Keynote address by Ingrid van Wees, ADB Vice-President for Finance and Risk Management, at the 2018 Asian Regional Forum on Investment Management of Foreign Exchange Reserves on 23 October 2018.
Dear Distinguished participants, ladies and gentlemen, Good Morning.
On behalf of the Asian Development Bank, I am delighted to welcome all of you to the 2018 Asian Regional Forum on Investment Management of Foreign Exchange Reserves. I would like to thank our co-host, the Central Bank of Armenia for its valuable support in co-organizing this forum. I would also like to express my appreciation to our delegates and speakers for taking time to attend this important event.
This forum aims to serve as a discussion and knowledge sharing platform – a venue to exchange views on global financial markets, and discuss prospects and challenges facing Asian reserve managers.
With that in mind, today, I wish to touch on three key areas: first, the global and regional economic outlook; second, the significant developments in the reserve management area; and third, ADB’s role in developing local currency bond markets.
Global and regional economic outlook
Let me share with you the economic outlook documented in the recent update of ADB’s Asian Development Outlook (ADO) which we published at the end of this September.
The aggregate growth forecast for the major industrial economies of the United States, the euro area, and Japan are retained at 2.3% in 2018 and 2.0% in 2019. Growth in the US remains robust, supported by strong private spending, fiscal expansion, and job creation. However, recovery in the euro area and Japan stalled somewhat in the early part of the year, prompting slight downward revisions to their 2018 growth projections. The US and euro area are expected to gradually normalize monetary conditions to preempt inflation.
Developing Asia has enjoyed a good run since the Asian financial crisis (AFC) of 1997-1998, and weathered the global financial crisis (GFC) of 2008–2009. Growth in developing Asia continues to hold up against external headwinds. Our experts affirm that Asia’s developing economies - from the Pacific to the Central Asian countries - are projected to grow strongly, by 6% in 2018 and 5.8% in 20191.
Underpinned by prudent financial restructuring and fiscal reform, sound domestic macroeconomic fundamentals2 and improving external conditions3, developing Asia is the engine of the global economy and now accounts for more than 60% of global growth.
Despite generally benign economic conditions, however this momentum is not assured, due to heightened uncertainty in the external environment4.
As advanced economies normalize their monetary policies, new pockets of vulnerability—such as volatile capital flows, elevated debt levels, large and unexpected changes in exchange rates, sharp housing price increases, and contagion between economies—are risks the region must monitor closely5.
Moreover, escalating trade conflicts and rising protectionism, stand as sources of downside risk. The higher oil price6, too, – though mirroring economic recovery as well as some geopolitical tensions – poses a threat to inflation as well as to the current account balances of some large oil-importers. Other risks include economic disruption from geopolitical events, natural disasters, and social and political instability.
Appropriate policy must be implemented carefully to manage these multiple risks, but favorable results require careful coordination at both the domestic and cross-border level. Continued efforts are needed to promote prudent central bank governance, strong financial sectors, and adequate safety nets.
Developments in the reserve management area
Let me now move to significant developments in the reserve management area over the past decade.
Foreign exchange reserves have a central place in the monetary and foreign exchange policy toolkit of most economies. The notion of international reserves has expanded dramatically beyond exchange rate management. Financial crises, from the Asian Crisis of 1997-98 to the 2008-2009 Global Financial Crisis, saw international reserves being utilized as a buffer for supporting foreign exchange exposures of the whole economy, whether public or private sector.
In April 2015, the International Monetary Fund identified five reasons for holding reserves:
(1) to engender confidence in the currency;
(2) to counter disorderly market conditions;
(3) to support monetary policy;
(4) to facilitate inter-generational transfers, and
(5) to influence exchange rates7.
Further, market observers (investors, international organizations and credit rating agencies) have increasingly monitored international reserves as a gauge for a country’s creditworthiness and stability as central banks are being relied on to act as ultimate backstop for the economy and financial markets. Thus, reserve adequacy discussions have become broader and more complex.
And as the notion of international reserves expands, so does the scale of international reserve accumulation. According to IMF data, global holding of reserves grew dramatically from 2 trillion US dollars in 2000 to roughly $11.5 trillion today, with the surge primarily driven by emerging market economies. And as reserves grow to unprecedented level, central banks have had to cope with larger balance sheets and any associated risks that may potentially arise.
Further, over $8 trillion of assets are held by sovereign funds8 and other state investment agencies beyond the central banks.
With regards to operating environment, reserve managers are facing a number of novel challenges and issues.
Unconventional monetary policies by the world’s major central banks is one, having resulted in a low-yield environment, and in a few advanced economies, even negative interest rates.
It remains true that central banks focus on the traditional reserve portfolio objectives of preservation of capital and maintaining liquidity. However, with sharp growth in reserves, central banks have been steadily looking at investment returns. In the pursuit of higher yields, traditionally conservative reserve managers are exploring new investment avenues and have diversified into other fixed income asset classes, such as
- high-grade corporate bonds,
- second tier developed markets and
- high yield developing market government bonds.
In addition, many central banks have invested in equities9 and exchange traded funds.
For some nations with growing reserves, sovereign wealth funds are essentially a part of the tranching process, under which those responsible for central bank reserve activities assign reserves into different tranches with varying risk, liquidity and return criteria, depending on the perceived overall level of reserve adequacy.
Allocations to the Chinese Yuan have been supported by its inclusion in the IMF’s SDR and with PRC’s continued rise as a dominant player in the global economy there is growing momentum to include the Yuan in global portfolios. The Yuan’s prospects will be shaped by domestic policies, especially those related to financial market development, exchange rate flexibility, and capital account liberalization, factors that reserve managers will need to monitor and assess.
Across the globe, investors are pondering their asset universe in the search for yield, thereby further suppressing investment returns to the level insufficient to compensate for the risks undertaken. This, together with abundant liquidity in the global financial system which is now being withdrawn, could impact the risk/return profile of financial assets sooner than markets expect.
Ladies and gentlemen,
Given the ever-expanding role of international reserves, endless debates over reserve adequacy, and the dynamic operating environment, managing reserve management is a demanding vocation.
With issues like asset universe, investment approach, risk management, and governance requiring constant consideration and assessment, effective and sound management of foreign exchange reserves is therefore of key importance.
Your role as foreign exchange reserve managers is now becoming more critical.
ADB’s role in developing local currency bond markets
Let me now turn to ADB’s role in developing the local currency bond markets.
Asian financial systems remain bank-dominated and heavily reliant on US dollar denominated debt instruments. The region’s continued foreign borrowing and reliance on foreign portfolio investment flows remain a primary source of risk. Combined with weak macroprudential regulations, high debt levels and imbalances between foreign assets and liabilities could make Asian economies vulnerable to sharp capital flow reversals10.
As such, it is important for Asia to continue to further develop its capital markets. A study by ADB in 2017 on the lessons learned 20 years after the Asian Financial Crisis stressed that the continued development of local currency bond markets across the region remains pivotal to mobilizing long-term finance. In addition, the study drew attention to the need for greater regional cooperation efforts to reinforce regional financial safety nets for financial resilience11.
I am pleased to highlight that ADB is committed to supporting initiatives that broaden and deepen local currency bond markets in the region. ADB has not only been a pioneer issuer in the regional markets, serving to attract foreign investors, setting new benchmarks and introducing best practice but has also used its considerable resources to support the development of financial markets through program lending and technical assistance. ADB has played a role in developing both onshore and offshore markets.
To share some examples of successful financial markets development, I will, of course, start with Armenia:
In August 2018, ADB raised AMD2.66 billion (about $5.4million) from a new issue of a 5- year fixed rate offshore Armenian dram-linked bonds. The transaction represents ADB’s first fund raising in Armenian dram and marks another landmark in ADB’s strategy of delivering local currency funding in developing countries.
Another innovative approached was adopted in Kazakhstan with the support of the government and the central bank, where ADB has been able to source local Kazakhstan tenge currency through a cross currency repurchase facility. This has been a first for ADB, but it certainly has its applications in a post-crisis country where the financial markets are still developing. There could surely be opportunities to replicate this structure.
Apart from this, ADB supports the Asian Bond Markets Initiative, commonly known as ABMI, under the ASEAN+3 framework. The ABMI fosters the development of local currency bond markets following a regional approach.
Ladies and gentlemen, over the next 2 days, you will hear from distinguished experts on reserves management. I hope that you can take away important concepts and lessons that will help your institutions efficiently manage your reserves. I encourage you to share your thoughts and ideas.
In closing, let me again express my sincere appreciation to the Central Bank of Armenia and ADB’s organizing team for arranging this important forum.
I wish you all a productive and successful forum.
1Healthy domestic demand reinforces regional prospects detailed in Asian Development Outlook 2018. The September 2018 ADO update maintains that while the region is expected to meet the Asian Development Outlook 2018 forecast of 6.0% growth in 2018, the projection for 2019 has been trimmed by 0.1 percentage points to 5.8%. Excluding Asia’s high-income newly industrialized economies, the region is expected to expand by 6.5% this year and 6.3% in 2019.
2The region’s macroeconomic fundamentals improved with its moves toward greater exchange rate flexibility and central bank independence, and with its implementation of financial and fiscal reform. When the GFC struck, Asian economies were able to endure its impact with timely fiscal and monetary countermeasures to stimulate growth. The PRC’s large fiscal stimulus, in particular, supported the region.
3Rapid growth in the volume of global trade before the GFC provided strong external demand for Asian exports. After the GFC, unprecedented easing of monetary policy in the advanced economies, in the form of sustained low interest rates and sizeable direct asset purchases by central banks, sent investors in search of higher yields and, consequently, large-scale capital flows into developing Asia. This fueled credit growth in the region that further supported the good run and boosted asset market valuations.
4As the US and other advanced economies unwind their asset purchase programs and normalize their interest rates, the end of the era of super-low interest rates could reverse capital flow heretofore into the region.
5Net capital inflow to developing Asia increased rapidly post-AFC, reversed sharply during the GFC, rebounded quickly in the GFC aftermath to reach a peak of $391 billion in 2010, and declined from 2013, after which outflow started to outpace inflow. Emerging economies are susceptible to steep currency depreciation caused by financial shocks, the extent of the pressure determined partly by their dependence on short-term capital. The ratio of debt to GDP in Asia stood at 186% in 2016, driven mainly by a rapid accumulation of private debt, which increased in the preceding decade by over 60 percentage points in an environment of low interest rates, strong growth, and financial deepening. Analysis showed escalating ratios of house purchase price to rent in major Asian cities, notably in Hong Kong, China; Malaysia; the PRC; the Republic of Korea; and Taipei,China. Asian trade and financial markets have grown in the past 20 years in both absolute and relative terms, with deeper integration both globally and within the region.
6Commodity traders Trafigura and Mercuria said Brent could rise to $90 per barrel by Christmas and pass $100 in early 2019, as markets tighten once U.S. sanctions against Iran are fully implemented from November.
7The International Monetary Fund.2015. Assessing Reserve Adequacy-Specific Proposals. Washington DC
8Source: Sovereign Wealth Fund Institute. https://www.swfinstitute.org/sovereign-wealth-fund-rankings/
9Swiss National Bank, Bank of Korea and Bank of Israel have invested in equities.
10ADB Brief no. 85, September 2017.
11ADB Brief No.85, September 2017.