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Speeches & Transcripts October 6, 2016

Navigating the Multicurrency Reserve Environment

Good morning, let me start by thanking all of you for coming to this forum.  We have an early start and your presence here today reflects how topical the subject is.

I would also like to thank OMFIF for partnering with the World Bank Treasury for organizing this timely discussion.

As many of you know, these are no ordinary times. The ability of central banks to utilize conventional and even unconventional monetary policy tools is being tested. Some new tools, such as negative rates and macroprudential policies, have already been introduced and others are in the making. At the same time, the risk of unexpected political outcomes has increased, and events like Brexit remind us that low probability events may now occur frequently.

Economics textbooks are being rewritten. I never studied negative interest rates. Global capital markets are being transformed. In this “brave new world” – or “new normal” or “new mediocre” as some have called it - we are faced with increased regulations, lower returns and evolving role of central banks. Reserve managers are today confronted with even more formidable challenges than a typical asset manager as they operate in a multicurrency environment and have to adapt to each market as well as to the increasing linkages and interdependences between markets. We, at the World Bank, serve many of you in different capacities and I thank you for your trust, including managing your assets. We all face similar dilemma.

Therefore, what I thought I would do today is, first, share with you some of the challenges that keep us alert and then, tell you about our strategies to address them. Finally, I will touch upon some emerging trends that may present opportunities going forward.

From our perspective, and what we hear from you as well, the main challenges on the investment side are decreased investment opportunities and low expected returns on financial assets. As some of you are no doubt aware – I may add painfully aware - there is a shrinking supply of high grade fixed income instruments due to unprecedented quantitative easing (QE) purchases by major central banks and high investor demand, which is partly driven by regulatory changes.

Major central banks have been on a buying spree of financial assets to implement unconventional monetary policies and stimulate their respective economies. Some commentators are already wondering if central banks are becoming buyers of first resort!

The BoJ has been buying assets at a rapid pace with no short term plans to stop. It has already bought about 30% of Japan’s government debt, and with the current momentum, it is on track to own about half of the Japanese bond market in two years or so.  The ECB has also been actively purchasing EUR-denominated fixed income instruments. At the current pace of purchases, it may run out of some eligible types of bonds in 18-24 months. The BoE restarted its easing policies in August by reinstituting QE with purchases of government and corporate bonds. The U.S. Fed is the only major central bank which is currently not in active QE mode but still has more than 4 trillion of bonds on its balance sheet.

These policies have led us to increasingly unsustainable valuations and consequently lower yields and returns for investors – with possibility of a shock when markets turn.

Widespread negative yields is another challenge faced by us all. In the government bond market, negative yields are now a global phenomenon. There are now more than USD 8 trillion worth of government bonds with negative yields. This amounts to over a third of the industrialized countries’ sovereign bond universe. Recently negative yielding bonds indeed reached a new ‘milestone’ – if I can call it that - when Henkel (household products maker) and Sanofi (pharmaceutical company) became the first public companies to sell euro bonds to investors for more than the buyers will get back (Henkel and Sanofi set new milestone with negative yielding bonds, FT, September 6, 2016).

Government bonds is not the only low-yielding asset class for global investors. Lower sovereign yields affect valuations of all developed market asset classes and make ex-ante returns unattractive. For example, reports from the likes of McKinsey and BlackRock claim that “total returns from both stocks and bonds in the United States and Western Europe are likely to be substantially lower over the next 20 years than they were over the past three decades.”  (“Diminishing Returns: Why Investors May Need to Lower Their Expectations” McKinsey Global Institute, May, 2016) Indeed we need to adjust our expectations!

And funding ratios of pension funds are among the worst hit by the challenge. Many public pension funds have to address the gap between expected investment returns and projected pension liabilities. Last year, several large, high-profile public defined benefit (DB) pension plans have either lowered their long-term return assumptions or indicated an intention to do so. For example, the $184bn New York State Common Fund lowered its assumption to 7.0% from 7.5%  and the roughly $300bn California Public Employees’ Retirement System (CalPERS) approved a plan to gradually reduce its assumed rate of return to 6.5% from the current 7.5%. Several corporate pension plans have also been lowering their expectations, such as Boeing and Macy’s, each reducing its long-term target from 7.5% to 7% (“Seven is the New Eight” Goldman Sachs, 2015). As has been said “7 is the new 8” and even that recalibration may not be sufficient. Going forward emerging market assets (across both equities and fixed income) look relatively attractive both from a fundamental (higher expected economic growth rates) and valuation perspective if one can manage the currency dynamics.

At the World Bank, we are continuously striving to develop solutions for our clients and help them navigate this difficult environment. At the World Bank Treasury, we manage about $170 billion on behalf of the Bank Group and its clients. Our investment teams are also facing the challenges of declined liquidity and low returns and have been working tirelessly to find risk-return optimal solutions. Let me give you some examples of the strategies that we employ.

On the strategic asset allocation level, we have diversified into new markets and new instruments to enhance returns. We invest in selected Emerging Market sovereign government bonds and recently built up our exposure to China. We also invest in derivatives-based strategies that allow us to capitalize on global market dislocations and USD shortages and transform negative yields in Europe and Japan into positive returns in USD while outperforming prevailing USD money market rates. Because of our conservative policies and high liquidity levels, we can also take advantage of market opportunities which become available due to ongoing regulatory changes. Furthermore, our focus on cost optimization led us into the direction of seeking alternatives for repo transactions, as the traditional counterparts, such as dealers and brokers are facing difficulties due to deleveraging and disintermediation. By transacting directly with asset owners, such us insurance companies, money market funds and university endowment funds, we not only maximize returns but also minimize credit risk.

Our pension team, which manages assets with a long investment horizon, has sought to gradually reduce exposure to government bonds in the fixed income space and has increased our allocation to the investment strategies that are either less sensitive to a potential rise in rates or that present attractive opportunities due to changes in the structure of the financial markets. As an example, we have increased exposure to opportunistic private direct lending strategies in the US and Europe.

As asset managers, we understand that navigating these challenging economic times requires the highest level of investment expertise, effective governance, and risk management. It also requires strong communication – internally and externally – and constantly refreshing our skills. Therefore, we constantly support our clients, public asset managers, by building their institutional capacity in all relevant dimensions. The Reserves Management and Advisory Program (RAMP) run by my Treasury team has grown organically from a handful of central banks in 2001 to 61 official institutions at last count, including sovereign wealth funds and national pension funds. Each year we run about 25 workshops around the world, with topics ranging from investment policy to portfolio management to operations and accounting.  By educating senior decision makers and staff and building technical capacity, we contribute to better investment decisions, which in turn leads to better economic outcomes for our member countries.

Through our funding activities – and I will be very brief – we provide opportunities for investments in fast disappearing AAA rated asset class. The World Bank Group has done significant work to support a global multi-currency environment and provide its investors with more diversified investment options. Since 1947, the Bank has issued its bonds in over 56 different currencies and just in FY2016 we issued in 22 currencies. 

In particular, I emphasize that the issuance of local currency bonds is a ‘win-win’ for us because we not only contribute to our development mandate by adding product and credit diversity to domestic capital markets but also lower our borrowing costs by reaching out to a wider investor base. In this regard, in August the Bank issued the first ever publicly offered SDR-denominated bond, which was also the first bond for the World Bank in the China onshore interbank market. The bond issue – Mulan bond - raised SDR 500 million (approximately equivalent to USD 700 million) and was 2.5 times oversubscribed with around third of the offers (29%) from central banks and official institutions providing SDR based investors with a unique value proposition.

Our bond issue in SDR relates to the ongoing trend of the globalization of RMB. According to our recent client survey more than 40% of reserves managers have some allocation to RMB and others are considering it in the future. As you know, effective this month RMB is included in the IMF’s SDR basket. The SDR basket is now comprised of 42% USD, 31% EUR, 11% RMB, 8% GBP, 8% JPY, so the RMB has the third largest weight. This is a historic change. The last time SDR currency composition was modified was approximately 17 years ago when the Euro replaced the French Franc and Deutsche Mark. A more inclusive SDR composition creates new opportunities to extend its role in the global financial system. SDR-based instruments could be a good diversifying asset or a liability hedge in the current multicurrency world.

Another important trend that we see is in the area of risk management solutions at the country level. Perfecting the management of foreign reserves is not good enough as there are explicit and potential liabilities that could plunge the country’s economy into chaos. We believe it is critical to help our member countries to find practical ways to hedge their vulnerabilities related to commodity prices, natural disasters, or other weather events. Some solutions that we are currently working on include the application of an ALM approach to a sovereign balance sheet. Coordinated actions between reserves and debt managers can minimize financial risk and cut costs.

Lastly, I would like to reflect on the information technology trends that some have called the "fourth industrial revolution" and that are already starting to shape the future of asset management. It is well known that information is power, but for centuries data had been scarce and hard to collect. However, in today's digital world data is becoming increasingly abundant. The unprecedented availability of data has led to innovative analysis and new technologies. Let me share just a handful of fascinating examples that foreshadow the investment management of tomorrow:

In a 2013 paper, a French academic demonstrated the impact of information demand on liquidity in the French stock market. Using Google web searches as a proxy for "information demand", he found that adding search volume to a model of turnover in the French stock market improves out-of-sample forecast performance. Furthermore, higher search volume was positively and significantly correlated with liquidity.

Another paper used an index of investor sentiment based on Facebook's Gross National Happiness (GNH) measure, which is calculated using textual analysis of emotion words posted on Facebook. The author built an econometric model and found that Facebook's GNH predicts changes in both daily returns and trading volume in the US stock market.

Some investment analysts already take advantage of low-cost satellites to parse millions of images a day. For example they look at car parks outside retailers such as Walmart to get a sense of daily revenues, or they estimate the size of oil stocks by looking at the lengths of shadows cast by oil tanks in satellite pictures (apparently the height of the roofs of most crude-oil tanks varies depending on how full the tank is).

Blockchain, is a decentralized public ledger of transactions that no single entity owns or controls and every transfer of funds from one account to another is recorded in a secure and verifiable form by using mathematical techniques borrowed from cryptography. By using this technology, individuals can sell real estate, event tickets, stocks, and almost any other kind of property or right without a broker. By some estimates, by 2022, Blockchain technology could save banks more $20 billion annually in costs. Some 50 big-name banks as well as IBM, Google and Microsoft have announced Blockchain initiatives. But perhaps the most important potential benefit of this technology is to help rebuild the trust which has evaporated after the global financial crisis among financial counterparties. The Blockchain can enhance security and protection of transactions by enforcing rules that equally apply to all counterparties.

Artificial Intelligence (or AI) is another example of emerging technologies that has the potential to transform the current asset management practices. The investment industry has long relied on computers and data scientists to build large statistical models and use them for trading. But AI programs go a step further by attempting to improve themselves over time -- mimicking the human brain's capacity for learning. This includes techniques such as evolutionary computation, which is inspired by genetics, and "deep learning", a technology now used to recognize images and identify spoken words. As you might have heard, there are already some hedge funds that rely on AI for making trades. In fact, according to a leading hedge fund database (Eurekahedge) since the start of 2015, twelve such funds have outperformed all other hedge funds (including during the Brexit-fueled market turmoil in June). This of course is not a statistically significant timeframe, but it highlights the increasing focus on the use of AI in investment management.

We face many challenging issues as I outlined earlier. Nevertheless, let us not forget about the long-term trends that I just mentioned, which might not be the pressing issues of today for central banks and public asset managers, but I believe, sooner rather than later, these trends will transform our industry. The World Bank Group, including our RAMP program, is uniquely positioned to help our clients navigate changing environment whether it be the inclusion of a new currency in the SDR or adaptation to emerging technologies. Our global reach, diverse partnerships, and convening power are part of our value-creating capacities and today's event is a good illustration of that.

In closing, I would like to thank again our partners from OMFIF for collaborating with us to organize this event. I wish you all a fruitful discussion. Thank you!