3.6 Foreign exchange reserve management

In the subject of PSD2, in the extraordinary situation that evolved as a result of the pandemic, the MNB held various professional presentations and training courses as well as several consultations in cooperation with the Banking Association online as well.

The MNB’s international reserves increased by around EUR 5.3 billion in 2020, with holdings at the end of December 2020 amounting to EUR 33.7 billion. During the year, the level of foreign exchange reserves was raised by the ÁKK’s foreign currency bond issuances, inflows of EU transfers from the European Commission and the rise in deposits placed by domestic financial institutions. At the same time, disbursements by the state to repay debt, foreign exchange expenditures of the Treasury and the change in the central bank’s forint liquidity providing FX swap holdings mitigated the increase. For financing the euro liquidity providing swap tenders over year-end, the MNB used its framework agreements concluded with international organisations.

Purposes of holding reserves

Similarly to other central banks, one of the key tasks of the MNB – as specified in the MNB Act – is to manage the country’s foreign exchange reserves. The MNB holds foreign exchange reserves for the purpose of fulfilling several functions:

– to ensure the level of reserves expected by market participants (‘international collateral’),

– to support the monetary and exchange rate policy (providing intervention capacity),

– to provide foreign currency liquidity for the banking sector,

– and to meet the state’s transaction-related foreign currency needs.

In terms of transaction goals, servicing the management of government debt continued to be the most important objective in 2020. In addition, the continuous provision of foreign currency to cover the needs of budgetary institutions should also be mentioned. The transfers received from the European Union also flow through the MNB, and as in previous years, they boosted the foreign exchange reserves in 2020. The aforementioned transaction goals were met smoothly in 2020 as well. The MNB regularly reviews the desirable level of reserves and, if necessary, takes measures – within the permitted limits – to reach the adequate level. Throughout 2020, international reserves of the MNB exceeded the reserve indicators followed by the central bank and investors as well. Of these indicators, the MNB pays special attention to the Guidotti–Greenspan rule, on the basis of which the reserves considerably exceed the level of short-term external debt.

Reserve size

The level of Hungary’s international reserves rose by nearly EUR 5.3 billion in 2020 and amounted to EUR 33.7 billion at the end of the year.

New foreign currency bonds issued by the state had the largest reserve increasing impact in the period under review. In April, the Government Debt Management Agency (Ákk) issued 6-year and 12-year government securities series with nominal values of EUR 1 billion each, followed by a 15-year green bond with a nominal value of EUR 1.5 billion in June, a Samurai bond series with a total nominal value of JPy 62.7 billion and maturities of 3, 5, 7 and 10 years in September, as well as 10-year and 30-year bond issues with nominal values of EUR 1.25 billion each in November.

The EU transfers received from the European Commission in a net amount of EUR 4.3 billion and an increase of EUR 215 million in deposits placed by domestic financial institutions also contributed to the growth in the reserves.

These items were partly offset by the bond redemptions with original nominal values of USD 2 billion in January and EUR 1 billion in February, the Panda bond maturity worth RMB 1 billion in July as well as by the bond buybacks amounting to nearly USD 1 billion that took place in January and the foreign exchange expenditures of the Hungarian State Treasury.

The increase was further mitigated by the flows related to the FX pillar of the third phase of the Funding for Growth Scheme and by the change in a total value of EUR 2.3 billion in the central bank’s forint liquidity providing FX swap holdings.

For financing the euro liquidity providing swap tenders announced in the second half of the year, the MNB used its framework agreements concluded with international organisations.

Chart 10 Developments in the size of foreign exchange reserves

40 EUR Billions EUR Billions 40

35

30 35

30

25

20 25

20

15 15

10

Dec 2007 Jun 2008 Dec 2008 Jun 2009 Dec 2009 Jun 2010 Dec 2010 Jun 2011 Dec 2011 Jun 2012 Dec 2012 Jun 2013 2Dec 013 Jun 2014 Dec 2014 Jun 2015 Dec 2015 Jun 2016 Dec 2016 Jun 2017 Dec 2017 Jun 2018 Dec 2018 Jun 2019 Dec 2019 Jun 2020 Dec 2020 10

Financial performance and risks of foreign exchange reserves

In carrying out its core tasks as stipulated in the MNB Act and especially in the management of the country’s international reserves, the MNB inevitably faces financial risks. The basic principle followed by the central bank is that the degree of the assumed risks should be aligned with the objectives of the core activity, the size of the risks should be known, and risk assumption should be conscious and limited, in accordance with the institution’s risktaking capacity. In the course of foreign exchange reserve management, the threefold objective of liquidity, security and yield must be satisfied, meaning that the MNB strives to achieve the highest possible yield level while continuously keeping the risks at a pre-defined low level and maintaining the necessary liquidity.

As is the case with the other core duties of the central bank, the Monetary Council of the MNB is the supreme decision-making body in respect of foreign exchange reserve management: it defines the objectives and requirements related to the foreign exchange reserves such as the level and liquidity of the reserves, decides on the currency used for optimisation, the risk strategy and the most important quantitative strategic parameters of reserve investment. The operative decision-making powers are exercised and the foreign exchange reserve management strategy is implemented by the Executive Board of the MNB, within the framework stipulated by the Monetary Council. The Executive Board approves the limit system serving as a framework for risk taking: the permitted maximum deviation of the reserve portfolios from the benchmarks, the counterparty limits and the range of investment instruments permitted in the field of reserve management. The benchmark system and the limit system comprise the two main pillars of reserve management. Independent performance measurement is an important element of the risk-taking policy. In order to measure the success of portfolio management, the performance of each reserve portfolio is compared against the performance of a reference (benchmark) portfolio. The benchmark portfolios show the yield that would have been earned by a passively managed portfolio representing a wide market segment with the same investment parameters. The performance of the foreign exchange reserve management activity is presented in comparison to these benchmark portfolios. The benchmarks reflecting the riskreturn preference of the MNB and serving the performance measurement of the portfolios are maintained by the risk management unit, independently of portfolio management.

The most important risk categories related to foreign exchange reserve management comprise market risk, liquidity risk and credit risk (settlement risk and counterparty risk). The MNB controls the possible degree of financial risks related to foreign exchange reserve management with limits. In accordance with the conservative reserve portfolio management characteristics of central banks, the MNB applies a strict limit system, which considers market and other indicators, in addition to the expected high level of credit ratings. In the course of reserve management, the MNB also considers the foreign currency liquidity requirement of the monetary policy instruments.

In the course of foreign exchange reserve management, the MNB employs a variety of risk-minimising techniques to ensure that the assumed risks correspond to the MNB’s risk tolerance. In the case of derivative instruments, the MNB concluded ISDA (International Swaps and Derivatives Association) and related CSA (Credit Support Annex) agreements with its counterparties, which keep the credit risk exposure potentially arising in respect of the counterparty at a low level through the margin arrangement. In the case of repo transactions regulated by GMRAs (Global Master Repurchase Agreement), the prescribed margin also helps to limit the risks. In the case of foreign exchange transactions, in accordance with international best practices, the MNB settles its transactions in the CLS system, thus minimising its settlement risks.

In the first years following the global financial crisis that erupted in 2008, in view of the declining yield environment and the resulting typical rise in the prices of bonds held in central bank portfolios, most central banks realised profits on the FX reserves. With government bonds and other bonds generally featuring high credit ratings in its portfolios, the MNB also benefited from this process through the revaluation of the positions, as a result of the decreasing yield environment. In

the ensuing interest rate environment, which was close to zero or even negative in certain markets, the largest challenge faced by the central bank in reserve management was to ensure capital preservation. In the period immediately prior to 2020, several central banks ended or slowed down their easing measures in the field of monetary policy, but as a result of the coronavirus crisis this trend stopped in 2020, and central banks clearly shifted towards easing again. Fiscal and monetary policy decision-makers introduced measures of various types and degrees to mitigate the negative economic impacts of the coronavirus. In March 2020, at its two extraordinary meetings the Federal Reserve reduced the base rate by 50 and 100 basis points, respectively, into the band of 0–0.25 percent, and increased its assets purchases within the framework of its announced crisis mitigation and liquidity expansion programmes. The ECB left the policy rate unchanged, but at the same time it also increased its asset purchases further through its various programmes.

As a result, a major decline in yields was observed in many of the markets relevant in terms of reserve management in 2020. During the reporting period, there was a parallel downward shift in the yield curve in the euro area: yields in the segment within one year declined to different degrees by maturity, but typically fell by 5–10 basis points, whereas they dropped by 10–50 basis points in the segment over one year. yields were in negative territory for all relevant maturities at the end of the year. yields on US government securities fell by 1.5 per cent, with close-to-zero yield at short maturities. volatility increased as a result of the crisis, and swap spreads expanded significantly in March before normalising.

Credit rating agencies downgraded several issuers, which only affected the MNB’s foreign exchange reserves to a minimal degree due to the conservative investment principles. In addition, the price of gold increased significantly during the year in view of geopolitical uncertainties, the rise in central bank demand and the coronavirus crisis. In 2020 H2, the price of gold in USD reached a peak unseen for years. As for the EUR/USD exchange rate, a continuous weakening of the US dollar was observed in 2020 (from 1.12 to 1.23).

In early 2020, the MNB was prepared to manage the intense uncertainty caused by the pandemic. The level of FX reserves significantly exceeded the value of relevant indicators. In addition, the MNB created an international safety net consisting of bilateral swap and repo agreements, representing additional FX liquidity (foreign exchange liquidity may be increased by as much as EUR 10 billion within a short time) and expanding the leeway of the central bank, while maintaining the safe level of international reserves: – repo agreement with the European Central Bank,

– repo agreement with the Bank for International

Settlements,

– access to the repo facility announced by the Federal

Reserve,

– currency swap agreement concluded with the People’s Bank of China (PBoC) in 2013 and renewed several times.

Continuously monitoring the developments representing a risk to the reserve level, the MNB – similarly to most central banks – regularly revises the reserve investment framework. In line with the reserve holding objectives and bearing in mind the conservative investment framework, the MNB continued to diversify its investments in 2020 and took steps to reduce other risks related to foreign exchange reserves.

– In January 2020, the MNB decided to create a Central

Eastern European government securities portfolio, which contains Czech and Polish government securities.

Government securities issued in the given country’s own currency may be purchased in the portfolio. Following its creation, the portfolio continues to be managed in a passive style.

– In 2020, the MNB paid special attention to the developments resulting from Brexit, taking account of the central bank’s GBP exposure and the wide range of partners located in London and used in reserve management. Applying a proactive approach – limiting the execution of transactions with entities in London – from early 2019 the central bank initiated the novation of GMRAs as well as ISDA and CSA agreements with

Uk business partners and also other service provision contracts related to reserve management (portfolio management systems, futures account management, securities lending, MBS asset management activity and trading platforms) to entities in continental Europe. While continuously monitoring developments, the MNB took the necessary steps to minimise the related risks.

In 2020, the MNB basically managed foreign exchange reserves in 8 currencies (EUR, USD, JPy, GBP, AUD, RMB, PLN, Czk), in a variety of portfolios. The MNB assumes exchange rate exposure basically in euro: it hedges the other currency/euro cross rate risks via derivative instruments. The holding of foreign currency instruments denominated in currencies other than euro is justified by the greater diversification and, in the case of the US dollar, the higher liquidity available. Altogether, the MNB actively manages 8 portfolios in euro, US dollar, British