- International Monetary Fund
- Published Date:
- April 2005
Governance and Institutional Framework
Reserve management objectives and coordination
191. The major responsibilities of the Bank include the management of foreign exchange reserves on behalf of the government. The Bank ensures their safety and return by diversifying investments within a framework of acceptable risks. A major feature of the reserves management practice is to divide the reserves into sub-portfolios, namely, the Pula Fund (long-term) and the Liquidity Portfolio (short-term). The Bank’s policies for the management of the foreign exchange reserves can be summarized in terms of three main principles. In order of importance, these are safety, liquidity, and return. With respect to the long-term portfolio, the Pula Fund, return takes priority over liquidity, while safety continues to have the highest priority for both the Liquidity Portfolio and the Pula Fund. As of the end of 2001, the split between the Pula Fund and Liquidity Portfolio was 80 percent and 20 percent, respectively.
192. The appropriate level for the Liquidity Portfolio is determined such that the portfolio acts as a buffer against short-term trade and capital account fluctuations, and as a cushion to finance unforeseen developments in the external payments situation. The Liquidity Portfolio is further subdivided into two tranches: the Transactions Balances Tranche (TBT) and the Liquidity Investment Tranche (LIT). The TBT functions as a current/checking account to take care of inflows and outflows. The rest of the reserves are invested in the long-term Pula Fund. It is relevant to note that the government has not experienced a need to issue government securities for funding purposes, as budgetary surpluses have been a feature of the Botswana economy for a long time (Figure 4).
Figure 4.Portfolio Structure
193. Relative to many other central banks in the region, the Bank of Botswana has for many years had a high level of external reserves, approximately 39 months of import cover as of December 31, 2001. As such, the maintenance of a minimum level of reserves has not been a concern to the Bank. Furthermore, the high level of reserves has permitted the Bank to create the long-term fund (Pula Fund).
194. One of the objectives of establishing the Pula Fund is to take advantage of the high level of the reserves and invest part of them in assets such as long-term bonds and equities, with the expectation of earning a higher return than could be achieved on conventionally managed foreign exchange reserves, thereby developing a long-term earner of foreign exchange for the country. Such earnings would allow sustained long-term income even if export revenues were to be adversely affected by factors over which Botswana has no control. Based on historical data and financial theory, long-term bonds and equities are expected to outperform short-term assets, such as cash and short-term bonds, which comprise the bulk of investments in the Liquidity Portfolio. Returns on long-term assets are, however, more volatile than returns on short-term assets. Therefore, it became necessary to have a longer investment horizon for the Pula Fund in order to benefit from the expected higher returns.
Coordination with monetary policy and external debt management
195. To date, the external reserves have not been used as a mechanism for supporting the exchange rate in the context of the Bank’s monetary policy objectives. The Bank of Botswana does not intervene in the foreign exchange market.
196. With regard to coordination with external debt management policy, the Bank had a Matched Asset Liquidity Portfolio (MALP), which was established for the purpose of separating a portion of the reserves and investing them in fixed income instruments that had the same maturity profile as external debt. It was considered that combined asset/liability management would lead to better risk management than when assets and liabilities are managed separately. While the reason behind establishing MALP was considered to have merit, matched asset/liability management was later considered to be more useful for countries with more debt or very low reserves in terms of import cover and, accordingly, the assets held in MALP were transferred to the potentially higher yielding Pula Fund in the mid-1990s.
197. In Botswana, one of the key features of reserve management is the contribution that the income earned from the reserves makes to government funding. In this regard, over the past five years, income from external reserves has been the third most important constituent of budgetary revenues.
198. The Bank of Botswana Act, 1996, outlines the primary functions of the Bank, which include, inter alia, the management of the foreign exchange reserves. In particular, the Act provides that the Bank shall be responsible for establishing and maintaining a Primary International Reserve (Liquidity Portfolio), which shall, in general, consist of liquid short-term assets. Furthermore, the Act provides for the establishment of the long-term investment fund (Pula Fund), subject to meeting the requirements of the primary reserve.
199. Within this enabling legislation, other parties in the reserve management process are the Board, Investment Committee, Financial Markets Department, and external fund managers.
200. The Board is composed of members from the public and private sectors as well as academia. The Board is responsible for governance and ultimately the investment results; it enunciates the mission, goals, and policies, as well as designs the structure with appropriate accountability. Consequently, the Board sets the overall strategy for the management of reserves by approving investment guidelines, size of portfolios, asset allocation, strategic benchmarks, and exposure limits.
201. The Investment Committee is responsible for strategic decisions against the benchmarks as well as the rebalancing of the portfolios. In doing this, the Investment Committee receives and acts on the recommendations of in-house analysts, who maintain close contacts with the Bank’s counterparties in major markets. The Investment Committee meets periodically about 12 times a year to discuss developments in the international financial and capital markets, based on background papers prepared by the implementing Department. At the Investment Committee meetings, broad decisions are made for the Bank-managed portfolios on currency composition and modified duration within each market. The decisions made by the Investment Committee are subsequently implemented by the Department responsible for reserve management. The Investment Committee is composed of the Governor as Chairman, Deputy Governor responsible for the Financial Markets Department, Director of that department, analysts for respective markets (including the Chief Dealer), and the Director of the Research Department.
Financial Markets Department
202. The Financial Markets Department is responsible for the implementation of the decisions of the Investment Committee. In addition, the Financial Markets Department is responsible for monitoring external fund managers and other external relationships. The Department is structured as follows:
Dealing and Strategy Unit
203. The Dealing and Strategy Unit is responsible for research and analysis of various financial and capital markets and for the compilation of the background paper for the Investment Committee. The Unit implements the decisions of the Investment Committee by trading in bonds and foreign exchange.
Risk Management Unit
204. The Risk Management Unit focuses on the risk associated with all the investment portfolios. The Unit coordinates the risk management process and advises on all aspects of risk, performance, and compliance with the investment guidelines for the externally and internally managed portfolios.
Open Market Operations Unit
205. The Open Market Operations Unit is not directly involved in the management of the foreign exchange reserves; it is complementary to that function. The Unit is responsible for the provision of foreign exchange to the Bank’s customers, dealing in Bank of Botswana Certificates (BoBCs), and the management of daily liquidity in the domestic money market.
206. The Settlement Unit’s primary responsibility is to ensure that the Bank meets its obligations to pay and receive correct value for transactions as contracted with counterparties, and to execute foreign currency payments for the government and other customers.
207. The Verification Unit provides the necessary “checks and balances” to ensure that the Settlement Unit pays out and receives the correct amount of funds on due dates and at the right places. In the event that any of these factors are incorrect, the necessary steps are immediately taken to restore the position, and this includes, in the main, communication with foreign counterparties and banks. The Verification Unit is also responsible for following up on issues raised by the Reconciliation Unit of the Accounting Department.
208. A cardinal feature of the Bank’s operational strategy for managing the reserves is the use of external fund managers. The Bank has had contractual arrangements with overseas fund managers since 1981. External management of reserves provides an alternative or a fallback position in the absence of specific relevant skills in the Bank (e.g., equity management) and in case of a possible brain drain of the Bank’s scarce manpower resources. Furthermore, the incremental benefits that accrue to the Bank in terms of the training provided by the fund managers to Bank staff over the years have made a positive impact. The fund managers also provide the Bank with a means of performance comparison, given that both the fund managers and the Bank’s performance are measured against common benchmarks.
209. The Bank manages approximately 50 percent of the foreign exchange reserves internally. The intention is for the Bank to eventually manage a higher proportion of the fixed income portfolios internally in line with development of relevant skills. A small proportion of reserves would be managed externally for the purpose of performance comparison. In pursuing this objective, the Bank would obviously have to be cognizant of local manpower constraints in reserve management.
Specialist advisory support
210. Since its establishment, the Department responsible for managing the reserves has benefited from the services of a number of advisors. At present, there is one advisor for the reserve management function. Consistent with past practice, the advisor is also engaged in in-house training of citizen staff. Furthermore, the Bank has retained the services of an offshore investment consulting firm that advises the Bank in three main areas, namely, asset allocation, manager search, and performance measurement.
Transparency and accountability
211. The Bank of Botswana has recognized that accountability and transparency must be built into the reserves management process. The Board has given decision rights and delegated authority to the Governor, with the actions of the latter being measurable in terms of performance against the Board-issued benchmarks. The following are other mechanisms that are built into the reserve management process:
212. These are a strategic set of rules that defines the means of achieving the Board’s investment policy. They address issues such as currency risk, equity risk, interest rate risk, credit risk, and instruments and liquidity.
213. The front, middle, and back office operations are guided by operations manuals, which are specific to respective functions. The responsibilities and functions are defined such that there is clear separation of duties between the front and back office. The middle office acts as a policeman to ensure the proper implementation of the written procedures.
214. The reserves management procedures and processes are subject to regular audits by both the internal and external auditors.
215. Regular reports to the Board and Audit Committee are produced outlining the reserves levels, trends, and performance as measured against the benchmarks. The reserves are also marked to market with currency and market gains and/or losses disclosed to the Board and Audit Committee as part of the financial statements.
Capacity to Assess and Manage Risk
216. The objective of tranching the foreign exchange reserves is to reflect the different roles of reserves in the Botswana economy. The Liquidity Portfolio is maintained at the equivalent of nine months of import cover and is invested in short-term money and bond market instruments. On the other hand, the Pula Fund is invested in long-term instruments, such as long-term bonds and equities. The Liquidity Investment Tranche (LIT) serves to insulate the Pula Fund from frequent drawdowns, which could undermine the latter’s investment objectives.
217. In determining the adequate level of the Liquidity Portfolio, the Bank undertook a comprehensive analysis of factors that impact on the foreign exchange reserves. Based on these factors, a framework for the determination of an appropriate level of liquid assets was derived. For each factor, an estimate of monthly import cover is used to arrive at a total of an equivalent of nine months of import cover.
218. Risk is controlled at various levels of the reserve management process by different entities in accordance with the broad strategy of risk management, investment guidelines, and procedures manuals.
219. This is a key decision in the investment process as it seeks to balance return with risk as well as recognize correlation of asset classes. With regard to the Pula Fund, 40 percent of assets are allocated to equities and 60 percent to long-term fixed income assets. The appropriate asset classes for the Liquidity Portfolio are a combination of short-term income and money market instruments. The underlying objective in asset allocation is to diversify across the main asset classes and geographic regions in order to achieve a low correlation coefficient.
220. Using the currently allowed asset classes, a portfolio optimization process is undertaken every three to four years to determine the Pula Fund asset mix. This process is complemented by “what if” scenario analysis to assure the Management and Board about the risk/reward profile at the aggregate portfolio level.
221. The Bank follows conventional policies in establishing an appropriate currency mix. Eligible currencies must be convertible, relatively less susceptible to frequent and sharp exchange rate fluctuations, generally free from restrictions on their use, and products of well-developed financial markets. Accordingly, the Bank has established a minimum credit rating of a country’s sovereign debt to be Aa2/AA for its currency to be eligible, except for the G-7 member countries, whose minimum rating is Baa3/BBB-.
222. The underlying philosophy for currency exposure is that it is not appropriate to modify currency weights in response to short-term exchange rate fluctuations. The Bank mainly invests in the U.S. dollar, euro, pound sterling, and yen. The other eligible currencies are for purposes of diversification. In determining the appropriate currency weights, the following approaches were considered: the SDR-based currency allocation, relative size of the economy, relative use of the currency, market capitalization, equal weighting, and optimal currency allocation. The Bank has adopted a combination of the “SDR-based currency allocation,” the “optimal currency allocation,” and a market capitalization approach.
223. The TBT currency benchmark is constructed in such a way that it matches the international trade flows affecting the domestic currency.
224. The Pula Fund fixed income currency benchmark replicates the SDR weights. The rationale for this choice is the neutral and unbiased character of the SDR currency basket as a representation of world economic activity and SDR use as a reserve currency. The currency benchmark for LIT is SDR-based and the portfolio is invested in fixed income instruments with a shorter duration (currently around 1.5 years).
Interest rate risk
225. Modified duration is used to control interest rate risk. Overall interest rate risk is a function of three factors—the size of the portfolio, modified duration, and the actual or expected change in bond yields. The Bank has adopted mainstream and market-based benchmarks to facilitate risk management and attribution of performance to various decision levels. Customized versions of the JPMorgan and Salomon Smith-Barney Government Bond Indices have been adopted for the Pula Fund and Liquidity Investment Tranche, respectively.
226. Liquidity and the safety of the funds are paramount in the TBT. For this reason, no specific duration benchmark is specified other than a maximum maturity period of four months.
227. The Bank is exposed mainly to three kinds of credit risk, that is, bank risk, sovereign/supranational risk, and corporate risk. Additional risks relating to the use of counterparties, fund managers, and the global custodian are also addressed. The Bank subscribes to Fitch/IBCA in order to monitor bank risk and utilizes rating reports of Standard and Poor’s and Moody’s Investor Services to monitor sovereign/supranational and corporate risk.
228. Credit risk is low for the TBT because of the strict limit on counterparties’ credit ratings. In the Pula Fund, corporate risk is allowed but constrained to top-quality issuers and to a small portion of the portfolio.
Fund management styles
229. A combination of active and passive fund management styles is adopted for diversification purposes. In addition, the award of a management contract takes into consideration the firm’s technical expertise with regard to global or regional mandate. Fund management styles are also diversified, for instance, U.S. equity value, growth, or broad market styles.
Global/regional equity mandates
230. Specialist fund managers are appointed to manage various equity components. The portion allocated to each equity market is determined by MSCI country weights. Generally accepted restrictions are detailed in the investment guidelines.
Risk management at portfolio level
231. Once the portfolio is constructed, the actual portfolio management brings a different level of risk, as the portfolios are allowed to deviate from the neutral position in order to outperform the benchmark. The main risks incurred in portfolio management are of three types—operational, liquidity, and market risk.
232. The Bank manages operational risk by using generally accepted practices, including segregation of duties. The internal and external audit work add a level of oversight to the initial strong emphasis on control risk self-assessment. Straight-through-processing will be achieved shortly, thus reducing manual intervention and its inherent risk.
233. The liquidity risk is addressed mainly by the layering17 of the portfolio into different tranches that take into account the recognized norm of three months of import cover as well as the “Greenspan rule”—the importance of taking into account capital flows in the whole economy.
234. Market risk includes currency risk, interest rate risk, and credit risk. The currency risk is controlled in a more traditional way by defining ranges around the neutral positions. For example, U.S. dollar exposure can be in the range of 35–55 percent of the portfolio—plus/minus 10 percent deviation from the benchmark.
235. The interest rate risk is monitored in a similar way to the currency risk. A range of plus/minus 1.5 years is allowed around the aggregate portfolio duration. This currently translates into allowing duration to fluctuate between zero and three years for the LIT portfolio.
236. As mentioned earlier, the fixed income benchmark is 100 percent government bonds. It is, nonetheless, allowed to hold spread products in the actively managed portfolios. The permitted risk taking is offset by the need to diversify by country, industry, and issuer as well as a very high minimum credit rating.
237. The Bank of Botswana is gradually evolving toward quantitative risk management methodologies that will allow the portfolio risk to be managed at an aggregate level.