On in the economy and serve a wide variety

On April 7, 2017, I posted a tweet on my
official twitter account, celebrating the good news regarding our level of
international reserves– “Historical: net international reserves reach USD
8,000 million. Solid external position of Paraguay #Paraguay @BCP_PY #RIN”. The
news was widely celebrated and that tweet is perhaps one my most successful
ones, but why?

An adequate level of foreign reserves provides
confidence within a nation. Foreign Reserves have a central role in the economy
and serve a wide variety of purposes including: intervening in the FX market to
mitigate irrational volatility, backing the domestic currency, safeguarding
liquidity of financial markets, enabling international trade, and providing
trust that the country is capable of repaying its foreign debt. Paraguay´s
foreign reserves have grown at an annual rate of 18.4% since 2008, whilst
average GDP grew 4.9%. Reserves represent 8.5 months of imports, X% of GDP, X%
of M0, and X% of Foreign Debt. These indicators, not only help measure adequate
levels of reserves, but have also outlined the traditional asset management
approach defined by the following investment priorities: Safety, Liquidity, and

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Safety, liquidity and return
as an investment guideline has led many central banks to allocate a large
portion of reserves to the short end of the soverieign yield curve, primarily
in US dollars (64% of global reserves). An overweight position in U.S. dollars has
been a profitable strategy in the last thirty years, whilst rates have been
declining, but this becomes a less attractive strategy in a rising rate
environment and could provide considerable FX and Interest-Rates risk.

Diversification is key, in order to reduce risk
exposures, but globalization is driving asset class correlations higher, making
it harder to diversify via classical asset class diversification (PIMCO, 2016). Furthermore, correlations increase during
market downturns, as many investor see the US as the predominant
“flight-to-safety”. As a Central Bank, it is important to understand the
objectives behind foreign reserves and create strategies that can create
optimal risk-adjusted returns.

However, creating these
strategies have been challenging for Central Banks. Instead of having a long
investment horizon, public accountability of reserves leads to a short-term
horizon mentality where “safety” does not only mean zero tolerance for default
risk, but also zero tolerarnce for loss in principal in any interest rate
environment. Diversification in this universe limits the pool of asset classes
and currencies. Within this limited pool, common approaches to strategic asset
allocation such as mean variance optimization (Markowitz), mean VaR optimizion,
minimum variance are applied. The returns generated on foreign reserves in the
low interest rate environment has not been able to offset the rising cost of
monetary policy, driving many Central Banks on a search for yield.

The “search for yield” has driven many Central
Banks to re-think Safety and Liquidity. From a risk-based perspective, Safety
can be defined by a comfortable level of volatility that a Central Bank is
willing to absorb, whilst Liquidity can be defined by the liability and crisis
coverage needed. Taking this into consideration, acceptable asset classes and
risk exposure are redefined. An analysis recently done by the BIS shows that
investors from 36 countries have increased their credit risk exposure on their
search for yield (Ammer, 2018). An allocation framework looking to maximize
returns subject to constraints on liquidity, volatility budget, credit quality
and currency allocation can bring clarity in risk-based diversification.

The success of diversification through the
application of investment models does not hinge on the ability to select the
“best” model, but by combining several models that truly provide
diversification of risk factors. Furthermore, diversification can be improved
by not relying on a single style or manager. For this reason, the Central Bank
of Paraguay has decided to join the RAMP program with the World Bank. By
dividing the risk budget into external and internal managers who make
investment decision independently, qualitative and quantitative approaches in
generating alpha can be diversified.

In conclusion, we
have seen that diversification strategies based on correlations have become
less effective due to the increase in capital flows and globalization. The
possibility of looking for new qualitative and quantitative methods such as
diversification based on risk factors is important, however we must remember
that Central banks have a fairly limited universe of instruments. As
administrators of public funds, the tolerance for losses is practically nil due
to public accountability. We face a continual challenge in effectively
investing our reserves to meet its objectives, whilst adhering to stringent
investment guidelines.