Czech National Bank moves into positive capital

By Miroslav Singer, Governor, Czech National Bank.

The Czech National Bank’s foreign exchange reserves expanded significantly in both absolute and relative terms in the early 2000s. Between the end of the Asian currency crisis in 1998 and 2005, reserves grew by $16.8bn to $29.3bn, 23% of GDP.

This growth sparked an informal discussion at the CNB about whether
and how to invest the reserves. As at other central banks, the principal
aims of such diversification were to reduce non-market risks and
improve returns.

In considering a possible equity purchase programme, the key issues that
had to be analysed were the liquidity and ownership. In terms of liquidity, it was clear that only equities represented in major indices could be used. As to ownership, there was talk of transferring the part of the reserves not needed for monetary policy purposes to the Treasury or using it as the initial capital of a new Czech sovereign fund.

However, both such ownership transfers entailed legal uncertainties, so CNB focussed on an in-house equity programme. The bank was acutely aware that any losses incurred at the start of an equity investment programme would do huge damage to its reputation. Timing was the most sensitive issue. The possibility of investing part of the reserves in equities was first discussed in June 2005.

Preparatory work continued until it was time to decide on the form of the tender to find an asset manager. However, in June 2006 the board postponed the process. It decided gradually to invest 10% of the euro portfolio in the composite equity index comprising national stock markets within the euro area, and 10% of the dollar portfolio in US, Japanese and UK equity indices according to weights derived from the capitalisation of these markets in June 2007.

In retrospect, the delay – requested by board members wary of the dizzy heights reached by equity markets in mid-2006 – saved the CNB from entering the equity markets just before one of the sharpest equity price corrections in modern history.

In October 2007 the board finally approved the tender for asset managers, and in March 2008 BlackRock and State Street Global Advisors were selected as managers. The gradual build-up of the equity portfolio began. By mid-2011 the portfolio had reached the 10% target level, and in November 2011 the board set the maximum allowed deviation from that level at 2% of reserves.

As to the results, the equity portfolio has been loss-making in only two years – 2008 and 2011. The relatively large loss in 2008 (about one-third of the investment value) was mitigated by the fact that it was incurred on only 2.5% of the reserves – one-quarter of the intended equity portfolio size. The total cumulative return for the six-year period from June 2008 to September 2014 was 61.4% – quite a respectable figure in these times of low returns. The fixed-income returns were meanwhile close to the benchmark, reaching 15% cumulatively in the same period. Thanks to the considerably better performance of the equity reserves, CNB reserve management was profitable during the financial crisis.

New issues are always cropping up. The use of the exchange rate as an inflation-targeting tool at the zero lower bound on policy rates may lead to a further build-up of CNB reserves and thus necessitate sizeable increases in the equity reserves this year or in the future. The CNB may decide to diversify further its reserves geographically or in terms of asset classes.

There has been one more important side-effect. After more than a decade of operating with negative equity – with a cumulative loss on its balance sheet – the CNB has achieved a position of positive capital. This may result in increased demands from the Treasury to transfer part of the bank’s current profits to the state coffers. Such demands are likely to increase the attention paid by the general public to the quality and results of CNB reserve management.

Investing 10% of the CNB’s reserves in equities has been a success. The bank has diversified into a better-performing asset class and improved its risk-return position. It has diversified, too, into territories other than the EU and US. Crucially, by delaying the start of the reserve build-up phase, the bank prevented initial losses that might have compromised the programme.

This article was originally published by the Official Monetary and Financial Institutions Forum (OMFIF) in the The OMFIF Commentary.


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