Reserves to fund SWF?

Of substance and spirit

A good anchor in foreign exchange (FX) reserves management is Section 71 of the amended BSP Charter which provides that the BSP “shall endeavor to maintain at all times a net positive foreign asset position so that its gross foreign exchange assets will always exceed its gross foreign liabilities.”

As we wrote last week, the June 2022 gross foreign debt climbing to $107.7 billion and our aggregate FX reserves whittling down to only $100.9 billion should not suffice to raise those red flags. Not yet, anyway.

We have not reached that alarming disparity between our FX assets and FX liabilities, although such conflicting trends are risky.  One cannot imagine what awaits us as foreign debt continues to rise and foreign reserves sustain their decline at the end of the next couple of years when economic growth is seriously threatened by global recession and high inflation rates. We will likely struggle earning FX from exports, remittances and outsourcing business. It is possible to see more FX investment outflows exceeding those coming in, making more foreign borrowing necessary.

When growth supports business’ loan exposure only steady income stream is expected. This is not possible when the global economy stalls and market risks multiply. As of end-June 2022, our short-term foreign debt at $13.9 billion accounts for around 13 percent of the total. That could easily be called in. By denomination, some 56 percent or $60.6 billion of our liabilities pose some FX risks because they are denominated in the strong US dollar. Restructuring may be problematic as 27 percent or $28.7 billion of our liabilities are owed to multilateral institutions that disallow restructuring. Bondholders account for 35 percent of the total, or $37.6 billion. It would be disorderly if they get nervous and start selling our bonds at huge discounts.

These key risks should always nuance our appreciation of the results of the usual assessment of reserves adequacy (ARA) metrics. There is more beyond saying we have excess reserves for contingency purposes.

What are we doing with our “excess” reserves?

The BSP has been lending to the Fund since 2010 through the New Arrangement to Borrow (NAB) at SDR interest rate, relatively low as the Fund is triple A rated. The Fund also borrows via the Bilateral Borrowing Arrangement (BBA) and the Financial Transactions Plan (FTP). By participating in these global efforts to promote economic and financial stability, the BSP is also able to signal the country’s resilient external position, something that is positive for foreign investment and credit rating. At some point, total BSP lending to the Fund reached $2.4 billion.

Lending to the Fund keeps the BSP’s FX reserves steady. Only the reserves composition is changed.

The rest of the reserves are invested according to a set of investment guidelines formulated by the BSP Investment Committee that limits it to only investment-grade and highly rated financial instruments of non-residents. Foreign investment banks are screened and rated based on specific criteria to decide which among them may be mandated to manage a small part of the BSP reserves, a norm for other central banks. They run their own treasury departments to manage their FX reserves and conduct the usual open market operations for liquidity management.

Which makes it easier for advocates of establishing sovereign wealth fund (SWF) out of FX reserves. We see trouble if Congress decides to establish an SWF to invest in domestic industries, infrastructure projects and payment of the government’s foreign debt. The BSP itself has been absolutely clear in citing the Charter’s current “prohibition against development financing and the use of its capital and foreign exchange to support government development projects.” The lessons of the past involving the old Central Bank’s foray into development financing that led to its significant losses and rehabilitation are too fresh, too painful to be forgotten.

Infrastructure projects do not immediately yield revenue stream to restore any FX advances of the BSP. A negative event that would require the deployment of BSP reserves could compromise the availability of reserves and the ability of the monetary authorities to stabilize the financial market.

Using FX reserves to service the government’s foreign debt will result in FX outflow, a reduction in both the BSP’s net foreign assets (NFA) and domestic liquidity by the same amount. This is not growth friendly.

Even if the SWF is allowed to invest only abroad, there could also be rough edges to such an idea. One concern is national security given the size and motives of some SWFs. Another is the so-called non-commercial motives that could run counter to well-functioning, open and liquid global financial markets.

It is for this reason that the International Working Group of Sovereign Wealth Funds (IWG) was established in the spring of 2008 under the auspices of the Fund involving 26 member countries with SWFs. The idea was to develop a set of generally accepted principles and practices (GAPP) which was subsequently finalized as the 24 Santiago Principles.

As then IMF First Deputy Managing Director John Lipsky stressed, in September 2008 in Santiago, Chile, effective wealth management evolved to be “an important public sector responsibility.”

But since observance of these principles is voluntary, one is justified to be concerned about the possible mismanagement of SWFs. What happened to Venezuela’s FONDEN involving the reported disappearance of $145 billion, or even more recently to embezzlement of Malaysia’s 1MDB amounting to $4.5 billion, and involving no less than its former Prime Minister Najib Razak, should make us more circumspect about forming and running, especially an FX reserves-funded SWF for the Philippines.

A nightmare it could be.

 (Next week: SWF and budget “underspending”)