Negative Euro Area Interest Rates and Spillovers on Western Balkan Central Bank Policies and Instruments
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FX Reserve Management in a Negative Interest Rates Environment: The Macedonian Experience

Author(s):
International Monetary Fund
Published Date:
May 2017
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First of all, I would like to thank the organizers, the Bank of Albania, the International Monetary Fund, and the Swiss Government for giving me the opportunity to represent the National Bank of the Republic of Macedonia and our experience in coping with negative interest rates in the area of reserve management.

1. FX Reserve Management – Global Trends

I would like to start talking about some global trends first. Over the past two decades, on the back of growing foreign exchange reserves, central banks have positioned themselves as influential investors in the global financial markets.

Figure 1.FX Reserves management. Global trends (1)

The IMF data show that the US dollar is still the dominant reserve currency of the central banks, followed by the euro. There is, however, some visible diversification in other currencies in recent years.

Some surveys of central banks’ opinions show that diverging monetary policies among major central banks are still a dominant concern when managing the FX reserves, although there are other important factors such as economic development in China and in other emerging markets, and oil prices. The persistence of negative rates in some major reserve currencies has induced many central banks to introduce changes to their portfolio management, namely, in the portfolios and in the investment behavior. In terms of portfolio allocations, we are seeing reduced allocations to euro, yen, Swiss franc, extended duration, increased exposure to credit risk, and broader investments diversification in corporate bonds and equities. On the other hand, in terms of investment behavior, the aim is still to preserve the capital, which means that investors are searching for yields. There is higher risk tolerance among all the central banks as well as visible changes in the investment horizon and diversification across and within asset classes.

Figure 2.FX Reserves management. Global trends (2)

Source: HSBC Reserve Management Trends 2016.

2. FX Reserves Management – The Macedonian Experience

I will continue with our experience. The purposes of FX reserve holdings in the National Bank of Macedonia can be divided into three groups. One is the monetary policy purpose, namely, we have been pegging our domestic currency to the euro for 20 years now, and the exchange rate of the Macedonian denar to euro has not changed. We support this by intervening in the FX market through six banks, so called market makers. The reserves are held for precautionary objectives, as they serve as buffers against balance of payment shocks. In turn, we see there is a high investor confidence in the country’s ability to meet FX obligations, reduce the cost of external financing, keep the confidence in the national currency, give emergency liquidity assistance to the banking sector in case of market disruptions, and provide funding in case of a national disaster and emergencies.

Figure 3.FX Reserves management. Macedonia (1)

And of course, there are non-precautionary objectives, namely to generate income to cover the central bank’s operational costs in order to ensure central bank independence. Almost all operational costs of the central bank, which are salaries and other costs, are covered by the profit from the FX reserves management. Another element is to preserve the wealth for the future generation.

Moreover, we are led by the investment principles, which are: safety, liquidity, and profitability.

Our country is a small, open economy with exchange rate commitment to the euro. We have been growing steadily over the past couple of years, despite several external and internal shocks. You can see from Figure 4 that our GDP growth has been mainly above the average of the region. This has been supported by structural changes in the economy. We have encouraged foreign direct investments, and diversified the exports a lot in recent years, as shown on the right side of Figure 4. The current account deficit was also rapidly reduced from the levels recorded at the end of the last decade and has been kept at very low levels since 2010.

Figure 4.FX reserves management. Macedonia (2)

The foreign exchange reserves of the Republic of Macedonia have been generally set on a growing path and are constantly maintained at adequate levels, considering major measures for adequacy. What is the leading contributor to the reserve build-up? It is the government transactions, but we have also had foreign exchange inflows, and to protect the exchange rate, we have purchased a lot of FX in the market in recent years.

Figure 5.FX reserves management. Macedonia (3)

Macedonia’s foreign exchange reserves as a percentage of the GDP correspond approximately to the average of the countries with similar pegged exchange rate commitments, as shown in the left-hand graph of Figure 6. They are also is in line with the average of the countries from the region, as shown in the right-hand chart of Figure 6.

Figure 6.FX reserves management. Macedonia (4)

When looking at factors influencing our FX reserves currency composition and tranching, the exchange rate regime is the most important factor, because the euro is the currency of intervention. Then we look at the currency structure of trade. We export and import predominantly with the European Union. Additionally, 80 percent of our gross external debt is denominated in euro.

Figure 7.FX reserves management. Macedonia (5)

A changing investment environment and low yields for long periods have urged us to consider changes in the portfolio management strategic orientation. Namely, the markets are characterized by insufficient compensation of risk, low and negative rates, compressed spreads, diverging monetary policies, and a lot of disturbances due to political risks.

In the portfolio changes, we opted for currency diversification, extended the duration, increased credit exposure, added new instruments within asset classes, added new issuers, increased the level of the HTM (hold-to-maturity) portfolios, and increased the share of active portfolio management. Still, our investment behavior is searching for yield, and we are increasing our risk tolerance and extending the scope of eligible assets.

Figure 8.FX reserves management. Macedonia (6)

Considering the tranching of the reserves, the liquidity objective for us is very important, because we need ample liquidity to intervene in the FX market and to service the government’s debt obligations. Since 2016, we have introduced a new portfolio: the working capital or operational portfolio. It is predominantly in euro and it is covering one-month needs for interventions and services of government obligations. On the other hand, the liquidity portfolio is based on the rolling principle; it should mostly cover the working capital needs for 12 months in advance on a rolling basis. And the rest is the investment portfolio.

Figure 9.FX reserves management. Macedonia (7)

We keep the operational portfolio only in euro, whereas in the liquidity portfolio, we have euro, US dollars, and other currencies in which we have diversified our reserves since 2012. We have also introduced commodity currencies in our portfolio like the Canadian dollar, Pound sterling, Norwegian krone, and other currencies. In the investment portfolio, we still have the euro and US dollar. The euro is the dominant currency excluding gold, which accounts for around 10 percent of our reserves. As of 2016, we have around 60 percent of the reserves in euro and around 40 percent in US dollars. You can see from Figure 10 on the left-hand chart that we started to increase the exposure toward the US dollar from 2014 and it is unhedged, whereas the exposure towards other currencies declined from a combined 10 percent of our total reserves in 2015 to less than 1 percent in 2016.

Figure 10.FX reserves management. Macedonia (8)

We mostly invest euro in euro area countries, but, to avoid negative yields, a part of the funds is invested in other EU countries as well. In 2016 and now also in 2017, we have also increased investments in securities issued by Asian issuers.

How are we coping with the risk? I said earlier on during my presentation that the US dollars position is unhedged, but as Roberto previously mentioned, central banks have sometimes some buffers. In the case of our central bank, we have revaluation reserves for exchange rate differentials from previous years. So, from a currency risk management perspective, we did not leave the currency risk unmanaged, but we precisely quantify our currency risk and have an upper limit to the exposure we can take.

Thus, we have a defined explicit measure of currency risk, which is VaR at 95 percent confidence interval over a one-year horizon. Then, we introduced the so-called currency risk budget, which consists of the accumulated revaluation reserves from previous years. This is the upper limit for the FX exposure. We divided the currency risk into strategic and active risks. The strategic one is that we need to have US dollars without any activity for active management. That means that for some import purposes, we need to have, for example, 20 percent of the US dollars and it needs to be there. But, as I mentioned, we have 40 percent of our FX reserves in US dollars, 20 percent above the strategic level of 20 percent. So we have some active position in the currency risk and both strategic and active currency risk, as you can see from Figure 11, are below the revaluation reserves of the central bank. Also, other unhedged commodity currencies, which I mentioned previously, are not strategic but tactical ones.

Figure 11.FX reserves management Macedonia (9)

For interest rate risk, we extended in the past years the duration as part of our efforts to avoid negative yields. Hence, we accepted higher interest rate risk. We increased the duration mainly for the euro portfolio and we never invested at negative yields, except for the working capital tranche.

As part of our efforts to avoid negative yields, we also increased the credit risk exposure at the end of 2016 and the beginning of 2017. The additional credit risk allowed us to avoid negative yields while decreasing the interest rate risk. In the previous years, the duration was increased, but in the second half of the last year, and the beginning of 2017, we decreased rapidly the interest rate risk and increased the credit risk.

In order to avoid the effects of rising yields and improve interest rate risk management, the formal process of the strategic asset allocation was developed. We also introduced the risk budget and divided it for the actual portfolio and for the benchmark. The risk budget for the benchmark represents the strategic risk budget, which is complemented by an active risk budget for the active position taking of portfolio managers. You can see from Figure 12 that strategic and also active risks never were above the risk budget in total, which is EUR 25 million for benchmark and the active positions. We are in the process of allocating the risk to specific active positions.

Figure 12.FX reserves management. Macedonia (10)

As regards asset allocation, the structure of FX reserves is rather conservative since 80 percent of our FX reserves are invested in fixed income instruments, but we have also investments in gold and money market deposits. In the second half of last year and at the beginning of this year, we have increased the placement of money market deposits and we have introduced commercial papers and certificate of deposit as eligible investment instruments as part of our coordinated response to rising yields.

You can see from Figure 13 how the asset allocation is changing, and the part of exposure to commercial banks issues is increasing. This is also driven by the decreasing duration of old portfolios. About credit exposure, our criteria for credit risk have been slightly loosened. The policy document from the Board does not formally allow any investment in assets with credit rating below the investment grade, but de facto the internal guidelines set out stricter and more prudent credit risk criteria.

Figure 13.FX Reserves management. Macedonia (11)

Figure 14.FX reserves management. Macedonia (12)

For the credit risk management, due to increased credit risk, we introduced an updated credit notebook, meaning that we follow more deeply the performance of major commercial banks. We have also a quarterly review of the countries’ macroeconomic indicators and, in addition, a quarterly review of the banks with which we have larger exposures. We look at the banks’ financial indicators, and riskier investments are only with Basel III-compliant banks.

What is in preparation? As we came up with a figure for the currency risk and interest rate risk budget, a model to quantify the credit risk is in preparation to come up with a figure for the total credit risk that we are exposed to.

About gold, we have a constant share of gold in the FX reserves in strategic orientation, and we place most of the gold into deposits. What are additional activities we undertake for capital preservation and to generate higher income? We have active management, active positions in other currencies, and we undertake securities lending and repo and reverse repo transactions under GMR agreements with a few commercial banks. We have agreements for automatic securities lending with our custodians and regularly revisit settlement and custody costs.

Figure 15.FX Reserves management. Macedonia (13)

We are currently aiming at introducing financial derivatives, namely interest rate futures, as part of our active portfolio management eligible instruments, although for the part of the RAMP portfolio (that the World Bank is managing for us), futures are already used. So, currently we are in the process of building our institutional capacity for transacting in futures.

Figure 16.The challenges ahead

What are the challenges ahead? Of course, there are divergent monetary policies, and ECB tapering – when and with what speed. In the US, there is uncertainty surrounding the policy stance of the new US administration and its global ramifications.

From a political perspective, the challenges include the Brexit negotiations between the EU and UK, the protectionist pressures, the geopolitical risks, as well as the refugees and migrants crises. In Europe there are many question marks, and too little positive impulses with a dense political calendar and the fundamental question of whether we will have a multi speed Europe – a more divided Europe – or Europe will find a new political and economic cohesion.

About us, of course, the fundamental decision is how to properly allocate our investments to asset classes. This is constrained by our country’s specific factors, as we have our exchange rate regime. We need to take into account our reserves levels and the country’s liabilities.

Then the low yielding environment forced reserve managers to employ diversification. The National Bank of the Republic of Macedonia (NBRM) has undertaken currency as well as asset diversification, but limit them in scope.

FX reserves are increasing, but, at the same time, the liability side of the balance sheet of the NBRM is creating additional requirements for FX reserve management, and the NBRM is dedicated to ensuring implementation of best practices of the FX reserve management process, and, at the same time, to exploring possibilities for diversification in new asset classes.

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