1. Monetary incentives and their effects: global dimension
Following the onset of the recent global economic crisis in 2020, the world’s central banks have taken decisive actions for supporting the aggregate demand and lending process by lowering the policy interest rates, purchasing assets in the market and expanding loans to financial institutions, business and government agencies.
In particular, the US Federal Reserve and the European Central Bank (ECB) have taken the following steps in terms of monetary stimulus:
- resumption of targeted long-term refinancing operations for banks (for loans to the corporate sector –TLTRO III program of ECB),
- launching pandemic emergency longer-term refinancing operations (PELTROs),
- introduction of special programs with negative interest rates entitled for the refinancing of bank loans to small business,
- launching or expanding existing asset purchase programs in the market (“quantitative easing” programs – QE),
- practicing the direct lending by central banks to reliable corporations (the Primary Market Corporate Credit Facility – PMCCF in the USA),
- launching the direct lending by central banks to municipalities and local governments (Municipal Liquidity Facility in the USA).
Expansionary monetary policy mediated the rapid growth of assets of the world’s leading central banks. According to Yardeni Research, the growth of the assets of the European Central Bank, the US Federal Reserve and the Bank of Japan for the year (from December 2019 to December 2020) was 52%:
- the assets of the balance sheet of the US Federal Reserve from March 4 to December 23, 2020 increased from USD 4.2 trillion to 7.4 trillion, or by 56.7%.
- the assets of the European Central Bank from March 6 to December 25, 2020 increased from EUR 4.7 trillion to 7.01 trillion, or by 40.0%.
As the global economy reduced production volumes, such processes meant an increase in uncovered money supply, inflating of “bubbles” in the financial markets and increased general instability of the global financial system.
One of the consequences of monetary expansion during the pandemic was emergence of negative real interest rates on highly reliable government bonds, and in the case of EU issuers – even negative nominal rates. As of January 15, 2021, the real yields on US Treasury bonds ranged from -0.25% per annum to -1.63%, and on German government bonds from -0.65% to -1.24% per annum (Fig. 1).
Fig. 1. Real interest rates on government securities of various maturities in the United States and Germany, % per annum (as of 15.01.2021).
Sources: Tradingeconomics, US Treasury, germany / government-bond-yield and own calculations.
The volume of global debt at the end of 2020 reached USD 277 trillion, or 365% of GDP. According to “Deutsche Bank Research”, the combination of high debt and monetary expansions in the future will contribute to the rapid transmission of financial shocks and more frequent emergence of financial crises (“The Age of Disorder – the new era for economics, politics and our way of life”).
2. The role of international reserves and standard requirements for their management
Under the instability of the global financial system, the role of international reserves is growing, and the adequate size of reserves provides a margin of safety and supports macro-financial stability. As of December 31, 2020, the NBU’s international reserves amounted to USD 29.1 billion. This volume, although covering almost 5 months of future imports, is 5.5% lower than a threshold ratio according to the IMF composite criterion. The difference between the actual and normative value according to this criterion – USD 1.7 billion – indicates the need for the National Bank of Ukraine to continue interventions to repurchase excess foreign currency in the market.
But in the face of increased currency and financial risks and growing global imbalances, the NBU’s policy should be aimed not only at accumulating sufficient reserves, but also at achieving their reasonable structure. The structure of reserves should not allow bringing the negative real yields on deposits or securities in which official reserves of the central bank are invested.
According to international standards, central banks should hold their reserves only in banks and financial instruments with high credit ratings. Traditionally, the main forms of external reserve assets for central banks have been foreign currencies on deposits / correspondent accounts in foreign banks and balances of investments in government securities on depository accounts. Under the rules of the IMF, the accumulation of international reserves is allowed in convertible foreign currencies, i.e. freely usable currencies for settlements of international transactions, SDR holdings, reserve position in the IMF and monetary gold. According to the IMF, monetary gold accounted for 11.5% of the world’s foreign exchange reserves of central banks at the end of 2018 (IMF Annual Report 2019, Appendix I).
3. Changing approaches to reserve management in Ukraine is the imperative of our time.
New challenges within the global financial system require a reassessment of the traditional benchmarks and a radical change in approaches to foreign exchange reserve management. In our opinion, the main challenges are:
1) increased instability of key currencies and emergence of negative real interest rates on bank deposits and AAA-rated government securities;
2) the growing role of gold and other precious metals as “anchors” of stability, which in most cases guarantee the preservation of their real value;
3) achieving the high yields on corporate bonds of reliable borrowers and the ability to bring the positive real yields when investing official reserves into the AAA-rated corporate bonds
Table 1. Nominal and real interest rates of different assets in USA in 1999-2020, per annum
|Corporate bonds ratedААА||10-year US Treasury bonds||30-year US Treasury bonds||Short-term US Treasury securities||Gold|
Source: Deutsche Bank “The Age of Disorder”.
In terms of yields on various assets in which official reserve funds could potentially be invested, Deutsche Bank Research revealed that in 1999-2020, the most profitable assets in the United States were gold and AAA-rated corporate bonds. In contrast, short-term US Treasury securities had negative real returns (see Table 1). In 2020-2021, the negative real yields of highly reliable government securities exacerbated even more (Fig.1).
As of the beginning of December 2020, the share of gold in the structure of Ukraine’s international reserves was only 5.8%, while at the beginning of 2014 this share was almost in two times higher (9.6%). The current share of gold in Ukrainian reserves also looks low compared to the world average (11.5%).
Therefore, taking into account the existing disparities and challenges, the following key areas of investment in international reserve assets of the NBU are:
- raise in the share of gold from the current 5.8% to 12-15% of the total value of international reserves;
- growing investments in AAA-rated corporate bonds issued by the corporates from the EU and the US, which have optimistic growth prospects and offer a relatively high nominal yields;
- alignment of the currency composition of deposits and securities in which foreign exchange reserves are invested with the currency composition of Ukraine’s public debt (currently excluding the hryvnia and SDR, the share of the US dollar is 72% and the share of the euro is 26.6%).
Adherence to these guidelines in the policy of management of foreign exchange reserves of Ukraine should ensure the preservation of the real value of reserves while increasing the volatility of international markets and the dominance of real negative returns in the markets of traditional financial instruments.
Scientific Director, the Growford Institute Tetiana Bogdan for Investgazeta.