Global reserve managementGlobal reserve management(research in progress)(research in progress)

SEMINARSEMINARWarsaw School of EconomicsWarsaw School of Economics

2626 April 2007 April 2007

Dr Krzysztof Rybiński*Dr Krzysztof Rybiński*National Bank of PolandNational Bank of Poland

Deputy GovernorDeputy Governor

Email: Email: krzysztofkrzysztof..rybinskirybinski@@nbpnbp.pl.plBlog: Blog: www.www.rybinskirybinski..eueu

* 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

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Research motivationResearch motivation

• Huge, unprecedented reserves growth in recent Huge, unprecedented reserves growth in recent years, well in excess of standard central banks years, well in excess of standard central banks needs in many emerging marketsneeds in many emerging markets

• Observed change in central banks’ asset Observed change in central banks’ asset management strategy (new, global approach). management strategy (new, global approach). Why?Why?

• Assessing implications for the global economy Assessing implications for the global economy and global financial marketsand global financial markets

• The end of US „exorbitant privilege”?The end of US „exorbitant privilege”?• Implications for the NBP asset allocation strategyImplications for the NBP asset allocation strategy

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Growth of Official ReservesGrowth of Official Reserves

0

500

1 000

1 500

2 000

2 500

3 000

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Developing and Emerging Economies, USD bln.

Sources: BIS, IMF

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0

500000

1000000

1500000

2000000

2500000

3000000

Western Europe CEE Asia Oil exportingcountries

Latin America Africa

2000 2006

Growth of Official ReservesGrowth of Official Reserves – – selected countriesselected countries

Source: IMF

USD m

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Top Five Reserve HoldersTop Five Reserve Holders

0

200000

400000

600000

800000

1000000

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

China JapanRussia TaiwanSouth Korea

Source: IMF, RBS

USD m

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0

100000

200000

300000

400000

500000

600000

700000

800000

900000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

0

10

20

30

40

50

60

70

Export of oil exporting countries, mln USD

Total reserves, mln USD

Oil Brent spot price, USD (right axis)

Sources: IMF IFS, IMF DOTS

Growth of Official ReservesGrowth of Official Reserves – – OOil il EExporting xporting CCountriesountries

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Reserves Adequacy: Months of Reserves Adequacy: Months of ImportsImports

Developing and Emerging Economies, Weighted Average

Sources: BIS, IMF

0

1

2

3

4

5

6

7

8

9

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

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Reserves Adequacy: Months of Reserves Adequacy: Months of ImportsImports – Selected Countries – Selected Countries

0

2

4

6

8

10

12

14

WesternEurope

CEE Asia Oilexportingcountries

LatinAmerica

Africa

2000 2005

Sources: IMF IFS, IMF DOTS, WDI

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0%

10%

20%

30%

40%

50%

WesternEurope

CEE Asia Oilexportingcountries

LatinAmerica

Africa

2000 2006

Reserves Adequacy: Reserves Adequacy: Reserves Reserves to M2 Ratioto M2 Ratio

Sources: IMF IFS, WDI, NBP

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Reserves Adequacy: Reserves Adequacy: Short-Term Debt CoverageShort-Term Debt Coverage

0,0

0,5

1,0

1,5

2,0

2,5

3,0

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Developing and Emerging Economies, Weighted Average

Sources: BIS, IMF

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Reserves Adequacy: Reserves Adequacy: Short-Term Debt CoverageShort-Term Debt Coverage

Sources: IMF IFS, BIS-IMF-OECD-WB

0

1

2

3

4

WesternEurope

CEE Asia Oil exportingcountries

LatinAmerica

Africa

2000 2005

USD m

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

0

500

1,000

1,500

2,000

2,500

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006e

Source: IMF

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0

200000

400000

600000

800000

1000000

1200000

1400000

1600000

CEE Asia Oil exportingcountries

Latin America Africa

2000 2005

Excess ReservesExcess Reserves Above Short- Above Short-Term Debt – Selected Term Debt – Selected CountriesCountries

Sources: IMF IFS, BIS-IMF-OECD-WB

USD m

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XX century investing vs. XXI XX century investing vs. XXI century investing by CBscentury investing by CBs

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

T-Bill

USG1-3

Govts

+Agcy

+ABS/MBS

+Corps

+Hi Yield

+Equity

+EmgMkt

+Commdty

+HedgeFunds

Very conservative central bank, capital protection strategy

GIC, 9.5% pa.

Source: World Bank Treasury

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Global and US 1970 onwardsGlobal and US 1970 onwards

US Only Global

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

Dec

-70

Dec

-72

Dec

-74

Dec

-76

Dec

-78

Dec

-80

Dec

-82

Dec

-84

Dec

-86

Dec

-88

Dec

-90

Dec

-92

Dec

-94

Dec

-96

Dec

-98

Dec

-00

Dec

-02

Dec

-04

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Real Return on a Typical Pension PortfolioReal Return on a Typical Central Bank PortfolioCumulative Real Return on a Typical Pension PortfolioCumulative Real Return on a Typical Central Bank Portfolio

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

Dec

-70

Dec

-72

Dec

-74

Dec

-76

Dec

-78

Dec

-80

Dec

-82

Dec

-84

Dec

-86

Dec

-88

Dec

-90

Dec

-92

Dec

-94

Dec

-96

Dec

-98

Dec

-00

Dec

-02

Dec

-04

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Real Return on a Typical Pension PortfolioReal Return on a Typical Central Bank PortfolioCumulative Real Return on a Typical Pension PortfolioCumulative Real Return on a Typical Central Bank Portfolio

Source: World Bank Treasury

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Probability of Negative Probability of Negative Real Real ReturnReturn

1-yr 1-yr

Holding Holding PeriodPeriod

5-yr 5-yr Holding Holding PeriodPeriod

10-yr 10-yr Holding Holding PeriodPeriod

25-yr 25-yr Holding Holding PeriodPeriod

StocksStocks 32.3%32.3% 21.9%21.9% 13.3%13.3% 0.0%0.0%

Typical Typical Pension Pension PortfolioPortfolio

33.2%33.2% 18.4%18.4% 12.5%12.5% 0.0%0.0%

Typical Typical Central Central Bank Bank

PortfolioPortfolio

34.8%34.8% 32.8%32.8% 37.0%37.0% 38.1%38.1%

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100% Govt 1-3 Yr Portfolio vs. 100% Govt 1-3 Yr Portfolio vs. 50% Broad Fixed Income, 50% Equities50% Broad Fixed Income, 50% Equities

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Years

Val

ue

(Bas

e =

1)

A: Gov

B: Agg/Eq

VaR A 90%

VaR B 90%

Pct A 90%

Pct B 90%

Source: World Bank Treasury

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Cumulative Return On a Cumulative Return On a Typical PortfoliTypical Portfolioo

0%

100%

200%

300%

400%

500%

600%

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

Cumulative Return on a TypicalCentral Bank Portfolio

Cumulative Return on a TypicalPension Portfolio

Source: Own calculations based on Merill Lynch Indices

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Cumulative Return for the Cumulative Return for the Previous Five YearsPrevious Five Years

0%

20%

40%

60%

80%

100%

120%

140%

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

Cumulative Return on aTypical Central BankPortfolio

Cumulative Return on aTypical PensionPortfolio

Source: Own calculations based on Merill Lynch

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Financial MalpracticeFinancial Malpractice• ““Is it financially responsible to invest accumulated reserve Is it financially responsible to invest accumulated reserve

assets only in short-term liquid securities of industrial assets only in short-term liquid securities of industrial countries?”countries?”

• ““A university with a substantial endowment that invested its A university with a substantial endowment that invested its resources only in Treasury bills would be guilty of financial resources only in Treasury bills would be guilty of financial malpractice. A corporation with significant pension liabilities malpractice. A corporation with significant pension liabilities that invested its pension fund only in short-term financial that invested its pension fund only in short-term financial investments would be guilty of financial malpractice.  A state investments would be guilty of financial malpractice.  A state and local government in the United States, with substantial and local government in the United States, with substantial liabilities to its retirees that invested only in short-term liabilities to its retirees that invested only in short-term financial instruments would be guilty of financial malpractice.”financial instruments would be guilty of financial malpractice.”

• - Larry Summers, September 14, 2006, Bank of Korea and - Larry Summers, September 14, 2006, Bank of Korea and World Bank Treasury Forum on Foreign Currency Reserves World Bank Treasury Forum on Foreign Currency Reserves Management, Seoul, KoreaManagement, Seoul, Korea

Source: World Bank Treasury

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Opportunity CostsOpportunity Costs• If the wealth tied up in reserves were invested in a fully If the wealth tied up in reserves were invested in a fully

diversified long-term way in global capital markets, the resulting diversified long-term way in global capital markets, the resulting gain would be close to $100 billion a per year. Aggregating the gain would be close to $100 billion a per year. Aggregating the 10 leading holders of excess reserves, the opportunity cost 10 leading holders of excess reserves, the opportunity cost comes to 1.85% of their combined GDP…comes to 1.85% of their combined GDP…

• …….This is comparable to the gains thought to be achievable from .This is comparable to the gains thought to be achievable from the next round of trade liberalization, to global foreign aid or to the next round of trade liberalization, to global foreign aid or to spending on key social sectors in a number of countriesspending on key social sectors in a number of countries

--Larry Summers, March 24, 2006--Larry Summers, March 24, 2006

L.K.Jha Memorial LectureL.K.Jha Memorial Lecture

Reserve Bank of IndiaReserve Bank of India

Source: World Bank Treasury

Rybinski.euSource: Central Bank of Latvia

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CBs internal constraints.CBs internal constraints.Example – bad incentives Example – bad incentives

Portfolio Perfomance Hedonic Benefit Performance-Based

Base SalaryPat on the BackBonusBigger BonusMaximum Bonus

ConcernHeadacheMigraine

ScreamingFired

Jail

Source: World Bank Treasury

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Dochodowość aktywów i Dochodowość aktywów i pasywów NBPpasywów NBP

2005 rok - dane przybliżone PLN mld

Procent aktywów/pasywów

ogółem Dochodowość

Aktywa - rezerwy 133.8 89.4 2.5%

Pasywa - gotówka62.6

41.8 0.4%

Pasywa - zobowiązania wobec MIF 41.8 27.9 4.8%

Pasywa ogółem (główne kategorie) 134.2 89.6 1.8%

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

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

),,()()(

riskreturnfL

))()1()(max( SVarSE

Maximization subject to policy and legal constraints

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Examples (reducing USD)Examples (reducing USD)

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

• It resulted in foreign exchange reserves It resulted in foreign exchange reserves level being higher at end-2006 by level being higher at end-2006 by PLN750mln equivalent, and increased PLN750mln equivalent, and increased return return in 2006 in 2006 by 60 bps (higher allocation by 60 bps (higher allocation to appreciating cto appreciating cuurrency)rrency)

• Diversification strategy continued by NBP Diversification strategy continued by NBP in 2007 as wellin 2007 as well

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ExamplesExamples

• 2007 issue of RBS Reserves Management Trends confirms 2007 issue of RBS Reserves Management Trends confirms that CBs are planning to gradually diversify across that CBs are planning to gradually diversify across currencies and across asset classes, with 56% of survey currencies and across asset classes, with 56% of survey respondents agreeing that CBs should invest in equities respondents agreeing that CBs should invest in equities

• China has created a new giant reserve management China has created a new giant reserve management institution, it will receive an estimated by markets institution, it will receive an estimated by markets USD200-300 bn worth of reserves to invest in high USD200-300 bn worth of reserves to invest in high yielding assets (including commodity funds, private yielding assets (including commodity funds, private equity, possibkly hedge funds), out of USD1equity, possibkly hedge funds), out of USD12200bn 00bn reserves held by PBoC-SAFE (reserves held by PBoC-SAFE (SState tate AAdministration of dministration of FForeign oreign EExchange)xchange)

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What are the implications?What are the implications?

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US C/A deficits accumulated to US C/A deficits accumulated to large negative IIPlarge negative IIP

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

1980 1983 1986 1989 1992 1995 1998 2001 2004

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Bilans rachunku obrotów bieżącychjako % PKB, LOMiędzynarodowa pozycja inwestycyjnanetto jako % PKB, PO

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

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Positive US income account Positive US income account puzzlepuzzle

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

1980 1983 1986 1989 1992 1995 1998 2001 2004

Saldo rachunku bieżącego jako % PKB

Saldo dochodów bilansu płatniczego jako %PKB

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

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Will Will US exorbitant privilegeUS exorbitant privilege go go away?away?

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

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Consequences of improvement in Consequences of improvement in global reserve management (long-global reserve management (long-term)?term)?• US will loose exorbitant privilegeUS will loose exorbitant privilege

• Dollar will loose the status of world first reserve currencyDollar will loose the status of world first reserve currency

• Faster developments of financial markets in Asia, maybe Faster developments of financial markets in Asia, maybe leading to common „asian”leading to common „asian”

• Better allocation of assets globally leading to higher Better allocation of assets globally leading to higher global global growthgrowth

• Changes in relative valuation of asset classes (higher Changes in relative valuation of asset classes (higher demand for more risky assets)demand for more risky assets)

• Possibly higher short-term volatility Possibly higher short-term volatility

• RISK!?RISK!? What if global event shuts off many markets, and What if global event shuts off many markets, and liqudity is gone. Will CBs acting as good asset managers be liqudity is gone. Will CBs acting as good asset managers be able to act as lenders of last resort as well?able to act as lenders of last resort as well?

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Some recent evidenceSome recent evidence of risk of risk diversificationdiversification

Source: BIS quarterly, March 2007. Record low emerging market CDS spreadssuggest significant reduction of credit risk in emerging markets relative to UScorporate risk in the same credit category

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Implications for the NBPImplications for the NBP

• Define the practical meaning of legal and Define the practical meaning of legal and policy constraints (e.g. ERM2)policy constraints (e.g. ERM2)

• Create a long-term vision of foreign asset Create a long-term vision of foreign asset management (in principle no assets should management (in principle no assets should be excluded from such a vision – equities, be excluded from such a vision – equities, FHF, credit derivatives)FHF, credit derivatives)

• Embark on change process to fulfill that Embark on change process to fulfill that vision, observing policy constraintsvision, observing policy constraints

• Consider consolidated ALM approachConsider consolidated ALM approach