Daniel Mminele: Challenges today - opportunities tomorrow
Keynote address by Mr Daniel Mminele, Deputy Governor of the South African Reserve
Bank, at the African Central Bank Reserves Management 2020 Conference, Arusha,
1 December 2015.
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Good morning, ladies and gentlemen.
It is indeed a privilege to have been invited to deliver the keynote address at this prestigious
African Central Bank Reserves Management Conference. I would like to thank the Bank of
Tanzania, Allianz Global Investors, and the Deutsche Gesellschaft für Internationale
Zusammenarbeit (GIZ) for affording me the opportunity to share some thoughts regarding the
challenges and opportunities we face in managing official reserves. Thank you also for
creating this valuable opportunity to discuss and swap notes on best reserve management
practices.
The ever-changing landscape in the financial markets poses significant and exciting
challenges for reserves managers, but change can also bring new opportunities, which could
require a rethink in the way that central bankers manage official reserves.
As is always the case with change, new risks also emerge. This is even the case when
considering only the primary objective of capital preservation, for which historically there
were seemingly simple solutions. In the not so distant past, there was a clear formula for
achieving capital preservation by placing deposits with AAA- rated counterparties or buying
highly rated government bonds. However, holding government bonds in the current
environment may not necessarily guarantee capital preservation. For instance, in countries
such as Germany, negative yields prevailing in the short to medium maturity notes actually
guarantee not being able to achieve capital preservation.
How to deal with negative interest rates is just one of the challenges we face as reserves
managers. Judging by the structure of the agenda and the speakers for this conference, I
have no doubt that many other issues will be unpacked, to help enhance our understanding
as we grapple with these extraordinary economic circumstances that have created today's
trying conditions under which reserves managers have to operate.
In my remarks this morning, I will touch briefly on the global economic and financial markets
context; then talk about recent developments in reserves management, and the challenges
currently facing central bank reserve managers. Before exploring, towards the end of my
remarks, possible opportunities stemming from this changing global landscape, as we cast
our eyes out to 2020, I will briefly share with you how we at the South African Reserve Bank
(SARB) have been thinking about and approaching these challenges.
Recent economic and market trends
Due to the global financial crisis in 2007 and 2008, there was coordinated global easing in
monetary policy in an effort to boost the global economy. Given the severity of the crisis, it is
probably fair to say that investors and other market participants had believed this would
remain the policy stance for a protracted period. But the game changer came in May 2013
with what is now commonly referred to as the 'taper tantrum', when the then Fed Chair, Ben
Bernanke, indicated that the authorities may consider reducing the pace of asset purchases.
This was the starting point of markets needing to adjust to a world of diverging monetary
policies.
Since then, the Federal Reserve has entirely ceased with its asset purchases by slowly
reducing its monthly purchases to zero from December 2013 to October 2014. Subsequently,
the debate shifted to the timing of the rate hiking cycle. While the United States (US) has
shown sound economic performance amid resurgent domestic spending, and indications by
the monetary authorities of the need to reduce the accommodative stance in interest rates,
the market chose to focus on the lack of consumer and wage inflation. Consequently, there
was a divergence between the indication from Fed officials and the market pricing about the
expected path of interest rates, adding uncertainty and volatility to the market. More recently,
labour market statistics and Federal Open Market Committee (FOMC) communication has
seen the market move to bring forward its rate hike expectations, with the chance of a
December hike now priced at around 74 per cent.
During this period of uncertainty in the US markets, the European Central Bank (ECB)
embarked on quantitative easing with consequential negative interest rates. On
18 November 2015, Germany issued 2-year bonds at a record low of -38 basis points! The
spread of the US 10-year yield over the equivalent maturity German bond is now trading
around 175 basis points, close to its historic high of 190 basis points.
At the same time, China's process of transitioning to a more domestic, consumption-driven
economy from one that is investment-led and relies heavily on exports, was a major factor in
slowing down its overall economic growth. We are all acutely aware that this slowdown
adversely affected commodity prices and export-driven countries, which has severe
repercussions for emerging-market economic growth, including on the African continent. In
addition, the falling oil prices, partially due to downward revisions to Chinese growth
expectations, contributed to keeping inflation tame and adding to the deflation dilemma in
some developed markets.
Today, we therefore face divergent monetary policies, with the US on the verge of increasing
interest rates, likely to be followed by the United Kingdom next, while the Eurozone and
Japan are set to continue with looser monetary policies. This dichotomy presents reserves
managers with a clear dilemma: investments in US treasuries may produce negative returns
during an interest rate hiking cycle. At the same time, with reserves generally reported in US
dollars, non-US dollar investments are expected to underperform in response to an expected
stronger US dollar. This is of course adding to the complexity faced in global policy-making
and investor decision-making.
Trends in reserves management
With the investment environment clearly becoming more complicated, it may be useful to
review recent trends in reserves management, both globally as well as on the continent.
According to International Monetary Fund (IMF) data, global foreign-exchange reserves
(excluding gold and Special Drawing Rights (SDR) increased from US$2,5 trillion to
US$8,3 trillion, or 332 by per cent, in the ten years to 2014. Over the same period, total
foreign-exchange reserves in Africa increased from US$81,9 billion to US$271,8 billion, or
331 per cent. This sudden increase in reserve accumulation did not happen in isolation. The
increased globalisation of economic relationships brought with it the requirement for holding
additional reserves. This as many of the reserves adequacy metrics will involve the ratio of
either trade data or debt levels to gross domestic product. Consequently, as economies open
up, so their required reserve holdings need to increase. Such strong growth in reserve
holdings brought with it a number of changes in reserves management practices.
According to the April 2015 HSBC Reserve Management Trends Survey, conducted in
association with Central Banking Publications, central banks continue to focus on
diversification into non-traditional markets, such as Australia, Canada, Scandinavia and,
recently, China. Central bank respondents to the survey expect that the Chinese Renminbi
will reach 10 per cent of global reserves by 2025. In terms of asset classes, more than 20 per
cent of central banks are either investing now or considering investment into
emergingmarket bonds and equities. Furthermore, more than 10 per cent of the respondents indicated
that either they are investing now or considering investment into exchange-traded funds.
Interestingly, the survey also points out that about 70 per cent of central banks are active in,
or considering, securities lending.
Based on our interactions with colleagues in other central banks on the continent, the recent
focus among African reserves managers has been on: (i) formalising the investment decision
processes; (ii) introducing the use of bond futures for efficient portfolio management; and (iii)
investigating the viability of including Chinese bonds, onshore and/or offshore, into their
reserves portfolios.
Work currently under way under the auspices of the Committee of Central Bank Governors of
the South African Development Community (SADC) indicates convergence in reserves
management practices in this sub-region of Africa. The initial research results show that
reserve management activity in the region is governed by proper policies and guidelines, and
nearly all central banks have adopted strategic asset allocation (SAA) frameworks. It also
notes that there is a general approach of using tranching when constructing reserve
portfolios. The SAA framework determines tranche sizes where relevant. Most central banks
invest in cash, cash equivalents and fixed income instruments, with the US dollar and the
euro being common currencies in all portfolios.
Challenges facing reserves managers
With that contextual backdrop, and before moving on to discuss some of the challenges
faced by reserves managers, it is worth reflecting on one of the consequences of the global
financial crisis that we are still grappling with today. This is the deterioration in the credit
quality of the reserve currencies. Since 2008, using Standard & Poor's ratings, we have seen
the Japanese government debt being downgraded from AA to A+ and the US drop from AAA
to AA+. Within Europe, while Germany has remained AAA-rated, France was downgraded
from AAA to AA and peripheral European countries such as Spain (from AAA to BBB+) and
Portugal (from AA- to BB) saw an even more dramatic drop in their ratings. This narrowed
the high-grade investment universe, requiring, in some instances, adjustments in investment
guidelines to accommodate these changes. With issuers consequently falling outside the
traditional investment universe, finding yield-enhancing assets became more difficult. These
challenges persist and with the continued subdued global economic growth outlook are
unlikely to go away anytime soon.
Moving on to developments that are more recent, and with reference to my earlier discussion
on diverging monetary policies, the key challenges that reserves managers have been facing
since the latter part of 2013 have been around the ongoing uncertainties on the timing of the
rise in US interest rates and the negative yields in Europe. This has required reserves
managers to take stock of their SAA as well as review their tactical strategies.
For central banks with low reserves, the SAA tends to be set along the currency patterns of
their foreign trade and external debt. While debt obligations tend to be dollar based, trade
patterns can vary more significantly. I remarked earlier that all SADC central banks have
euros in their portfolio, which reflects the importance of this region to the continent. However,
central banks typically invest in maturities up to three-years, and this part of the German
yield curve has negative yields of around 40bps. For countries with larger reserve holdings,
there are opportunities to enhance returns through lengthening the maturity of investments or
adding credit risk to the portfolio. However, such strategies in turn bring additional market
and credit risk to the portfolio, potentially coming into conflict with the overarching objective
of capital preservation.
With expectations of higher interest rates in the US, the dollar has strengthened and
investors have started to shy away from investing in commodities, including gold. According
to Bloomberg, the amount of gold held in exchange-traded funds has dropped from
2,633 tonnes in late 2012 to 1,494 tonnes in November 2015. There has been a striking
correlation between the gold held by these funds with the dollar price of gold. Gold holdings
in these funds are still substantially higher than pre-2008 levels and therefore there is a risk
of further unwind. For South Africa, the decline in the gold price has seen the dollar value of
gold holdings decline from US$ 7,1 billion in September 2012 to US$ 4,6 billion at the end of
October 2015.
Another consequence of the global financial crisis was a significant tightening in the
regulatory framework. The new regulatory environment (introduction of Basel III and
DoddFrank) in financial markets has raised concerns about liquidity, especially in fixed income
markets. The concerns stem from the fact that many global investment banks and market
makers are adjusting their balance sheets, and consequently their business operating
models, in order to comply with these new regulations and deal with the associated costs
structures. As reserves managers, we should be acutely aware of how market liquidity
develops so that we are confident that we will be able to convert assets into cash when
required. The risk is that it is exactly in crisis times when central banks may need to tap into
reserves, and it is in crisis times that market liquidity tends to disappear.
Finally, we should not overlook the role of technology, which is another challenge reserves
manager are dealing with. With the growing complexity of the investment environment
reserves managers are required to enhance their analytical skills and capabilities, but the
increasing cost of technology could stand in the way of a proper assessment of the long-term
benefits of such essential investment. This is particularly important for central banks
diversifying into new assets classes across various currencies and instruments. It is essential
for reserves managers to invest in prime technology in order to receive an optimal
riskadjusted return and reduce the probability of negative returns. At the SARB, we are keenly
aware of the benefits and risks associated with new technology, a subject I will return to in a
moment.
The South African Reserve Bank's response to these challenges
One of the steps the SARB took when thinking about how best to deal with expected higher
rates in the US was to include the use of bond futures in its investment guidelines in order to
provide an efficient way to protect the internally managed bond portfolios invested in the US
and other major markets. Secondly, the SAA was diversified to allow investment into
currencies of some of the high credit-rated and liquid bonds from markets with low debt to
gross domestic product (GDP) ratios. For the SARB, this meant fixed income investments in
Canada, Sweden, South Korea, and China. The diversification into the Chinese onshore
bond market was a result of a strategic view on the long-term outlook for the role of China in
the global economy and its economic relations with South Africa. The Chinese bond market
also offered good yields together with diversification benefits that have proved to be very
valuable.
In addition to the diversification of our currency universe, the SARB included high-rated
covered bonds and mortgage-backed securities in the SAA in order to diversify the sources
of return and reduce the negative impact of rising rates on the overall portfolio.
Other strategies employed by the SARB to reduce external vulnerability and ensure access
to foreign exchange in times of stress included negotiating swap lines with the Peoples Bank
of China (PBoC) and the Contingent Reserve Agreement among the BRICS nations.
Lastly, the SARB is making considerable investments in improving technology by acquiring
new systems and staff capacity so as to future-proof the reserves management function. We
have undertaken a comprehensive review of our system architecture used in the
management of gold and foreign-exchange reserves. To this end, we have decided to
replace our existing IT system with a new one, more appropriate to our current and future
needs, so as to enhance the reserves management value chain.
Potential opportunities for reserves managers
What opportunities does the current environment provide when we think about the next five
years or so? Firstly, the prospect of higher rates in the US will provide an opportunity for
reserves managers to invest in higher yielding but safer investments. The indication by the
FOMC that it intends to raise rates at a measured pace should help manage the risk of
negative portfolio returns. As central banks tend to invest in short maturity bonds with a
duration of three years or shorter, a 'sweet spot' may exist in that when rates are expected to
increase modestly, longer maturity investors may shorten durations in order to avoid losses,
keeping the short end of the yield curve somewhat supported. As the bulk of global reserves
are held in US dollars, there is no doubt that after some initial mark-to-market losses, higher
rates will in due course increase the yield in the portfolio. Here it becomes important for
reserves managers to focus on the investment horizon, and not on annual financial
accounting outcomes.
After the global financial crisis, bond yields in the developed economies became highly
correlated as these countries added stimulus to their economies in order to avoid, among
other things, deflation. Consequently, risk adjusted returns of portfolios invested in advanced
economies were depressed owing to the loss of diversification benefits. The current diverging
monetary policies may in future provide diversification benefits, which will improve the
riskadjusted returns of the overall portfolio of reserves.
Furthermore, African countries have improved in respect of overall political and economic
stability, thus providing possible opportunities for long-term stable investments. As these
countries provide both hard and domestic currency investments, the weaker exchange rates
could now be providing entry points for reserves managers who may want to diversify their
investments and benefit from the higher yields.
Likewise, the devaluation of the Chinese Renminbi in recent years may have created an
opportunity for reserves managers to enter the market at a more favourable exchange rate.
With the Chinese authorities taking steps to support economic growth and recent measures
announced to further internationalise the Renminbi, the Renminbi is likely to become more
attractive. The most recent reforms have certainly made things a lot easier for central banks
in particular. In this light, and with the Renminbi set to be included into the IMF's SDR basket
from October next year, following approval by the IMF executive board yesterday, central
banks and other official institutions are likely to include this currency into their reserves
portfolios (or increase current holdings). An opinion piece by Jukka Pihlman in yesterday's
Financial Times pointed to the potential significant demand for Renminbi, estimating that
even a conservative one per cent reallocation of global reserves each year would result in
inflows of about USD80bn annually.
Amid the lack of allure of traditional government bonds, which could be in play in the
foreseeable future, alternative instruments and assets, such as equities, could feature in
future SAAs. Some research has shown that improved capital preservation, while generating
somewhat higher returns, is on offer from equities relative to bonds. But any broad based
moves into equities will be highly country-specific.
Concluding remarks
There can be no doubt that the game has changed for central bank reserves managers. The
fast changing world and investment landscape is requiring of reserves managers to adapt to
a playing field that is characterised by high levels of uncertainty and volatility, resulting in the
need to reconsider investment strategies on a more frequent basis. This will necessitate SAA
processes that are vigilant and rigorous. Old and trusted assets are not yielding returns and
some are even eroding capital. New instruments and assets that fall within the familiar and
accepted investment universe are not plentiful.
Reserves managers must keenly evaluate factors such as investment time horizons, what
constitutes and acceptable risk-return balance, what role alternatives should play alongside
traditional asset classes, and whether our traditional benchmarks still fit it in with new
strategies. However, at all times reserves managers must also remember that they are
custodians of public funds, and have to be guided by prudent strategies, which implies that
there must be a limit to "thinking outside the box" in the quest for ever higher returns.
Dealing with these challenges will certainly require human capital that is appropriately skilled,
and equipped with the right technology. Conferences such as this one present a unique
opportunity to share experiences, and transfer skills and knowledge among African central
banks, as it brings together central banks with private-sector players, and development
institutions, a uniquely powerful combination. I understand that the conference is the
culmination of two years of work involving members of the East African Community. I would
encourage the organisers to find ways of sustaining this momentum.
Finally, I trust that you will leave Arusha with better insights and an improved network of
contacts in the central banking community to help you navigate the future as you strengthen
reserves management practices in your own environments to the benefit of your respective
central banks and countries.
Enjoy the rest of the conference.
Thank you.