The award for reserve manager of the year is judged primarily on three simple metrics: safety; liquidity; and return. All central bank reserve managers live according to this holy trinity - and often tend to prioritise asset allocations in that order. In a constantly evolving world of financial risk and return, however, what defines safety and what counts as a good return is a dynamic question - requiring constant monitoring and flexibility.
The past year has presented some challenging dynamics. Emerging market currencies waxed and waned as changing expectations of advanced world monetary policies led to sharp movements of hot money flows. US Treasury yields rose dramatically in the middle of 2013, although the movement was less dramatic at the short end of the yield curve. Meanwhile, the value of gold holdings tumbled 30% since late 2012. In aggregate, this means many central banks will have suffered mark-to-market losses on their reserves holdings in 2013, eroding their overall capital bases.
In this context, the achievements of the Central Bank of Colombia (CBC) stand out. Located in a part of the world that is traditionally most sensitive to US monetary policy, the team at the Colombian central bank has implemented a dynamic reserve management strategy that has effectively balanced risk and return.
Of the $43 billion managed by the foreign reserves department headed by Marco Ruiz (pictured), $558 million is kept in liquid assets. Out of the remainder, 70% is passively managed. The rest is actively managed by both an in-house team and a group of external managers, which is constantly reviewed - as one major asset manager found to its cost this year. External mandates are changed both for performance reasons as well as due to the central bank developing the in-house capabilities to make investments directly.
One year ago, a particularly radical change was made to the reserves management framework. The list of reserve currencies used as benchmarks by the central bank was modified from just three – the US dollar, euro and yen – to include Canadian, Australian and New Zealand dollars as well as the Swedish kronor and the British pound. The Australian and New Zealand dollars are viewed as good, liquid proxies for the big emerging markets that Colombia trades with – particularly China (although the central bank monitors this closely as correlations can be prone to break down). The Swedish currency, Ruiz says, closely tracks a trade-weighted basket of currencies for Colombia - and is very liquid.
The Colombian central bank had already drastically cut its euro holdings. As Pamela Cardoza Ordiz, chief monetary and reserves affairs officer at the Central Bank of Colombia, told a Central Banking event in June 2012, the CBC had "changed the euro composition from 12% to 4%, but that was not a decision made by the central bank - that was just the output of the model".
The shift away from the number two and three reserve currencies has now been undertaken so wholeheartedly that the CBC no longer holds any euros or yen, Ruiz tells Central Banking. As fears grew that the Federal Reserve would taper its quantitative easing asset purchases, the central bank also managed to reduce its duration exposure from 0.8 to 0.77 years.
In addition, the CBC has returned to highly-rated corporate debt as an investment class. "That is something we had stopped doing in 2011, as the European crisis worsened," Ruiz says. Now, however, the central bank views corporate debt as a way of bringing more variation into the portfolio. "Corporate bonds actually give us a very important diversification into the strategy," Ruiz adds. What is more, the Central Bank of Colombia is dipping its toe back into investing directly in mortgage-backed securities, in addition to external managers the central bank has used being active in that market for several years.
A top official at one of the world's largest asset managers describes CBC's efforts to adopt a modern, professional approach to reserve management as "impressive". He says the Latin American central bank is in the process of insourcing some simpler asset management functions that it used to give to third parties but is at the same time seeking external asset managers to assist with more difficult investment allocations. It is a practice already deployed at reserves management pioneers the Hong Kong Monetary Authority, the Monetary Authority of Singapore, the National Bank of Austria and the Swiss National Bank, and demonstrates a growing maturity at the CBC.
During the 12 months under review, the Colombian central bank also faced significant headwinds with a return of -1.34% measured in US dollars in the first half of 2013, which was mostly explained by the appreciation of the dollar and the decrease in the price of gold. Despite the volatility in the international markets, policy intervention by the CBC prompted an injection of $7 billion into foreign exchange reserves during the past year. As a result, the value of reserves measured in US dollar terms increased by 19% by October 31, compared with the previous year.
The performance is well within the central bank's safety rules. These guidelines limit the probability of negative returns in 12 months, excluding the forex component, at 5% or less. This is done by keeping the probability and impact of credit events limited through well-defined limits for issuers and sectors, as well as imposing minimum credit ratings. The maximum deviations from the benchmark in terms of duration and currency composition, among others matters, are defined by strict limits. Additionally, the central bank has an accounting reserve to deal with periods of volatility in the exchange rates.
To maintain sufficient liquidity, the central bank only invests in financial assets that are easy to liquidate in the secondary market, such as advanced economy government securities with issue sizes above $250 million. The reserves team also ensures its investments are less than 10% of the outstanding value of each security. In addition, it divides the investment portfolio into two tranches: working capital, which covers short-term liquidity needs; and an investment tranche invested at longer maturities with a different risk profile to achieve a higher return than the working capital.
The most important decisions on foreign reserves are taken by two bodies at the Central Bank of Colombia.
The Foreign Reserves Committee is responsible for setting the objectives, principles and policies for the administration of the reserves. It is chaired by the governor, José Darío Uribe, and meets at least once every two months. The committee is responsible for establishing investment guidelines and the benchmark, which define the composition of the portfolio, eligible asset classes, authorised operations and maximum exposures to different risks. The investment policies are consistent with investing foreign reserves with low risk, but they also attempt to achieve an appropriate level of return, taking into account that this is also part of the legal mandate of the central bank.
The Internal Committee of Foreign Reserves is responsible for defining the internal operational framework required to meet the objectives, principles and investment policies determined by the Foreign Reserves Committee. Its decisions are mainly related to the portfolios managed internally.
Finally, the CBC fulfils its responsibilities of transparency to its government and citizens by providing public information about the management of its reserves through two official publications, both available on the central bank's website. One chapter in each semi-annual report to Congress is devoted to the management of foreign reserves, providing a detailed explanation about the most important investment policies such as currency composition, tranches, benchmark, active and passive management and types of instruments allowed. It also provides details about the composition of the foreign reserves at the end of each half, including currencies, sector composition, ratings breakdown, external managers and performance.
Every two years since 2009, the central bank also publishes Foreign Reserves Management, a detailed report about reserve management. Besides the information provided in the report to Congress, the central bank explains the rationale for holding foreign reserves, the governance and organisation of reserve management.
For its commitment to building sound practices in reserves management and its pioneering efforts to build a relevant reserves portfolio for a post-crisis world, the Central Bank of Colombia is Central Banking journal's reserve manager of the year.