Currency diversification at central banks: moderate but sustained

  My post at The Long Room, Financial Times Alphaville

Higher currency diversification towards the Australian and Canadian Dollar (AUD, CAD): this continues to be the path central banks follow in allocating its official reserves. By the end of 2012 the IMF properly started to publish those two currencies individually, along with the residual ¨other¨ currencies item, all exhibiting moderate but sustained gains since then.

No disaggregated information on the Chinese Renminbi holdings is available but evidence from some individual central bank annual reports suggested the CNY- (the off-shore Yuan)- has become eligible, mainly for time deposits. Its future significance as a reserve asset will depend on China´s progress towards further FX market floating. So far, market turnover for the CNY has increased, ranked ninth but still behind the Mexican Peso in 2013, according to the the well-known BIS triennial survey.

As expected, currency diversification has come at USD and EURs expense, the latter further hurted by exchange rate depreciation. Conversely, USD appreciation vis a vis continuing success in shrinking the US federal deficit over GDP, would lessen, eventually reverse, USD substitution trends.

Currency shares of allocated international reserves

(As of end of June, each year)

	2009	2013	2014	*Netting out exchange rate gains/losses  2009-2014
USD	62,81	61,86	60,66	59.93
EUR	27,57	23,85	24,19	25.02
GBP	4,28	3,82	3,88	3.57
JPY	3,02	3,84	4,03	4.41
CHF	0,12	0,26	0,27	0.23
AUD+CAD	n.a.	3,48%	3,92%	3.83
Other	2,20	2,89	3,05	3.01
	100	100	100
CAD	n.a.	1.79	2.02	2.05
AUD	n.a.	1.69	1.90	1.78
AUD+CAD+Other	2.20	6.37	6.97	6.84

Source: IMF Currency Composition of Official Foreign Exchange Reserves (COFER, Sept. 2014)

*Author´s calculations, assumes no exchange rate change for ¨other ¨, with the USD as the numeraire.

www.juanfoxley.com

Gold and humility lessons from the central banks of Switzerland and... Venezuela

   My post at The Long Room, Financial Times Alphaville

A Spanish version available at America Economía

Huge losses from gold holdings among central banks are a reminder that international reserves must be properly diversified, otherwise not serving its capital preservation purpose which is supposed they are there for.

Today´s news from the Swiss National Bank (SNB) said it expected to report a USD 9.9 billion loss in 2013, a year when the precious metal price fell 28%. Financially, losses are equivalent to less than 2% of total international reserves however; a tangible consequence is the SNB will not be able to distribute dividends to the Swiss Confederation and regional cantons.

It could have been worse. A plan contained in a popular referendum that would require it to keep at least 20% of its assets in gold has not been passed yet. In fact, Swiss authorities are suggesting a no-vote on that. Gold holdings are at a lower, but still risky, 8.3% of the central bank reserves.

Indeed, there may be good reasons to have gold as a reserve asset: the lack of credit risk, long term store of value and safe heaven behavior are key features for central banks.  More so, after 2008. The question is of course, not ´if´ but ´how much´ to hold.

But in the ´how much´ issue, the consequences of overdoing it may be terrible. Venezuela may turn the Swiss case as a minor anecdote in this respect. Its later government decided the central bank to move away drastically from USD holding into gold, ending up with 68.9% of less liquid, loss making international reserves. Therefore, even if sound macroeconomic management were in place in Venezuela-(which of course, is not)- the sole lack of diversification of its international reserves would have cost Venezuela USD 4.9 billion last year, that is about 20% of its portfolio. 

Bottom line: Switzerland and Venezuela may have sidereal differences but its central banks are not free from the adverse effects of asset missallocation of its international reserves.  Indeed, a new lesson in humility to investment policy authorities worldwide.

Traditional portfolio optimisation may be evolving to allow for more dynamics in parameter estimation but the basic fact remains: a fairly high degree of asset diversification is both fundamental and sound as a guiding principle for risk management. Portfolio concentration is undesirable and even a naive [1/N] rule is a perfectly robust heuristic when, as it is usually the case, the assumed stability of asset returns and correlations in Markowitz-type models does not make sense.  

 www.juanfoxley.com