Taylor Pearce: The Czech National Bank’s reserves are highly diversified across 34 portfolios. What was your experience diversifying your asset allocation over the past several years?
Jan Schmidt: There is a large number of portfolios which are dedicated to diversification as we have nine currencies currently. We can diversify the tactical approach to the management of the portfolio and diversify the managers themselves.
What initiates the diversification? In some cases, it’s a modelled analytical background. That was behind the equity portfolio as a diversifier to fixed income. Sometimes events drive diversification. Both are natural, but one kind of diversification is in our control. Others with external factors are not.
For instance, we saw credit risk after the 2008 financial crisis which led us to diversify from fixed income into equities. We had several downgrades of very important countries like the US and France. The downgrade of the US led us to diversify into Canadian and Australian dollars and the downgrade of France led us to diversify away from the euro into the Swedish krona.
Otherwise, we hired several external managers, which is a kind of diversification. We have four mandates, but the strategies are different. Two portfolios are more active, the other two are purely passive. The same could apply for anything else, even services – we also diversify the custodians.
Operationally, it is very difficult to manage so many portfolios. There are a lot of new things to do in new markets, new systems, new settlements. But also there is a limit to diversification. For everything above a certain limit, it is basically impossible to measure the diversification effects – nine currencies means that there are plenty of correlations between the bilateral currency pairs, and the same applies for assets.
TP: You mentioned that the CNB has significant exposure to equities. What is the reasoning behind that and what was your experience with equity exposure?
JS: Yes, the equity exposure is relatively large – 20% is a large exposure compared to our peers. Originally, the reason was to decrease the risk and keep the performance of the expected return more or less the same. For instance, this 10% equity exposure which we started with delivered the same expected return, while the value at risk would decrease, because of the low or negative correlations.
Over time, and taking into account external factors like bond yields dropping to zero or below zero, it increased the importance of equities as a source of returns. Between 2013-17 reserves increased by almost four times and we started thinking about equities as a source of return at the price of high risk. So, we gradually increased the portion of equities from 10% up to 20% of the reserves.
TP: Has the CNB’s experience of negative equity changed your strategic allocation to equity?
JS: Obviously negative equity is an important question internally. Externally, I think that the central bank can run its duties with negative equity or losses. We do everything we can to minimise the losses and, if they are on our balance sheets, to compensate them. The results are always designed to cover the losses from expected future returns.
Even if we had a positive return every year and were able to pay dividends to our government, we would still diversify into equities because we found that it is a natural hedge to fixed income and government bonds. That’s what I always say: the bonds are to be repaid by the government, so the government needs to be receiving taxes and the taxes usually come from corporates. So, the corporates must survive and deliver profits. This motivates us to own equities rather than government bonds to a small extent.
If the laws on negative equity didn’t exist, then maybe we wouldn’t be so aggressive in increasing the portion of equities in our reserves. With positive returns for the central bank, maybe this process would be slower. Maybe the pressure on the performance of our assets would be lower. But I don’t feel the pressure is material – we create it for ourselves. Of the losses we make, 99% are made in accounting when the reserves are valuated into domestic currency. Because the currency appreciates over time, it leads to negative performance. Regardless of what’s happening, the reserves are measured in a foreign currency.
TP: Last year, the CNB suffered losses. How have you adjusted your tolerance and are you taking on more risk to plug this gap?
JS: Yes, monetary policy has its costs. In our case, the cost is basically the current interest rate of 7% on our liabilities, which is too high for a developed country like Czechia. So, we believe that it will be not long standing with us. The other fact is that the assets, which are primarily euros and dollars, will never have such high yields. That’s something we have to consider as an external factor. This is motivation for searching for a higher return. On the other hand, the central bank lives on coupons and dividends. So, as long as the yields on bonds are high, the coupons are high and the performance of the reserves in the long run is high.
We could either believe that our own yields on our interest rates and liabilities will go lower, or the European Central Bank and Federal Reserve will increase the yields. The solution is not to increase the equities to 50%. But in the long run, the interest rate differential shouldn’t be that high.
Taylor Pearce is Senior Economist at OMFIF.
This article is an abridged version of an interview published in OMFIF’s 2023 Global Public Investor Report, which can be downloaded here.