It is a pleasure to speak at today’s conference. I may raise more questions with my presentation than answers, but hopefully you will understand the general trends in reserve management and how the Central Bank of Hungary reacted to the negative yield environment.
An important disclaimer, I have to make: what I will present today expresses my own views and not necessarily the views of the Central Bank of Hungary.
1. Background and Motivations for the Conceptual Change
The background and motivations for creating the new investment strategy are “the usual suspects.” Since the financial crisis, the financial markets and asset prices have been strongly driven by central bank policies, implemented by the major central banks. As a result, many emerging markets’ central banks often earn negative returns on their traditional safe investments, and, at the same time, liquidity in the markets of key central banks’ assets has been diminishing due to asset purchase programs and due to regulatory changes. So according to the Central Bank of Hungary’s view, a central bank has to rethink its portfolio composition to avoid capital losses.
2. Changing the Investment Attitude of Central Banks
So what happens when the preservation of the capital is in danger? In our view, you have to rethink the safety criterion from the safety-liquidity-return. Traditionally, the safety criterion meant that you had to focus on the left tail of the return distribution, on tail events, but what happens when the middle of the distribution is in negative territory? We think it is almost equally important to try to avoid smaller but certain losses than higher but unlikely losses on your reserves. We see that the general trend is that more and more central banks invest in riskier investments in order to achieve that goal.
3. Spread Compression Can Support Overall Performance
To have a broader picture of the balance sheet, we need to look at not only the asset side, but also the liability side. In Figure 1, you can see the spread difference between the one-year EUR benchmark and HUF base rate.
As you can see, the spread has significantly dropped in recent years, which means it has never been cheaper to hold reserves for Hungary and that is obviously a good side effect of this negative yield environment in Europe. But, the overall message is that regardless whether you have an asset-only perspective or an asset/liability perspective, holding your reserves incurs some kind of opportunity cost.
4. Broad Approach – Balance Sheet View
From a balance sheet perspective on the asset side, the FX reserve returns are 0 percent or below 0 percent due to the heavy concentration in the euro market. On the liability side, the financing cost is almost 1 percent. As Roberto mentioned, reserve adequacy is the outmost important aspect for our central bank. Most emerging markets’ central banks reserves, as shown in Figure 2, are above the IMF reserve adequacy ratio, and we think that this cushion or this buffer provides some flexibility in your reserve management, by employing some kind of tranching.
Figure 3 shows the Hungarian central bank roadmap for a new reserve management strategy in response to the negative yield environment. The end-product is a new strategic benchmark. I have already touched upon the background and the motivations to create that benchmark. In the meantime, we created a new framework because we felt the need to have a new limit system to manage and control the overall risk of the whole reserves. We calculated, then, the appropriate level for that limit and, in the next step, we created the new strategic benchmark with mean-variance-optimization. The implementation phase is still under way.
5. Assessment Criteria for New Investment Opportunities
Traditionally, when you are considering new investments, you have to assess how each new investment will impact your risk profile. For us, the return objective is to try to avoid or minimize the capital loss; from the risk perspective, the maximum tolerable/acceptable risk level should be based on macroeconomic and institution-specific factors; and if you believe in efficient financial markets, then you also believe that there is “no free lunch” on the market. Therefore if, you want to increase your expected return, then you have to increase your risk level also. So that is why we felt the need to have a new framework.
6. Risk Budget Framework
What is this framework? This framework is some kind of variation of the risk budget, and it is important to know that this additional overall limit will not replace the traditional limit system already in place, but they will work side by side, and hopefully the combined effect will be conscious and controlled risk-taking.
In practice, the risk budget is a numerical value. We have chosen the expected shortfall as a risk measurer with 95 percent confidence on a one-year time-horizon. We will express this number in a nominal value, and that’s the maximum limit that the portfolio could not breach even in market downturns. It’s also important to know that previously we monitored the risk level portfolio, but we didn’t try to manage it, and with this new framework, we are trying to achieve that.
7. Risk Budget Size
Now let’s look at the factors that affect the size of the risk budget. We can divide them into four groups. The most important we have touched upon is the reserve adequacy and other institutional – specific balance sheet item factors, but we also look at the historical evolution of the risk level on the current and previous portfolios that give you a good sense of how bad things can get. Also, we performed the scenario-analyses, stressed the portfolio, and of course we surveyed the management of the central bank about their risk appetite and what their preferences were. Based on those factors, we calculated the target risk level for the strategic benchmark, then we applied a tolerance level, a tolerance range around that, and of course we calculated the maximum risk, which would be like a final base line of defense. The regular reviews are done yearly, but there are certain trigger events that would require an immediate review of the size of the budget.
8. The New Strategic Benchmark
Now let’s look at the most important and interesting part of the presentation, the new benchmark. The creation of the new strategic benchmark is a product of a multistage process. In the first step, we tried to identify the relevant directions and promising asset classes by examining individual risk factors. In the next few steps, we tried to filter out the outlier portfolios and tried to create a short list of portfolios that would be in the proximity of the expected shortfall target level. Then we analyzed those portfolios with additional risk measures and applied different kinds of stress tests. In the final step, the management made the choice of the strategic benchmark based on their personal preferences.
This was basically done by looking at the different asset classes on a hedged or unhedged basis in the risk-return space. This analysis functions as a kind of knockout feature, because if there is an investment category or asset that would offer just a small amount of additional returns for a huge increase in the risk level, then you should probably cross out that investment category from your list. The three areas that we identified are displayed in Figure 4. I have to mention that when we were thinking about the new investment opportunities, we told ourselves: make only those investments that you would do under normal circumstances and in a normal yield environment rather than in this negative yield environment, because we want to be on the safe side of things, as Roberto mentioned.
Position of individual risk factors in the risk-return profile determines the relevant directions
So, the first area is the geographical diversification: entering a new market; the second one is taking open currency positions because right now the whole benchmark is hedged to euro; and the third is the asset allocation, for example, increasing “MBS” exposure or creating equity portfolios.
Related to the geographical diversification, we created a scoring system, and tried to rank the countries based on the fundamentals, sovereign credit rating, market size/depth liquidity, etc. And as you can see from Figure 5, Australian and Canadian markets topped the ranking.
We were glad to see that other central banks think about the new markets in the same way. Figure 6 is a glance from a HSBC reserve management survey that shows that other central banks favor the Australian and Canadian markets as well.
Geographical diversification and HSBC survey
Source: HSBC Reserve Management Trends 2017. Magyar Nemzeti Bank.
“Treasury” curves
Source: Bloomberg. Magyar Nemzeti Bank.“Treasury” curves
Source: Bloomberg. Magyar Nemzeti Bank.“Treasury” curves
Source: Bloomberg. Magyar Nemzeti Bank.Regarding the open currency position, most treasury curves are flat, so only a few markets offer carry potential, namely the Australian dollar and the US dollar.
As I mentioned, you can consider increasing your exposure to MBS. The agency MBS market is one of the largest US bond sectors, after Treasuries and corporates. It is a homogeneous bond market with deep market liquidity, and with a strong state commitment, as evidenced by Figure 8.
And this commitment is translated into the highest achievable credit rating, and it also offers favorable risk adjusted return, spread over Treasuries, as evidenced by Figure 9.
When you think about equities, you face several pros and cons. On the upper graph of Figure 10, you can see that by entering the equity market, you can increase your expected return with the inclusion of equities. They also provide diversification benefits through the number of issuers that you can invest in, and they have a favourable correlation with bonds.
On the other hand, you have to face a higher volatility in the short-run. The correlation tends to increase in times of market stress, when you need the diversification benefits the most. Also, you have to face serious headline and reputational risks if you decide to invest in equities.
Figure 11 is from an HSBC survey. On the right side you can see that about 10 percent of the central banks already invest in equities and 40 percent currently considers or would consider investing in equities. We can see that almost half of the central banks are interested in the equity market.
Our proposed new strategic benchmark would entail a 15 percent shift in the strategic asset allocation. The most important is that it would decrease the euro exposure and increase the US exposure.
Looking at the risk-return profile again, as displayed by Figure 13, we are trying to move up to the right, and hopefully, this will improve the return on the reserves.
The new strategic benchmark
Magyar Nemzeti Bank.The new strategic benchmark
Magyar Nemzeti Bank.The new strategic benchmark
Magyar Nemzeti Bank.
