Reserve Management

Reserve Management March 16, 2014 Welcome to Cairo

Reserve Management • Reserve management is • a process that ensures that adequate official public sector foreign assets are readily available • controlled by the authorities for meeting a defined range of objectives for a country or union Source: IMF

Why Hold Reserves? • Official reserves are held in support of a range of objectives: • support and maintain confidence in the policies for monetary and exchange rate management, including the capacity to intervene in support of the national or union currency; • limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed, and in doing so • provide a level of confidence to markets that a country can meet its external obligations; • demonstrate the backing of domestic currency by external assets; • assist the government in meeting its foreign exchange needs and external debt obligations; and • maintain a reserve for national disasters or emergencies. Source: IMF

Importance of Sound Reserve Management Practices • The importance of sound reserve management practices leads to • an increase a country’s or region’s overall resilience to shocks • significant exposure to financial markets that provides reserve managers with relevant insight that can be of relevance to policy makers • Support of sound macroeconomic management Source: IMF

Importance of Sound Reserve Management Practices Source: IMF • Weak or risky reserve management practices • restrict the ability of the authorities to respond effectively to financial crises, which may have accentuated the severity of these crises • can have significant financial and reputational costs

World Reserves • How much are the World Reserves?? • 2 trillion • 16 trillion • 7 trillion • 11 trillion • 988 billion

Global Reserves

Composition of Global Reserves

Global Reserves

Reserve Management Objectives Source: IMF • Reserve management should seek to ensure that • adequate foreign exchange reserves are available for meeting a defined range of objectives • liquidity, market, and credit risks are controlled in a prudent manner; and • subject to liquidity and other risk constraints, reasonable earnings are generated over the medium to long term on the funds invested

Reserve Management Scope Source: IMF • Reserves consist of official public sector foreign assets that are readily available to and controlled by the monetary authorities. • Reserve management activities encompass • the management of liabilities • other short foreign exchange positions • the use of derivative financial instruments

Reserve Management Strategy and Coordination • Reserve management strategies • should be consistent with and supportive of a country’s specific policy • should take into account strategies for the management of external debt for purposes of reducing external vulnerability • Include evaluation of alternative reserve management strategies Source: IMF

Transparency and Accountability • Clarity of Roles, Responsibilities, and Objectives of Financial Agencies Responsible for Reserve Management • Allocation of reserve management responsibilities between the government, the reserve management entity, and other agencies should be publicly disclosed and explained • Broad objectives of reserve management should be clearly defined and publicly disclosed and the key elements of the adopted policy clearly explained. Source: IMF

Transparency and Accountability • Public Availability of Information on Foreign Exchange Reserves • Information on official foreign exchange reserves should be publicly disclosed on a pre-announced schedule • Conduct of reserve management activities should be included in the annual audit of the reserve management entity’s financial statements • General principles for internal governance used to ensure the integrity of the reserve management entity’s operation should be publicly disclosed Source: IMF

Institutional Framework • Legal Foundation • Legislative framework should clearly establish the reserve management entity’s responsibilities and authority • Internal Governance • Structure should be guided by and reflect the principles of clear allocation and separation of responsibilities • Appropriately qualified and well-trained staff subject to a code of conduct is a necessity • Effective monitoring of internal operations should be supported by reliable information and reporting systems Source: IMF

Risk Management Framework • Framework that identifies and assesses the risks of reserve management operations and allows for the management of those risks at acceptable levels • risk exposures should be monitored continuously • reserve managers should be aware of and able to account for potential financial losses due to risk exposures • stress tests should be conducted to assess the vulnerability of the reserve portfolio Source: IMF

Central Bank of Egypt: RMU Reserve Unit Management 17

Central Bank of Egypt: RMU Introduction RMULaunch Before the establishment of the RMU, foreign reserves used to be held in USD and placed in Time Deposits and short Term US Treasuries. The Back-Office was in charge of managing the cash flows of the reserve starting from the execution of transactions up to the settlement The RMU was created in the fourth quarter of 2004 with the following Vision and Mission: RMU Vision Our vision is to fully utilize and preserve the country's international reserves while actively managing the investment portfolios to enhance returns; ultimately creating a model that would absorb unforeseen shocks/crises; within a framework that adopts a fully-synchronized asset-liability management system, while building a team of investment professionals who has the capacity and the know-how to achieve this vision. RMU Mission Our mission is to work towards diversifying our portfolio and our eligible asset classes through a coherent system that is dependent mainly on global fixed income markets adopting the most sophisticated yet prudent risk analyses and modeling techniques managed by a dedicated team of professionals. With this mission, the Central Bank of Egypt's Reserve Management Unit will be able to effectively respond to market imbalances and financial crises affecting the national economy. 18

Central Bank of Egypt: RMU Introduction Infrastructure 3 main Challenges • Necessary Systems to build the infrastructure were put in place: • Risk measurement system based on Parametric VAR model • Reporting system • Custodian • The RMU assisted in the implementation of Sungard, a straight through processing treasury system starting from the front office deals input to the final settlement by the Back-Office. • II. Human Capital: • In 2005: RMU was formed of a team of 8. • Now: we are 26 people out of which 12 earned their masters degree in finance, business and economics; 5 completed their CFA certificate while others are in process. This capacity building process was supported by the CBE. It was further enhanced through on the job training programs with external managers. 19

Central Bank of Egypt: RMU Introduction Infrastructure 3 main Challenges • III. Portfolio Construction • Portfolio Tranching • Currency Allocation • Benchmark Selection • Passive versus Active Management • Compliance Reporting • Performance Attribution and Risk Measurement • RMU Structure • Composed of 3 main divisions : • Portfolio Management • External Managers • Quant /Risk • Later a new division was introduced responsible for market strategy formulation 20

Central Bank of Egypt: RMU Currency Allocation • Currency model was formulated in a way that takes into considerations a multitude of variables such a: • Trade partners • External Debt Structure • Other considerations 21

Central Bank of Egypt: RMU Duration Model • The model assumes “Constant duration though not constant risk”. However, in fact, for the same duration, as yield decreases, the probability of negative returns increases (and vice versa). Accordingly, probability of negative return is a function of current yield level, volatilities and market environment. • Crisis shows us very low levels of yields (high probability of yields to rebound), which was not reflected in history 22

Management Central Bank of Egypt: RMU Portfolio Team Passive Management • The Money Market Desk conducted extensive research on all investment tools included in our investment universe before starting the investment process in CDs and Bills • In the transitional phase, funds were invested in USD deposits in a way to provide the funding requirements to the respective portfolios according to the agreed investment guidelines • The portfolios (P1, P2 & P3) were distributed among the major currency according to the currency allocation model prevailing at the time • The team carried a thorough study on benchmarks and recommended the use of a specific benchmark • Passive management entailed the creation of an optimization model for portfolio rebalancing on monthly basis. Portfolio managers used in-house excel sheets as well as the Risk system for optimization and performance. 23

Central Bank of Egypt: RMU Passive Management • The Money market desk is responsible for both the transaction and liquidity portfolios and the Fixed Income Desk became responsible of managing the investment portfolio The reserve was allocated into three Portfolios: • The transaction portfolio (P1) • This portfolio is designated to meet day to day cash management needs • The liquidity portfolio (P2) • This portfolio covers the non daily liquidity needs • Global Fixed Income portfolio (P3) • P3 is used for yield enhancement 24

Managers Central Bank of Egypt: RMU External Asset Initial Stage • Objective • The External Asset Managers Desk started in 2006 • The objective was to select the most qualified External Asset Managers that best suit the CBE needs and implement an ongoing monitoring and evaluation process to assess their risk and performance to the overall objectives set by the Board of Directors within the approved investments’ policies and guidelines. 25

Managers Central Bank of Egypt: RMU External Asset Development Phase • The External Mangers Team monitor and evaluate performance of mangers on a weekly, monthly and quarterly basis to gain insights on the current views as well as their short and long term market outlook. • We manage our relationship with the External Asset Mangers on a daily basis through which we exchange different views regarding their trades that are useful for the development of RMU’s internal portfolio management team. • We also ensure continuous flow of knowledge and expertise between RMU’s Team and the External Managers through continuous conference calls and on-the-job training programs Through the expertise and knowledge gained throughout the first stage, the External Management Team was capable of expanding and developing its program and moving to a second stage. 26

Managers Central Bank of Egypt: RMU External Asset Second Round • Expanding the External Managers Program • The success of the first round motivated the expansion of the External Managers Program. • The benchmarks for new mandates was then chosen on the basis of maintaining overall risk, with new guidelines introduced. • The need for an Investment Consultant was no longer necessary as the team was capable of performing quantitative and qualitative analysis, as well as due diligence on potential managers. • To facilitate the development process a subscription to a database was necessary to gather information that was an input to the analysis of asset mangers • Through a Service Level Agreement the team was then able to formalize their reporting and training requirements. • The agreement aids our quantitative and qualitative analysis as well as facilitates our process of manager evaluation. • The agreement facilitates effective knowledge transfer serving the general purpose of the external managers program. • Team Progress and Development • Essential Expertise developed over time through unconventional training programs • Effective communication with other central banks helped us to identify where we stand • A universe of potential Asset managers was developed through ongoing networking with global investment houses 27

Central Bank of Egypt: RMU Developments From 2008 till today • World Crisis • Economic recessionary pressures in the US started in mid 2008 that was followed by the Lehman crisis in September of the same year and the complete paralysis of world markets. • The fall of Lehman resulted in having a credit crunch that was extended in 2009 and coupled with a liquidity crunch across banks which markets still suffer from until the moment. • The banking crisis resulted in higher systemic risks to the economic situation of the Euro sovereigns in specific that led to a series of downgrades across most of the Euro sovereigns, and this was intensified in 2010, which resulted in worsening of the fiscal situation of sovereigns all through 2009 and 2010, during which time we took a decision to exclude a number of securities 28

Central Bank of Egypt: RMU Developments From 2008 till today • World Crisis • The following graph represents the CDS evolution of selected Euro sovereign countries that were previously part of our Euro benchmarks 29

Reserve Management