western Europe CEE Asia 2000 2005 Oil exporting countries Latin America Africa Sources: IMF IFS, IMF DOTS, WDI Rybinski.eu

Reserves Adequacy: Reserves to M2 Ratio 50% 40% 30% 20% 10% 0% Western Europe 2000 2006 CEE Asia Oil exporting countries Sources: IMF IFS, WDI, NBP Latin America Africa Rybinski.eu

Reserves Adequacy: Short-Term Debt Coverage Developing and Emerging Economies, Weighted Average

3,0 2,5 2,0 1,5 1,0 0,5 0,0

Sources: BIS, IMF Rybinski.eu

Reserves Adequacy: Short-Term Debt Coverage USD m 4 2000 3 2005 2 1 0 Western Europe CEE Asia Oil exporting countries Latin America Sources: IMF IFS, BIS-IMF-OECD-WB Africa Rybinski.eu

2,500 Growing Excess Reserves

Excess Reserves Above Short Term Debt* (US$ Billions)

2,000 1,500 1,000 500 0 1995 1996 Source: IMF 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006e Rybinski.eu

Excess Reserves Above Short-Term Debt – Selected Countries USD m 1600000 1400000 1200000 1000000 800000 600000 400000 200000 0 2000 2005 CEE Asia Oil exporting countries Latin America Africa Sources: IMF IFS, BIS-IMF-OECD-WB Rybinski.eu

XX century investing vs. XXI century investing by CBs

16.00% 14.00% 12.00% 10.00%

GIC, 9.5% pa.

8.00% 6.00% 4.00% 2.00% 0.00% 0.00%

Very conservative central bank, capital protection strategy

2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Source: World Bank Treasury

T-Bill USG1-3 Govts +Agcy +ABS/MBS +Corps +Hi Yield +Equity +EmgMkt +Commdty +HedgeFunds

Rybinski.eu

Global and US 1970 onwards US Only 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% Real Return on a Typical Pension Portfolio Real Return on a Typical Central Bank Portfolio Cumulative Real Return on a Typical Pension Portfolio Cumulative Real Return on a Typical Central Bank Portfolio Source: World Bank Treasury 8.0

40.0% 7.0

30.0% 6.0

20.0% 5.0

4.0

10.0% 0.0% 3.0

2.0

-10.0% 1.0

-20.0% 0.0

-30.0% Global Real Return on a Typical Pension Portfolio Real Return on a Typical Central Bank Portfolio Cumulative Real Return on a Typical Pension Portfolio Cumulative Real Return on a Typical Central Bank Portfolio Rybinski.eu

8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

Probability of Negative Real Return 1-yr Holding Period 5-yr Holding Period 10-yr Holding Period 25-yr Holding Period 32.3% 21.9% 13.3% 0.0% Stocks Typical Pension Portfolio Typical Central Bank Portfolio 33.2% 34.8% 18.4% 32.8% 12.5% 37.0% 0.0% 38.1% Rybinski.eu

100% Govt 1-3 Yr Portfolio vs. 50% Broad Fixed Income, 50% Equities 3 2 5 4 1 0 0 15 14 13 12 11 10 9 8 7 6 1 2 3 4 5 6 7 8 9 10

Years

11 12 13 14 15 16 17 18 19 20 Source: World Bank Treasury A: Gov B: Agg/Eq VaR A 90% VaR B 90% Pct A 90% Pct B 90% Rybinski.eu

Cumulative Return On a Typical Portfolio 600% 500% 400% 300% 200% 100% 0% Cumulative Return on a Typical Central Bank Portfolio Cumulative Return on a Typical Pension Portfolio Source: Own calculations based on Merill Lynch Indices Rybinski.eu

Cumulative Return for the Previous Five Years 140% 120% 100% 80% 60% 40% 20% 0% Cumulative Return on a Typical Central Bank Portfolio Cumulative Return on a Typical Pension Portfolio Source: Own calculations based on Merill Lynch Rybinski.eu

Financial Malpractice • • • “Is it financially responsible to invest accumulated reserve assets only in short-term liquid securities of industrial countries?” “A university with a substantial endowment that invested its resources only in Treasury bills would be guilty of financial malpractice. A corporation with significant pension liabilities that invested its pension fund only in short-term financial investments would be guilty of financial malpractice. A state and local government in the United States, with substantial liabilities to its retirees that invested only in short-term financial instruments would be guilty of financial malpractice.” - Larry Summers, September 14, 2006, Bank of Korea and World Bank Treasury Forum on Foreign Currency Reserves Management, Seoul, Korea Source: World Bank Treasury Rybinski.eu

• Opportunity Costs If the wealth tied up in reserves were invested in a fully diversified long-term way in global capital markets, the resulting gain would be close to $100 billion a per year. Aggregating the 10 leading holders of excess reserves, the opportunity cost comes to 1.85% of their combined GDP… • ….This is comparable to the gains thought to be achievable from the next round of trade liberalization, to global foreign aid or to spending on key social sectors in a number of countries --Larry Summers, March 24, 2006 Source: World Bank Treasury L.K.Jha Memorial Lecture Reserve Bank of India Rybinski.eu

Source: Central Bank of Latvia Rybinski.eu

CBs internal constraints.

Example – bad incentives Concern Headache Migraine Screaming Fired Jail Source: World Bank Treasury

Portfolio Perfomance Hedonic Benefit Performance-Based

Maximum Bonus Bigger Bonus Bonus Pat on the Back Base Salary Rybinski.eu

Dochodowość aktywów i pasywów NBP

2005 rok dane przybliżone

Aktywa - rezerwy Pasywa gotówka Pasywa zobowiązania wobec MIF Pasywa ogółem (główne kategorie) PLN mld Procent aktywów/pasywów ogółem Dochodowość 133.8

62.6

89.4

2.5% 41.8

0.4% 41.8

134.2

27.9

89.6

4.8% 1.8% Rybinski.eu

Cost of holding large reserves (on top of sterilization rate premium) Rybinski.eu

Amid rising (opportunity costs) bentral banks get over bad incentives and accept more short-term risk for the benefit of higher long term return

L



f

(  ) (

return

, (  )

risk

,  ) max( 

E

(

S

)  ( 1   )

Var

(

S

)) Maximization subject to policy and legal constraints Rybinski.eu

Examples (reducing USD) • • • NBP has reduced USD share in reserves in early 2006 and increased the share of GBP.

It resulted in foreign exchange reserves level being higher at end-2006 by PLN750mln equivalent, and increased return in 2006 by 60 bps (higher allocation to appreciating currency) Diversification strategy continued by NBP in 2007 as well Rybinski.eu

Examples • • 2007 issue of RBS Reserves Management Trends confirms that CBs are planning to gradually diversify across currencies and across asset classes, with 56% of survey respondents agreeing that CBs should invest in equities China has created a new giant reserve management institution, it will receive an estimated by markets USD200-300 bn worth of reserves to invest in high yielding assets (including commodity funds, private equity, possibkly hedge funds), out of USD1200bn reserves held by PBoC-SAFE (State Administration of Foreign Exchange) Rybinski.eu

What are the implications?

Rybinski.eu

US C/A deficits accumulated to large negative IIP

1% 0% -1% -2% -3% -4% -5% -6%

Bilans rachunk u obrotów bieżących jak o % PKB, LO Międzynarodowa pozycja inwestycyjna netto jak o % PKB, PO

-7% 1980 1983 1986 1989 1992 1995 1998 2001 2004 15% 10% 5% 0% -5% -10% -15% -20% -25% -30%

Source: K.Rybinski „Globalizacja w trzech odsłonach”, forthcoming May 2007 Rybinski.eu

Positive US income account puzzle

2% 1% 0% -1% -2% -3% -4% -5% -6% -7% 1980

Saldo rachunk u bieżącego jak o % PKB Saldo dochodów bilansu płatniczego jak o % PKB

1983 1986 1989 1992 1995 1998 2001 2004

Source: K.Rybinski „Globalizacja w trzech odsłonach”, forthcoming May 2007 Rybinski.eu

Will US exorbitant privilege go away?

Source: Gourinchas, Ray (2005) and IMF WEO, April 2007 Rybinski.eu

• • • • • • • Consequences of improvement in global reserve management (long term)?

US will loose exorbitant privilege Dollar will loose the status of world first reserve currency Faster developments of financial markets in Asia, maybe leading to common „asian” Better allocation of assets globally leading to higher global growth Changes in relative valuation of asset classes (higher demand for more risky assets) Possibly higher short-term volatility RISK!? What if global event shuts off many markets, and liqudity is gone. Will CBs acting as good asset managers be able to act as lenders of last resort as well?

Rybinski.eu

Some recent evidence of risk diversification Source: BIS quarterly, March 2007. Record low emerging market CDS spreads suggest significant reduction of credit risk in emerging markets relative to US corporate risk in the same credit category Rybinski.eu

Implications for the NBP • • • • Define the practical meaning of legal and policy constraints (e.g. ERM2) Create a long-term vision of foreign asset management (in principle no assets should be excluded from such a vision – equities, FHF, credit derivatives) Embark on change process to fulfill that vision, observing policy constraints Consider consolidated ALM approach Rybinski.eu