Global reserve management (research in progress) SEMINAR Warsaw School of Economics 26 April 2007

1. Global reserve management(research in progress)SEMINARWarsaw School of Economics26 April 2007 Dr Krzysztof Rybiński* National Bank of Poland Deputy Governor Email: krzysztof.rybinski@nbp.pl Blog: www.rybinski.eu * Views presented during the seminar are my own and they do not necessarily represent the official position of the National Bank of Poland or the Financial Services Authority

2. Research motivation • Huge, unprecedented reserves growth in recent years, well in excess of standard central banks needs in many emerging markets • Observed change in central banks’ asset management strategy (new, global approach). Why? • Assessing implications for the global economy and global financial markets • The end of US „exorbitant privilege”? • Implications for the NBP asset allocation strategy

3. Growth of Official Reserves Developing and Emerging Economies, USD bln. Sources: BIS, IMF

4. Growth of Official Reserves – selected countries USD m Source: IMF

5. Top Five Reserve Holders USD m Source: IMF, RBS

6. Growth of Official Reserves – Oil Exporting Countries Sources: IMF IFS, IMF DOTS

7. Reserves Adequacy: Months of Imports Developing and Emerging Economies, Weighted Average Sources: BIS, IMF

8. Reserves Adequacy: Months of Imports – Selected Countries Sources: IMF IFS, IMF DOTS, WDI

9. Reserves Adequacy: Reserves to M2 Ratio Sources: IMF IFS, WDI, NBP

10. Reserves Adequacy: Short-Term Debt Coverage Developing and Emerging Economies, Weighted Average Sources: BIS, IMF

11. Reserves Adequacy: Short-Term Debt Coverage USD m Sources: IMF IFS, BIS-IMF-OECD-WB

12. Growing Excess Reserves Source: IMF

13. Excess Reserves Above Short-Term Debt – Selected Countries USD m Sources: IMF IFS, BIS-IMF-OECD-WB

14. XX century investing vs. XXI century investing by CBs GIC, 9.5% pa. Very conservative central bank, capital protection strategy Source: World Bank Treasury

15. Global and US 1970 onwards US Only Global Source: World Bank Treasury

16. Probability of Negative Real Return

17. 100% Govt 1-3 Yr Portfolio vs. 50% Broad Fixed Income, 50% Equities Source: World Bank Treasury

18. Cumulative Return On a Typical Portfolio Source: Own calculations based on Merill Lynch Indices

19. Cumulative Return for the Previous Five Years Source: Own calculations based on Merill Lynch

20. Financial Malpractice • “Is it financially responsible to invest accumulated reserve assets only in short-term liquid securities of industrial countries?” • “A university with a substantial endowment that invested its resources only in Treasury bills would be guilty of financial malpractice.A corporation with significant pension liabilities that invested its pension fund only in short-term financial investments would be guilty of financial malpractice. A state and local government in the United States, with substantial liabilities to its retirees that invested only in short-term financial instruments would be guilty of financial malpractice.” • - Larry Summers, September 14, 2006, Bank of Korea and World Bank Treasury Forum on Foreign Currency Reserves Management, Seoul, Korea Source: World Bank Treasury

21. Opportunity Costs • If the wealth tied up in reserves were invested in a fully diversified long-term way in global capital markets, the resulting gain would be close to $100 billion a per year. Aggregating the 10 leading holders of excess reserves, the opportunity cost comes to 1.85% of their combined GDP… • ….This is comparable to the gains thought to be achievable from the next round of trade liberalization, to global foreign aid or to spending on key social sectors in a number of countries --Larry Summers, March 24, 2006 L.K.Jha Memorial Lecture Reserve Bank of India Source: World Bank Treasury

22. Source: Central Bank of Latvia

23. CBs internal constraints.Example – bad incentives Maximum Bonus Bigger Bonus Bonus Pat on the Back Base Salary Concern Headache Migraine Screaming Fired Jail Source: World Bank Treasury

24. Dochodowość aktywów i pasywów NBP

25. Cost of holding large reserves (on top of sterilization rate premium)

26. Amid rising (opportunity costs) bentral banks get over bad incentives and accept more short-term risk for the benefit of higher long term return Maximization subject to policy and legal constraints

27. Examples (reducing USD) • NBP has reduced USD share in reserves in early 2006 and increased the share of GBP. • It resulted in foreign exchange reserves level being higher at end-2006 by PLN750mln equivalent, and increased return in 2006 by 60 bps (higher allocation to appreciating currency) • Diversification strategy continued by NBP in 2007 as well

28. 2007 issue of RBS Reserves Management Trends confirms that CBs are planning to gradually diversify across currencies and across asset classes, with 56% of survey respondents agreeing that CBs should invest in equities China has created a new giant reserve management institution, it will receive an estimated by markets USD200-300 bn worth of reserves to invest in high yielding assets (including commodity funds, private equity, possibkly hedge funds), out of USD1200bn reserves held by PBoC-SAFE (State Administration of Foreign Exchange) Examples

29. What are the implications?

30. US C/A deficits accumulated to large negative IIP Source: K.Rybinski „Globalizacja w trzech odsłonach”, forthcoming May 2007

31. Positive US income account puzzle Source: K.Rybinski „Globalizacja w trzech odsłonach”, forthcoming May 2007

32. Will US exorbitant privilege go away? Source: Gourinchas, Ray (2005) and IMF WEO, April 2007

33. Consequences of improvement in global reserve management (long-term)? • US will loose exorbitant privilege • Dollar will loose the status of world first reserve currency • Faster developments of financial markets in Asia, maybe leading to common „asian” • Better allocation of assets globally leading to higher global growth • Changes in relative valuation of asset classes (higher demand for more risky assets) • Possibly higher short-term volatility • RISK!? What if global event shuts off many markets, and liqudity is gone. Will CBs acting as good asset managers be able to act as lenders of last resort as well?

34. Some recent evidence of risk diversification Source: BIS quarterly, March 2007. Record low emerging market CDS spreads suggest significant reduction of credit risk in emerging markets relative to US corporate risk in the same credit category

35. Implications for the NBP • Define the practical meaning of legal and policy constraints (e.g. ERM2) • Create a long-term vision of foreign asset management (in principle no assets should be excluded from such a vision – equities, FHF, credit derivatives) • Embark on change process to fulfill that vision, observing policy constraints • Consider consolidated ALM approach