By Sameer Sharma

Unlike many other central banks today, the Bank of Mauritius is still not very transparent when it comes to providing periodic information about its effectiveness and when it comes to managing the international reserves of the country. The purpose of international reserves in a country with a supposed floating exchange rate regime is to provide liquidity, security and returns, which in modern reserves management language means generating positive real returns over a full market cycle subject to a Board defined and quantifiable risk budget.

Central banks must manage their international reserves portfolios to essentially preserve their real purchasing power over a Board defined investment horizon subject to obvious liquidity constraints, given that central banks need to be able to defend their local currency in a period of excess volatility. Central banks outside of Mauritius typically manage liquidity risk by tranching the international reserves portfolio into working capital, liquidity and investment tranches. The sizing of such tranches is based on various tail risk measures of reserve adequacy, scenario analysis and stress tests.

The working capital tranche, for example, will typically contain cash and cash equivalents with durations that seldom exceed 2 to 3 months at worst. The liquidity tranche will typically have a duration that is similar to a US 1 to 3 year bond index, i.e. 1.4 years. The investment tranche is where the real return objective is typically met and the portfolio allocation of this sub portfolio will diverge depending on risk appetite, the investment horizon and return objectives. Competent Boards with a strong element of global markets experience are called to approve what is known as the Strategic Asset Allocation framework based on their risk (including liquidity risk) and return objectives over a certain investment horizon. Risk is typically measured in terms of expected shortfall or CvaR at the 95% level which is a tail risk measure which will also be liquidity risk adjusted. 

Competent staff look at the investment horizon on top of the global capital markets risk and return assumptions when designing and proposing the eventually Board approved Strategic Asset Allocation framework. The Board is accountable and must understand what they are doing. In many central banks, Board also appoints independent foreign advisors with extensive global markets experience in order to advise them on such technical matters.

Importantly, international reserves portfolios are simply lower risk investment portfolios, and such business models from an accounting stand point are akin to fair value through profit and loss (FVPL). There are obvious issues if one deviates from this concept when managing portfolios in dynamic global markets.

Diversifying asset allocations

Despite popular local belief, central banks have been busy diversifying their asset allocations and have been incorporating other asset classes beyond plain vanilla western Government bonds. The average asset allocation to non-traditional (for central banks) asset classes such as global equities, emerging market debt, asset backed securities and corporate bonds stood at 13% of total assets in 2023. Some central banks even invest in private lending structures, given the carry and favourable risk return trade-offs being currently experienced. Of course, the level of non-traditional assets in a portfolio will depend on the level of reserve adequacy which impacts the size of the investment tranche, risk-return objectives, long term diversification benefits of optimizing the portfolio mix and skill which includes adopting modern risk management practices.

Boards typically also approve the overall tactical asset allocation framework, but international reserves portfolio tilts vis-à-vis the strategic asset allocation benchmark (traditional benchmark or risk benchmark) are typically handled at the investment committee level. The day-to-day running and management of the portfolio is obviously left to seasoned portfolio managers, both external and internal. The idea of a tactical risk budget is to improve overall returns versus the benchmark over time. Outsourcing or no outsourcing, internal reserve managers must manage the entire portfolio holistically and tame risk factor exposures in order to manage risks and also take advantage of tactical opportunities.

Reserve managers must manage the entire portfolio holistically and tame risk factor exposures.

Many central banks, including the Bank of Mauritius (public knowledge based on annual reports), certainly invest part of their investment tranches via segregated mandates with external managers and even via Exchange Traded Funds (ETFs). However, central banks must all manage their risk budgets actively. This essentially means that central bank reserve managers must be able to understand risk factor exposures of their portfolios (both external and internal) and adjust these positions at the overall portfolio level via risk overlays and/or hedges. Yes, central banks use derivatives to manage the risk of their portfolios actively in order to maintain their risk budgets.

The less sophisticated central banks in Africa, for example, follow enhanced bond indexation where they manage their duration risk exposure versus the benchmark via bond futures or swaps. Central banks that carry credit exposures even invest in credit default swaps and can manage multiple risk factors via total return swaps too. Equity risk exposures can be actively managed via options on ETFs.

Mauritians may not be aware, but central banks manage billions of dollars and they do it professionally, at least outside of Mauritius. World Bank and Bank of International Settlement reserves management training programmes tailored to central banks in fact teach new reserve managers how to manage fixed income portfolios actively with derivatives.

From a governance standpoint, central bank Boards that want to adopt best in class governance practices publish annual investment performance reports that have no correlation with accounting entries in an annual report. These reports talk about risk and returns including various risk and return attribution reports. Central bank Boards are also accountable to Parliament in liberal democracies.

 In what currency should central banks report their return and hence risk metrics? In the currency that accounts for the largest share of the country’s external liabilities which for Mauritius includes imports, Global Business Companies, deposit foreign exchange composition and external debt. The US dollar by default plays a big role, and this is typical for most central banks. While all central banks publish accounting values in annual reports in local currency terms, this has zero to do with how performance and risk is actually measured. No one cares about international reserves in local currency unless one has a global reserve currency.

The Bank of Mauritius has a major forex liquidity problem itself.

This background on best practices above is critical before one analyses how the Bank of Mauritius has been managing the international reserves portfolio. The reality is that Mauritians are blessed with as little information as possible, but for those with a keen eye, it is possible to spot problems. An understanding of how the Bank of Mauritius has been managing the international reserves portfolio is critical especially when its foreign exchange interventions have become rare in an environment where local banks currently hold less than USD 100 million in excess forex liquidity (on top of their liquidity risk needs are themselves). The Mauritian Rupee has continued to depreciate and the spot market is currently very illiquid. In recent months in fact, the Bank of Mauritius has itself been buying USD via forwards rather than selling them. The right question for Mauritians to ask then is what is going on?

In a nutshell as shown in the Table which sources all its information from the central Bank’s forex liquidity templates and statistical bulletins, the Bank of Mauritius has struggled to manage portfolio risk in a rising global interest rate environment and has made significant unrealized losses surpassing USD 482 million in its fair value through profit and loss sub portfolio. These significant unrealized losses which account for the bulk of reserves portfolio variations between December 2022 (a pandemic period) and today would have had a significant impact on the level of equity of the central bank (it goes negative) had it not been for continued Rupee depreciation which artificially inflates the balance sheet.

Foreign Assets in MUR MillionsDec-22Feb-24Variation
Total International Reserves372,224,735326,825,305 (45,399,430)
Mark to Market FVPL Book MUR151,769,533123,704,483 (28,065,050)
Hold to Maturity Book098,458,560 98,458,560 
Fair Value OCI Book65,024,06020,226,754 (44,797,306)
Gold Deposits31,635,73537,337,893 5,702,158 
Cash & Cash Equivalents123,795,40747,097,615 (76,697,792)
Mark to Market FVPL Book USD Millions3,178.8192,697.182(482)
Gross International Reserves USD Millions7,796.2627,125.913(670)
Central Bank FX Borrowings-1,209.24-1,503.459
Central Bank FX Contingent Liabilities-1,733.966-991.582
Net International Reserves USD4,853.0564,630.872
(HTM+ Gold Deposits)/Total Reserves8.50%41.55%
(Borrowings + Contingent Liabilities)/Total Reserves37.75%35.01%

It is difficult for this author who has a reserves management background to know what kind of strategic asset allocation the Board has approved and what kind of tactical asset allocation the Bank of Mauritius team uses these days, but the losses are so significant that the risk profile is either not even looked at or mismanaged altogether. Why am I looking at the Fair Value Through Profit or Loss (FVPL) book, you may ask? Simply because while the Bank of Mauritius does not publish its return numbers for the overall portfolio, this book is not subject to redemptions and reallocations unlike the other books. Changes to the value of this book provide us a good gauge of how the Bank of Mauritius is doing without all the noises that impact other accounting books.  

We also see that as a reaction to the losses and balance sheet impact this could have in a rising interest rate environment globally, the BoM moved a large share of the portfolio from the Other Comprehensive Income (OCI) book into the Held To Maturity (HTM) book in an attempt to smooth balance sheet volatility. Today the Bank of Mauritius has MUR 98 billion equivalent in the HTM book. Why? Because it is likely pledging a large share of those assets as collateral for its borrowings and because it does not need to mark to market this accounting book.

Maintaining high levels of liquidity

So what is the issue? You cannot manage a reserve portfolio like an accountant in global markets and, more importantly, you lose your ability to be dynamic and take advantage of ever changing market conditions and, worse, you kill the liquidity of your portfolio. Remember that central banks need to maintain high levels of liquidity in their portfolios at all times.

Mauritius is blessed with many good accountants, but often the challenge is that they influence decisions in fields they are not qualified in. The front office is not the back office, but in Mauritius, such concepts are confused all too often. The Board of the Bank of Mauritius has more accountants and barristers than it has economists, and of course global markets experience is zero.  

Maintaining high levels of liquidity in the reserves portfolio is in the law! Currently more than 41.55% of the international reserves portfolio can be considered to be illiquid. This is why the Bank of Mauritius is busy buying dollars via forwards, increasing its borrowings and relying a lot on domestic banks placing their liquidity money at the central bank. The Bank of Mauritius has a major forex liquidity problem itself, which is why it cannot intervene frequently but lets the currency slide. It attempts to impose demand quotas and leverages moral suasion to try to smooth the slide.

The Mauritian government has significant contingent liabilities.

At the same time, fiscal policy in Mauritius is expansionary, and the economic model is one that is consumption driven (which stimulates imports). In layman terms, you have fiscal policy stimulating imports, which pressures the currency while at the same time the Bank of Mauritius is busy engaging in accounting gymnastics which are self-defeating and cannot sell foreign exchange in large amounts and in a consistent manner. The Bank of Mauritius needs to fix its liquidity problems before it can intervene in a credible way. Recall that the reserve adequacy metric of the international reserves portfolio is currently at 97%, less than the bare minimum 100% requirement (Assessing Reserve Adequacy metric) which is why the International Monetary Fund is asking the Bank of Mauritius to REBUILD external buffers meaning BUYING dollars, not SELLING them unless absolutely necessary.

If one now starts to also look into inflated domestic assets (Mauritius Investment Corporation assets) on top of the sorry state of the international reserves portfolio which has suffered significant losses (USD 482 million loss for Mauritius is huge and no joke), and then conducts a proper quantitative asset liability study which takes all risks into account, the Bank of Mauritius is severely undercapitalized and would need major revamps in the way it manages international reserves and in terms of how the government must fund the offboarding of overvalued MIC assets. Until we put the right people in the right places, until we put people with strong quantitative backgrounds and strong global markets experience and until we stay away from some accounting approach to portfolio management, we will not have a well-functioning monetary policy framework and nor will we be able to do magic with the currency.

Very few Mauritians currently grasp the extent of the problem. Complicated subjects like these are not well understood and are under-reported by the local media. There are also too many pseudo experts out there who have likely never even managed portfolios in global markets for major institutions. The Mauritian government has significant contingent liabilities, and our external buffers are not strong despite all the accounting gymnastics. We are not well prepared for tail risk events, and we need to act sooner rather than later.

Sameer Sharma
Sameer Sharma is a Chartered Alternative Investment Analyst and a Certified Financial Risk Manager.