Chapter

9 Hungary

Author(s):
International Monetary Fund
Published Date:
April 2005
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Reserve Management Objectives and Coordination

Reserve management objectives

561. According to the Central Bank Act, one of the basic responsibilities of the National Bank of Hungary (NBH) is the management of foreign exchange reserves. The primary purposes of managing foreign exchange reserves, as for every central bank, are the following:

  • support for the monetary policy (intervention),

  • transactional purposes (supporting debt management, controlling crisis situations),

  • wealth management objectives.

562. In the past couple of years, with the economic development of the country and with the improvement of credit ratings and debt service ratios, the direct transaction objectives—such as supporting the repayment of debt—have been gradually losing their weight. At the same time, support of the monetary policy has become the principal reserve management objective. One way to ensure the credibility of the exchange rate system is to hold an adequate level of reserves that can support the inflation targeting system in the form of intervention, if needed. Although the cost of holding reserves has significantly decreased with the country’s improving credit ratings, the NBH still would not like to build reserves for the pure purpose of wealth accumulation. As stated above, the NBH aspires to manage reserves so as to help achieve the goals of monetary policy efficiently, meet the requirements of debt service, and, at the same time, try to optimize the return on the reserves without jeopardizing the above-mentioned goals.

Institutional framework

563. The reserve management policy of the NBH is defined by the Monetary Council (MC). The MC decides on the currency composition of foreign reserves, and interest and credit risk exposure. It approves the applied investment instruments and the list of business partners. Furthermore, according to the investment guidelines and the return requirements, the MC determines the benchmark portfolio. The MC monitors the results of the reserve management activity on a quarterly basis.

564. While the MC is a strategic decision-making body, the Asset and Liability Committee (ALCO) is responsible for tactical decisions related to reserve management. The ALCO holds a meeting at least once a month. The ALCO makes decisions on the deviation from the strategic benchmark and on the modification of operational limits. The ALCO also monitors closely the activity of the reserve management unit in charge of the implementation of daily investment and liquidity management operations.

Figure 7.Hungary’s Five-Year Credit Spread over Bund, 1994–2002

565. An independent risk management unit is responsible for the evaluation of daily business activities and monitors compliance with the operational limits. This unit is in charge of the elaboration of the risk management policy and the reporting systems the senior management. The unit also sets up and maintains the benchmark indices for the portfolio managers.

Determinants of reserve management policy

566. There are four special country characteristics that guide Hungary’s reserve management policy:

  • small open economy

  • emerging/converging country

  • relatively high foreign currency debt

  • quasi-ERM-II exchange rate regime with no capital controls

567. Hungary is a small open economy with an export/GDP ratio above 60 percent. This means that exchange rate developments have substantial influence on inflation. Hence, to run a successful exchange rate policy, Hungary must have sufficient foreign exchange reserves.

568. Hungary is an emerging/converging country, with fast developing but still less liquid domestic financial markets. This means that the central bank cannot easily build up and down reserves via foreign exchange market operations. In addition, the costs of holding foreign exchange reserves (spread between borrowing and investment rates) are, although decreasing, still negative. These facts must be taken into consideration when determining the adequate size of reserves.

569. Around 30 percent of the state debt is in foreign currency. The primary source of the annual EUR 2–3 billion debt service is the NBH’s foreign exchange reserves. Hence, the size and currency structure of the debt service are an important input to set the reserves management policy.

570. The country’s primary objective is to join the European Union and then the Economic and Monetary Union. The NBH is already running a quasi-ERM-II exchange rate regime with no capital controls. The currency is pegged to the euro with a plus/minus 15 percent fluctuation band. In order to give credibility to the band, the NBH must have adequate reserves in the current “quasi” and later in the real ERM-II system.

Optimal currency structure

571. Prior to 1999, the NBH was responsible for the foreign currency borrowing of the country. So taking the gross currency structure first, we match the foreign currency liabilities of our balance sheet. This means we hold EUR, US$, and JPY in our foreign exchange reserves.

572. In taking the net open currency position against the domestic currency, the Hungarian Forint, we take into consideration the following factors:

  • currency of intervention;

  • HUF basket;

  • orientation of external trade; and

  • macro level asset-liability considerations.

573. As stated above, Hungary is running a quasi-ERM-II system, where the central parity of the HUF is 100 percent pegged to the euro. As a consequence, more than 80 percent of the interbank HUF/foreign currency spot market turnover is against the euro. This means that the natural intervention currency is the euro.

574. Hungary is becoming increasingly integrated into the European Union. Hence, the currency structure of external trade, especially in the competitive sector, is more denominated in euros. This is also true for foreign direct investments and portfolio investments.

575. The currency benchmark for foreign currency debt of the government, managed by the State Debt Management Office, is 100 percent euro. To provide a hedge on a macro level, we take this fact into consideration when determining the optimal net currency structure to the extent it does not conflict with other objectives of holding reserves.

576. To summarize, the euro has a dominant part in the foreign exchange reserves. The dominance of the euro is justified by the fact that the Hungarian forint is 100 percent pegged to the euro, the objective of the country is to join the EU as soon as possible, the currency composition of government debt denominated in foreign exchange, and the fact that the intervention currency in the domestic market is the euro.

Adequate size of reserves

577. In setting the adequate size of reserves, we take the following into consideration:

  • nature of present and future foreign exchange regime;

  • Guidotti rule;

  • ratios to monetary aggregates;

  • foreseeable and potential future cash flows;

  • hot money potentially leaving the country in 3–6 months;

  • access to foreign exchange markets;

  • access to foreign capital markets;

  • cost of holding reserves; and

  • international comparison.

578. The level of reserves should be sufficiently high to support the current quasi-ERM-II, and the future real ERM-II foreign exchange regime. To perform this task, the reserves must meet the Guidotti rule, i.e., the reserves should cover the one-year liabilities of the whole country. Also, the level of reserves must be at least as high as the monetary base. Behind this, one can find the argument that to defend the currency, the system could be at any time theoretically converted into a currency board.

579. To keep the level of reserves in a desirable range, we try to quantify the foreseeable and potential cash flows. Debt principal and interest payments account for the biggest part of foreseeable outflows, amounting to $2–3 billion in the first part of this decade and falling sharply in later years. The government’s foreign currency borrowings are the biggest potential inflows. The NBH coordinates closely with the authorities responsible for debt management in order to harmonize policies. Privatization revenues are another possible source of inflows. These were considerable in the 1990s, but, looking ahead, NBH does not expect huge amounts from this source.

580. Stress tests are performed to see how external or internal shocks can affect the size of reserves in a three- to six-month horizon. We monitor nonresidents’ holdings of government securities and equities, the open foreign exchange positions of the domestic commercial banks, the liquidity of the domestic interbank foreign exchange market, etc. Using our own and international historical evidence during currency crises (like the 1998 Russian crisis and the 2001 Argentine crisis) we estimate the potential outflow in a three- to six-month period, a period during which internal policy adjustments can be executed, or after which foreign capital markets can be accessed again.

581. Rarely is the central bank entirely free in setting the exact level of reserves. Even in the case of an efficient foreign exchange market of the domestic currency, the central bank can purchase or sell domestic currency for reserve level adjustment purposes under normal market conditions. In the case of Hungary, it was only in 2001, after full foreign exchange liberalization, that the liquidity of the HUF spot market reached a level where the NBH could purchase foreign currency purely for foreign exchange reserve management purposes (to cover interest payments on the foreign state debt), without effectively affecting HUF market exchange rates. To minimize the impact on the exchange rate, it was executed in a transparent way, in equal, market-conform preannounced amounts (EUR 2.9 million a day, total EUR 374 million). Independent of this positive experience, when planning the future course of reserve levels, we conservatively do not take into account foreign market sales or purchases.

582. As the rating of the country is improving, access to international capital markets is getting relatively easier and easier. It means the necessary size of reserves can be lower than before, since the NBH does not have to build high precautionary buffers. The NBH has a formal agreement with the Ministry of Finance that for reserve replenishment purposes, the government is ready to execute borrowing transactions any time the central bank requests it. Moreover, in the future, other sources such as automatic borrowing facilities in the ERMII system will be available.

583. Looking at the cost of holding reserves (see Figure 8. where, as a proxy, we used the relevant credit spread), there is a clear tendency toward lower costs. Nevertheless, it is still negative; so, as in the past, the NBH does not intend to hold higher reserves than necessary. The lower cost of holding only means that the NBH can tolerate bigger swings in the size of reserves. Going forward until the prospective EMU-entry, we expect the cost of holding to approach zero.

Figure 8.Size of Official Foreign Exchange Reserves

(1990–2002; in billions of U.S. dollars)

584. Finally, to verify actual levels of reserves we regularly carry out international comparisons. Taking a longer period we look at figures like import coverage, ratios to monetary aggregates, reserves to GDP, etc. Concentrating mainly on countries with similar features as Hungary, we examine how successfully different countries run monetary and exchange rate policies with different levels of reserves.

Investment policy

585. With respect to the classical investment triad (return-liquidity-safety), the investment philosophy of the NBH is to achieve maximum return on reserves while maintaining the highest attainable liquidity and safety. Appropriate safety in this case relates to the obligation of the central bank to preserve the value of reserves held on behalf of the country. Concerning this special responsibility, reserve management is supposed to consider the appropriate risk level that allows a minimum probability of loss of capital in a certain given year. Liquidity requirement means the ability to provide an adequate amount of funds for a possible immediate foreign exchange market intervention. The adequate amount of funds has to be available with the lowest attainable cost and capital loss. The objective of maximizing returns ought to be considered only if all the liquidity and safety requirements are met. Developing this approach in the investment policy allows us to favor active against passive portfolio management.

586. In the process of developing the investment guidelines, the main objective of the NBH has been to adopt the best practices of central banks of developed countries. Like all central banks in the world, NBH has conservative guidelines that try to avoid instruments with high volatility and not permit investment in equities. The maximum time to maturity of bonds in the portfolio is ten years and the required rating is AA-AAA (by the big rating agencies). Our liquidity requirements with the mentioned maturity and rating considerations determine the available instruments in the bond market. Therefore, NBH holds mainly government, supranational and government agency issues of developed countries. The sufficiently high level of reserves and the development of bond markets in the last ten years allowed us to gradually increase the size of AA rated securities with excellent liquidity features in the bond portfolio. This part of the portfolio bears higher yield without adding significant risk.

Transparency and accountability

587. In 1999 and 2000, IMF addressed these issues in several proposals. The NBH joined the Fund’s Special Data Dissemination Standard among the first central banks. According to the current practice, the NBH discloses the size and internal structure of its reserves monthly with a 20-day lag using IMF’s Data Template on International Reserves and Foreign Currency Liquidity.

588. The management of our bank participated in meetings in Basel and Washington, D.C., where the framework of the Guidelines for Foreign Exchange Reserve Management was negotiated. Together with other central banks, we considered the proposed Guidelines in full detail and provided our bank’s 10–15 years of experience concerning this issue. Since the approval of these proposals, the National Bank of Hungary has adopted most parts of it.

Establishing a Capacity to Assess and Manage Risk

Risks incurred by the NBH

589. Risks incurred by the NBH in managing foreign exchange reserves are primarily of a credit, liquidity, and market nature. Within credit risks, we can distinguish counterparty and spread risks. Concerning market risks, we put the emphasis on the currency and the interest rate (yield curve) exposures. There is a framework in place for identifying and managing these risks on an integrated and centralized basis in line with best homologue35 and market practices, building on four key elements:

  • system of partner and issuer ratings;

  • system of partner, issuer, and sectoral limits;

  • restrictions concerning eligible assets and transactions; and

  • internal two-stage benchmark procedure—allowing for a certain range of permitted deviation—concerning sectoral allocation, duration, and currency composition.

Investment instruments

590. Authorized investment instruments are

  • bonds (authorized embedded options: put, call, cap, floor);

  • minimum AA rated sovereign;

  • supranationals (incl. BIS);

  • AAA agency papers;

  • AAA Pfandbrief;

  • min. AA corporate bonds;

  • min. AA commercial papers;

  • min. AA or tri-party repos, buy-sell-back, and sell-buy-back agreements;

  • AAA unsubordinated tranches of asset-backed securities;

  • “plain vanilla” OTC bond options (put/call, long/short);

  • interest rate futures and IRF options;

  • interest rate swaps, currency swaps; and

  • money market depos, rating: min. AA with certain exemptions.

591. Among the derivative instruments, only plain vanilla structures are permitted. (The minimum criterion to be a plain vanilla instrument is that we can price and analyze an instrument in our internal position-keeping and risk management system.) The primary condition for derivative deals is the existence of ISDA Master Agreement and mark-to-market agreement with our counterparties.

Portfolio structure

592. Similar to the practice of other central banks, the NBH distinguishes a liquidity and an investment portfolio. The liquidity part is held to satisfy daily foreign exchange cash-flow needs, such as interest and principal payments of government debt, interventions, special transactions, and transfers. The term structure of these cash flows is partly predetermined (by interest and principal payments) and partly uncertain (foreign exchange intervention needs). Since the investment horizon of this portfolio is very short, the NBH avoids the risk of interest rate movements in this segment. The other stable part of our portfolio has longer investment horizons and higher return requirements. The fact that the probability of liquidation of this part of the portfolio is low allows our bank to hold bonds with longer time-to-maturity characteristics as long as the market movements and the shape of the yield curve justify this. According to the result of our optimization process, we hold around 20 percent of the whole amount of reserves in the liquidity portfolio and the rest in the investment portfolio.

Benchmarking

593. NBH implemented a two-stage benchmarking system. The benchmarking policy, the actual strategic benchmarks concerning currency, interest rate, and credit structure of the investment portfolio, as well as the permitted deviations from these benchmarks, is set by the Monetary Policy Committee (MPC) in the annual Risk Management Policy Guidelines.

594. Tactical benchmarks, set by the ALCO, may deviate from the strategic ones within predefined ranges. Empirical evidence shows that ALCO deviated from the strategic benchmark only in case of major trend reversals (i.e., 1–2 times a year). This means the ALCO does not alter the benchmark in periods of normal business conditions.

595. In line with the tactical portfolio benchmarks, a separate Risk Management Department maintains internal model portfolios that serve as operational guidelines for portfolio managers. Portfolio managers may deviate from the benchmark within the predefined ranges so as to take advantage of favorable market conditions. Model portfolios are updated and investment portfolios are evaluated against the appropriate benchmarks and model portfolios on a monthly basis. The bonuses of portfolio managers are linked to performance vis-à-vis the benchmark.

Use of external managers

596. In the second part of the 1980s and the first part of the 1990s, the NBH used external portfolio managers. The altogether rather mixed experience showed that the services of external managers are most useful when building up reserve management activity (i.e., to learn) or when they can provide facilities a central bank cannot easily establish. Currently, the NBH uses external portfolio managers only for its securities lending programs.

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