A practical alternative to 3-ball cascade in managing sovereign’s foreign currency position

Marco, an entrepreneur living in an emerging country, decides to set up a business. He has small amount of cash inherited from his grandmother, however it is enough only for working capital. So, he needs to borrow. But, there is a trilemma that Marco is dealing with (i) keep the cost of borrowing at minimum (ii) get a reasonable return on financial assets (iii) minimize the risk. Marco is aware of the challenges but thinks that he can optimize his position without dropping any of the balls, like a juggler. First, he decides to borrow in Euros with low cost Because interest rates and volatility are high in the local currency market. Next, Marco believes that he can raise return without putting his inheritance at risk by investing in US Treasury bonds. So, Marco should be happy with this strategy as he anticipates making less interest payments to his Euro loans and benefiting from the relatively high dollar interest rates for his assets.

What is wrong with this scenario? As any MBA student or CFA candidate can easily point out: Marco is exposed to foreign currency risk and there is a clear mismatch between his assets and liabilities. Indeed, in Marco’s case, risk can be mitigated by making some adjustments in his balance sheet or entering into swap transactions.

Surprisingly, in many countries the size and currency composition of international reserves and government debt, which are the largest portfolios in a sovereign’s assets and liabilities, do not match each other, similar to Marco’s own balance sheet. However, unlike Marco’s case, risk mitigation may not be as easy for the sovereigns.

Foreign Currency Composition of External Debt and International Reserves

^{Source: Cangoz, Sulla, Wang, Dychala (2019) A Joint Foreign Currency Risk Management Approach for Sovereign Assets and Liabilities}

In almost all countries, debt and international reserves portfolios are being managed by different institutions with different objectives and mandates. To this end, Central Banks manage international reserves ensuring that: (i) adequate foreign exchange reserves are available for meeting a defined range of objectives; (ii) liquidity, market, and credit risks are controlled in a prudent manner; and (iii) reasonable earnings are generated over the medium to long term on the funds invested as described in the IMF Guidelines for Foreign Exchange Reserve Management. On the other hand, the main objective of public debt management is to ensure that the government’s financing needs and its payment obligations are met at the lowest possible cost, with a prudent degree of risk, over the medium to long run. (WB/IMF Public Debt Management Guidelines).

Therefore, the traditional approach suggests managing a sovereign’s largest assets and liabilities in an independent way, based on the priorities of debt and reserve management. However, this approach may simply result in policy inefficiencies, and cost increases because of over-hedging or being exposed to unanticipated risks due to under-hedging. On the other hand, as suggested by Cangoz, Sulla, Wang and Dychala (2019), a joint risk management approach, supported by a well-organized governance structure, can improve risk management across sovereign balance sheet and increase national wealth.

A practical asset and liability management approach allows the debt management office and the central bank reserves management unit to optimize their portfolios separately in line with their mandates while mitigating the risks through setting up the following framework:

1. Coordinate reserve and debt management both at policy and technical level. The asset and liability management approach does not involve merging or combining debt and reserve management. On the contrary, the framework suggests setting up the risk, cost and return indicators based on each institution’s policy objectives and mandates.
2. Identify sovereign’s net foreign currency exposure through assessment of the balance sheets of central government and central bank. This process allows sovereigns to optimize their foreign currency position in line with several factors, such as currency composition of government’s revenues, foreign trade and capital flows.
3. Execute natural hedges matching the currency composition of foreign currency inflows and outflows, to minimize the amount of uncovered liabilities and the cost of hedging through natural hedges.
4. Adopt macro hedging to hedge asset and liability mismatches at the aggregate level to mitigate threats arising from macroeconomic events. Macro hedging also mitigates potential conflicts among institutions and functions involved in joint asset and liability management.

In practice, joint risk management approach works as follows: (i) The central bank sets the level of foreign exchange reserves and identifies the strategic asset allocation considering the defined range of its objectives. Meanwhile, the debt management office defines the desired debt portfolio, specifying the composition of local and foreign currency denominated debt and the currency composition of debt denominated in foreign currency. (ii) Debt management hedges the foreign currency risk in the debt portfolio in two ways, offsetting certain liabilities with revenues in the same currency or fixing exchange rates on portions of the debt using derivative market transactions. (iii) Debt management transfers any residual risk to the reserve management. (iv) Reserve management desk eliminates the consolidated risks around macroeconomic events.

The portfolio optimization model by Cangoz, Sulla, Wang and Dychala (2019) demonstrated that the joint risk framework tends to generate higher expected returns on excess reserves given the currency mismatches between assets and liabilities mitigated due to the execution of natural hedges in a consolidated balance sheet.  The joint risk management approach can further provide cost saving through low or no-cost natural hedges and internal swap transactions which do not involve counterparty risk, collateral exchanges or complex modeling.

It’s clear that external shocks on unmanaged net currency exposure may result in unanticipated costs and could have significant impact on the wealth of a country. Similar to looking at the assets and liabilities of Marco to address the mismatches, governments need to manage their risks by an overarching approach. To this end, the joint risk management framework suggest that a sovereign can benefit from executing natural hedges and macro hedging, hence mitigates foreign currency risk spanned across assets and liabilities. Furthermore, this approach also allows the sovereigns to tackle the trilemma by reducing the cost and maximizing risk-based return on excess reserves.