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

Lending carnival

Public banks in Brazil

 Published at The Long Room, Financial Times Alphaville

A Spanish version available at America Economía

Increasing fiscal deficits and a higher chance of downgrading of its sovereign ratings are main factors behind the recent pledges of austerity on lending plans by public banks in Brazil. Finance Minister Mantega announced a 20% reduction on lending by BNDES next year, shortly after the IMF warned Brazil on the rapid expansion by its three major state owned banks.

BNDES (long term financing of development projects), Caixa (housing loans) and Banco do Brasil (rural credit) boosted their lending 25% per annum on average in 2011 and 2012, compared to 10% of private banks (domestic and foreign). They enlarged their books further this year, overtaking private lenders participation, reaching 50.7% share of the USD 1.09tr market.

As reported by the IMF´s mission last October: 

 “The substantial credit expansion in recent years by public banks has been financed significantly with transfers from the Treasury. Since the global financial crisis, the Treasury has provided subsidized direct lending to public banks, mostly to BNDES"

“The fiscal cost of government lending has also increased as the long term interest rate the rate public banks pay on obligations to the Treasury was reduced by 100 bps to 5 percent during 2012, with the lower rate applying to all outstanding loans”.

For those so called Sustainable investment loans, nominal rates are still as low as 3.5% while 12 month inflation is a higher 5.8%.

Government and IMF concerns added to earlier action by Moody´s when it lowered BNDES and Caxias’s ratings by two notches, to Baa2 last March. The deterioration of core capital indicators was a key factor in the downgrading decisions; however public banks were still in compliance with minimum regulatory Tier 1 requirement of 5.5% of capital adequacy, reflecting the usually healthy performance of a fairly young portfolio in its rapid growth phase. 

Brazil´s case illustrates very well the typical tension the development banks are subjected to: even if loans were not subsidized and fiscal costs were negligible- (often not the case, indeed) - the pressure to use lending as a development policy tool conflicts with banking supervision standards and prudential rules. This is especially so when government-promoted loans would perpetuate beyond what either counter-cyclical or market-failure motives would justify.

For the sake of financial soundness, Brazil is rightly signaling the need to curb public lending expansion. However, still needs to address implicit subsidies in government funded loans at negative real interest rates. The latter harms the efficiency of investments- (e.g. projects developed on the grounds of artificially cheap funding). 

As stated in the recent OECD recent country report when suggesting a desirable phasing out of BNDES lending to large corporations:   

“The development of private credit markets has much potential to relieve credit constraints and improve the allocation of credit”

As important as allocation efficiency, below market interest rates in public lending are also unfair - (e.g. the more you manage to borrow, the more you gain). Interestingly enough, 69 % of BNDES loan portfolio is concentrated in the 60 nation´s biggest corporations.

As much as financial crisis may burn tax payers’ money when rescue formulas are implemented to bail out private financial entities, public banks represent a potential fiscal destabilizer as well. Several developing countries have suffered from the fiscal burden of bad lending with honorable purposes, most notably by public but poorly regulated development banks and agencies. 

A case in point we learned first-hand in Chile: when the Chilean CORFO shut down its direct lending operations in the nineties, the best bid received in the auction of its old portfolio was a meager 12.8% of the face value. 

Since suffering from such an adverse policies, many development banks have moved from direct to on-lending. Chile pioneered on-lending schemes : long term funding was auctioned to, and then channeled through, private commercial banks, the latter absorbing the credit risks while the public bank or agency might provide some partial collateral to certain small commercial borrowers. As reported for Latin America, these reforms, together with the public provision of advisory and other services to small-medium scale borrowers have resulted in better performance of commercial loans in recent years. That is why, credit boosting through public direct lending as reported in the Brazilian case, represents not only a fiscal threat but a step back in improving development banks´ good practices.

As an analyst phrased when commenting the OECD report: “Brazil's wasteful state bank can learn from Chile”.

www.juanfoxley.com

Nobel laureates, market timers and pension funds in Chile

Published at The Long Room, Financial Times Alphaville
A Spanish version available at America Economía

A quick riddle: which of the following quotes corresponds to a strong believer on market efficiency, someone who thinks asset prices are always right (and if they were not, who are you to tell). – Or, if you will, which one comes from an efficiency skeptic, one who found that price volatility cannot be explained by fundamentals alone and bubbles are around the corner.

Nobel laureate #1:

“It’s not easy to make a lot of money fast, and that you can go for years losing money, even if you’re a very smart person”

Nobel laureate #2:

“If they know – (how bad the market is in setting absolute prices) - they should be rich men. What better way to make money than to know exactly about the absolute level of prices”.

“The problem is that, almost surely, expected returns vary through time because of risk aversion, wealth, everything else varies through time. But measuring that requires that you have a good variable for tracking (risk aversion) or good models for tracking it. We don’t have that”.

If understandably, you have not figured out yet, the additional quote would give you the answer:

Nobel laureate #1:

 “Well, Gene and I have a lot in common, more than you might think”.

Indeed, Eugene Fama and Robert Shiller may disagree on the need for the authorities to monitor asset valuations and regulate aggregate risk exposures. - However, they share a common view: regardless of how efficient the market is, nobody can systematically beat it, especially in the short run. So, no room for gurus within the bounds of licit information rules and practices. Just a tiny room for, both hard working and lucky, alpha seekers.

The case for active management is the main casualty of the above mentioned consensus. -  The paragraphs below offer a brief illustration using the Chilean pension fund system as a fresh case of the futility in advising active portfolio management.

The defined contribution´s pension system in Chile features five possible portfolios to choose from for both compulsory and voluntary savings of future pensioners. - Each portfolio allows for a different asset class composition: the riskiest, 80% max. held in stocks; the safest, 95% min. held  in money market, fixed income.- Although there are some restrictions to move into the riskiest funds to those near the age of retirement, the majority is free to move from one portfolio to another at a negligible fee.

Since 2012, concerns rise that an increasing number of contributors start to follow cheap advice from non-regulated investor counselors, the result being a boost in portfolio shifts and some subsequent disruptions in both stock and fixed income markets. 

As it turned out, the number of savers shifting to and from the riskiest pension portfolio peaked just during the days after specific recommendations were issued by a local ´guru´. Eventually, the authority issued further regulations to discourage market timing. 

Most interestingly, it was found out that six out of the eleven recommendations delivered by the referred ´expert´, proved wrong. - Indeed, that is slightly worse an outcome than failure chances when flipping a coin.

Others results came from research on pension affiliates’ moves from one fund to another between 2012-2013. - They did poorly. 

• Almost two thirds individuals ended up gaining less than the least profitable of the five existing funds (bought high, sold cheap).   
• As for the rest,  21% performed as well as one of the original portfolios and; 
•  Only 13% outperformed the most profitable among the five existing portfolios. 

Chile: effective annual returns to market timers in pension funds

(Real rates; ap. 2012-mar. 2013)

Real return bracket	Percentage of those who shift
Above the best existing passive portfolio	13.5%
Within range of existing portfolios [2.5%-4.1%]	21.6%
Below the worst existing passive portfolios	64.9%

Source: Superintendencia de Pensiones

Moreover, when following up on each individual original position, 77% of those who decided to move ended up worse off than not doing so.

Indeed, nowadays there is no need to be a Nobel disciple to learn that market timing is generally naïve, usually self-destructing.                                                     

www.juanfoxley.com