1. Introduction
I will start by thanking the organizers, the Bank of Albania, the IMF, and the Swiss Government, but I would also like to congratulate them on organizing such an event. I guess we all agree that such an event is useful for everybody to share our experience.
2. Setting the Stage
Just to set the stage, Romania’s foreign trade takes place mostly with European countries, as it is probably the case with most of the countries represented at this conference. The latest data are showing that Romania’s 86 percent of exports and 89 percent of imports take place with European countries as a whole. With the other 27 EU member countries Romania has around 75 percent of exports and 77 percent of imports. This is one of the reasons for which in the Central Bank of Romania’s investment strategy the benchmark share of euro has ranged for almost a decade between 55 percent and 85 percent of total foreign currency reserves, while, euro actual reserve holdings have ranged between two-thirds and three-quarters of our total foreign currency reserves.
Coming back to the euro negative rates spillovers, you can imagine that such a high percentage of foreign currency reserves invested in euro poses a real challenge for the foreign currency reserves management. I won’t elaborate on the reserve adequacy, which, in the case of Romania, has been appropriate even during the crisis. We are currently complying with all traditional metrics of reserve adequacy1.
You can see in Figure 1 that we had a significant increase in the level of foreign currency reserves in the period 2005–2011. I will briefly explain the main reasons behind it.
We joined the European Union in 2007. In the first couple of years, we were net payers to the EU budget. Afterward, as we gained some experience and some EU-funded projects were launched, we reversed the net position vis-à-vis the EU budget. For instance, last year we had more than 5.5 billion euro inflows. Overall, since joining, we have had approximately 20 billion euros equivalent net inflow, which contributed to such a sizeable level of foreign currency reserves.
The main outflow during the period was the repayment of the loan granted by the IMF, after the crisis, which is now fully repaid. The main sources for the FCR nowadays are the European Commission funds, earlier mentioned, and the euro bonds issued by our Ministry of Finance.
The gradual decrease of the minimum reserves requirements for foreign currency deposits from a maximum of 40 percent to a single-digit number at the present has represented during the period another source of foreign currency reserves outflows. In fact, FX assets held by commercial banks for reserve requirement fulfillment purposes contributed to gross reserves.
I will discuss now a little bit more about the management of those reserves.
Returning after a pause of 15 years to the central bank, I had to “rewire” my commercial banking and private equity mindset. Here at the central bank, the profit is not the most important objective. Liquidity and safety (as highlighted as well earlier by Roberto De Beaufort Camargo’s presentation) are the main goals.
Having said that, and although the profit is definitely not the most important goal, while complying with liquidity and safety paramount objectives, foreign currency reserves are also expected to contribute to central bank’s operating income with a view to maintaining a positive equity position.
In Figure 1, there are two components: the red part represents gold reserves, which have stood for many years at slightly below 104 tonnes. But depending on the exchange rate, the amount in euro, varies between approximately 3.5 billion and 4 billion euro. The gold is held partially abroad, and prior to the crisis we invested it regularly in short-term deposits.
At the end of March 2017, the level of the foreign currency reserves stood at more than 36 billion equivalent euro, increasing approximately 2 billion euro from the end of 2016 levels.
As you can see from Figure 2, providing a currency breakdown of the structure of foreign currency reserves, between two-thirds and almost 80 percent of the Central Bank of Romania reserves are denominated in euro. The next currency in terms of relative weight is USD for which we maintain as per the current strategy between 10 percent and 35 percent of the total foreign currency reserves. All other currencies can represent between 20 percent or less. We are in constant discussions internally to explore the scope for further currency diversification.
As most of you would probably expect, the “other currencies” were some time ago mainly the British pound and the Japanese yen. Recently we did diversify to other currencies that are common among the central banks.
3. The Key Strategic Objectives: Changes for the 2009–2010 Period
I will briefly mention the most salient features of our FCR management strategy in 2009–2010. The investment horizon was one year, and the modified duration of the portfolio was six months. The share of euro could fluctuate in a range of 55 percent and 85 percent of total foreign currency reserves and the US dollar between 10 percent to 40 percent of the total foreign currency reserves. The “other currency” part of the foreign currency reserves was at most 10 percent of the total. We included here as well the special drawing rights that we have as an IMF member country.
In terms of eligible issuers, we used to have the standard issuers, of very good quality and very high creditworthiness, therefore we incurred in minimum credit risk on our debt holdings. Since then, we have kept what we had before, at least in theory, 10 percent exposure to issuers of covered bonds and to private entities. However, although we did not lose any penny or cent, our board decided after the crisis, to temporarily suspend the eligibility of unsecured deposits placed with private entities – and since then, the suspension has remained in place. Unsecured money market deposits with private counterparts are still formally eligible as a management instrument in our FCR management strategic guidelines, but we need a formal approval from the board to restart placing them.
4. The Key Strategic Objectives: Changes for the 2011–2015 Period
We had some changes in 2011, after we drew the IMF loan that I mentioned earlier. The investment horizon has been increased from one to five years. But I guess that it is important to mention that we had an average modified duration of only six months. As you can see, we were at that time and we still probably are among the most conservative central banks in the region. And the colleagues from RAMP can probably certify that.
We increased the weight of “other currencies” to at most 15 percent from 10 percent and slightly reduced the maximum weight of dollars to at most 35 percent from 40 percent. We also added the Government of Japan to the list of eligible issuers.
5. The Key Strategic Objectives Changes for the 2016–2017 Period
What we further changed in 2016 is the use of a “three tranches” approach. We also extended the overall portfolio modified duration to 1.25 years – but that increase is due mostly to the investment tranche. New eligible currencies were also introduced. Still, there are no derivative products allowed – not even the plain vanilla ones. So we still have to work to convince our decision making bodies of the usefulness of including plain vanilla instruments for hedging interest rate and/or foreign currency risk in the list of eligible instruments for FCR management-and that is probably the case with some of your countries.
What we managed to do was to slightly increase the “other currencies,” weight to at most 20 percent (from 15 percent) of foreign currency reserves. And we relaxed the issuer risk constraint to accommodate a combination of increased duration, although one year and a quarter is far away from three, four, or even seven years that some of the central banks in the EU have. But we still increased the modified duration in combination with slightly greater leeway in terms of credit risk, which enabled us to play to a certain extent the spread game mentioned earlier in the presentation by Roberto de Beaufort. Exposure to private counterparts is still suspended for the time being. However, we convinced the board and the investment committee to grant portfolio managers greater leeway for more active tactical trading while accepting the obvious risk that comes with it. In this regard, I need to mention that – unfortunately, from the perspective of portfolio managers – unlike several other central banks, the treatment of the mark-to-market profit and loss is asymmetric at the Central Bank of Romania: negative mark-to-market is charged directly into the income statement, while positive mark-to-market is considered unrealized.
So, yes, we have to be very careful with those potential swing effects, as they can be quite sizeable (not many years ago we incurred a yearly loss, but luckily, we recovered the next year the full amount with a profit). The pattern in terms of income and annual yield, displayed in Figure 3, is probably more or less in line with the pattern you have at your own central bank.
Returns on foreign exchange reserves – revenues (LHS, million euros) and annual yield (blue, RHS. % per annum)
Source: NBR annual report 2016.Returns on foreign exchange reserves – revenues (LHS, million euros) and annual yield (blue, RHS. % per annum)
Source: NBR annual report 2016.Returns on foreign exchange reserves – revenues (LHS, million euros) and annual yield (blue, RHS. % per annum)
Source: NBR annual report 2016.And, as is the topic of today’s conference, the euro area spillovers, one can guess from Figure 3 in which year the interest rate on the euro became negative. It is the first year when the return on foreign currency reserves has turned a few basis points negative, but we managed to compensate for it with revenues from FX revaluation effects. So the total return is positive – but as I said, the profit is not the primary objective of a central bank.
I guess that it is important to highlight that while we repaid in full the IMF loan, the level of foreign currency reserves has increased. This comfortable level gives more confidence to the foreign investors, and it makes life easier for the Ministry of Finance to finance at lower costs and for longer tenors.
6. Challenges
Of course, the challenges are the same as most of you have. Having approximately three-quarters of foreign currency reserves denominated in euro creates a big pressure on revenues. Although, in theory, everybody agrees that the role of the central bank is not to make profit, I am pretty sure that most of you, if not all of you, heard from time to time either from an executive or from a Ministry of Finance representative, the question: “What is the new amount that you will pay to the budget?” Indeed, 80 percent of our revenues goes to the budget.
Considering that the income generation on euro funds is actually negative, that the high liquidity/quality assets tend to yield even lower returns, we are facing higher opportunity costs for holding reserve assets and potential capital losses if rates normalize.
On the other hand, higher yielding assets may be too risky or volatile and significant losses can arise due to asset switches.
So, the real question is how much to increase the portfolio duration, expand the asset classes, and diversify the currency structure.
Months of imports, short-term debt payments coverage, IMF-ARA (Assessing Reserve Adequacy)..
