Central Bank Reserve Management Practices

 Insights into Public Asset Management from the Second RAMP Survey

Determinants of Currency Composition of Reserves

The way central banks manage their foreign reserve assets has evolved over the past decades. One major trend is managing reserves in two or more tranches—liquidity tranche and investment tranche—especially for those with adequate reserves. Incorporating reserve tranching, this paper develops a central bank’s reserve portfolio choice model to analyze the determinants of the currency composition of reserves. 

Reserve managers move to equities

¨ ....the question arises as to why the investment tranche (which functions as a long-term investment tool for capital gains purposes) has such large exposure to passive fixed income and cash products. If the investment tranche is designed to produce extra yield in relation to standard bond portfolios, such an allocation seems ineffective. ¨

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