The Bank of Mauritius’ (BoM) 2024 report has attracted media attention for its reported profit of MUR 3.3 billion and its income strategy to diversify risks within its international reserves portfolio. However, these profits might be engineered paper profits rather than actual gains. This article will explore best practices in Central Bank Reserves management and examine how BoM generated these profits along with their implications on everyday lives.

Reserves Management Best Practices: The Mandate and Governance

Reserves management for central banks involves using a semiactive strategy prioritizing liquidity, capital preservation, and return as per BoM Act section 45-2. Portfolios are divided into tranches – working capital, liquidity, and investment – sized based on quantitative stress tests to ensure ample liquidity during shocks. The strategic asset allocation is approved by a knowledgeable Board and implemented by an asset management team who may partly outsource some portion of the portfolio to external managers. Modern central banks have adapted to changing macroeconomic conditions, diversifying into multi-asset strategies like multi-sector fixed income, global equities, real estate, alternatives, and gold. Advanced central banks, like the Swiss National Bank, use diversification to mitigate FX risk while maintaining allocations to G7 Government Bonds, corporate bonds and global equities for improved risk-adjusted returns. Capital preservation and a factor-based risk management approach are essential, using quantitative tools to analyze portfolio risk and return. Liquidity in the corporate bond market can be dynamic especially during tail risk events. Relationships with liquidity providers are important for estimating portfolio liquidation under normal and stressed conditions. Central Bank reserve managers utilize various derivatives to rebalance the risk factor exposures of their portfolios or to implement specific tactical tilts. The risk budgets for these tactical tilts are approved by competent Investment Committees. Accounting frameworks are aligned to a business model that is akin to marking the portfolio to market.

The Income-Driven Strategy: Increased Liquidity and Credit Risk in the International

Reserves Portfolio The internally and externally managed international reserves portfolios have been managed using an income-driven strategy, focused on a short investment horizon aligned with the financial year vs a typical investment horizon of 3 to 7 years. The focus seems to be on maximizing interest income and dividends while minimizing marked-to-market variations, to inflate paper profits.

While global interest rates remained high during FY 2023/2024, the reserves management team likely overweighted the portfolio with higher yielding securities and other illiquid fixed-income instruments. These investments appear to have been classified as held-to-maturity/ held-to-collect. Financial reporting was also smoothed. In 2023, the Hold to Maturity Book increased vs 2022 levels at a time when the Fed was increasing interest rates but this conveniently reversed in 2024 when the Fed started to cut rates again. Holding bonds at amortized cost limits the ability of the central bank to intervene in the local FX market by selling more dollars and reduces the ability of the reserve management team to dynamically adjust risk factor exposures should market conditions have changed or should new opportunities arise.

This income-maximization strategy also increased an asymmetrical risk known as credit risk, which is measured by the spread between the yield of these securities and the risk-free rate. These securities would also have higher liquidity risk in stressed market conditions. The overall risk of the portfolio has likely increased significantly.

This income-driven strategy leads to concentrated risk factor exposures with over exposure to credit risk, which contradicts the diversification and risk reduction strategy outlined in the annual report. It raises the question of whether the Bank’s Investment Committee was appraised by a strategy so heavily concentrated in credit risk, especially in a high-interest-rate environment. (Credit spreads have been at historic lows, and more liquid instruments, such as US Treasury Bills and Agency Mortgage Backed Securities offer better risk-adjusted returns with near zero credit risk- AAA rating).

Moreover, the reserves portfolio seems to lack diversification factors such as growth and quality, which are typically harvested through global equity allocations. Global equities and bonds performed well in 2023/2024, which prompts the question of whether the previous management really took advantage of these favorable conditions. Strong performance relative to which benchmark? What was the level of tail and liquidity risk for returns marginally above treasuries?

Is the Income-Driven Strategy Suitable for the Complex Macro Environment?

Market conditions are deteriorating, with significant corrections in risk assets this week. The Atlanta Fed predicts a contraction in the US economy for Q1 2025. Stickier inflation, lower consumer and business confidence, public sector layoffs, uncertainty surrounding Trump’s trade policies, a hawkish Fed and geopolitical fragmentation are hurting global markets. As we enter a more volatile period with potential economic contraction, credit risk premiums are increasing, and the new income-driven strategy may not be well-suited to this evolving macro environment. Wider credit spreads could erode the value of corporate bonds, exposing the BoM to greater credit and liquidity risks. The accounting framework the BoM uses also handicaps reserve managers to dynamically adjust risk exposures. The BoM relies too heavily on the performance of gold in times of shocks and is unable to take advantage of market volatility.

Central Banks Are Different Animals

Unlike commercial banks, central banks operate under a distinct institutional framework, where their primary objectives are price stability, financial stability, and the preservation of the real purchasing power of the international reserves – rather than profit maximization. Central banks, having the exclusive right to issue fiat currency, cannot technically go bankrupt unless their liabilities are foreign. As such, a central bank’s financial performance should not be evaluated solely through accounting metrics. Negative equity does not necessarily undermine a central bank’s functionality, but it can damage its credibility in the market – For example, if a central bank that has negative equity is forced to print money to fund its liabilities then this would conflict with its main mandate of price stability.

Profit Engineering: Allowing Excess Liquidity Levels to Remain High

In January 2023, the BoM adopted a flexible inflation-targeting regime with a 3.5% annual target. However, it failed to absorb enough excess Rupee liquidity, causing a divergence between the interbank rate and the key policy rate. Despite the expansion of the monetary base from November 2019 to June 2024, the issuance of monetary policy instruments was insufficient, distorting interest rates and currency valuations. This divergence, coupled with the BoM’s failure to align monetary policy with actual liquidity conditions, created discrepancies in the exchange rate, with the official rate of the Mauritian Rupee (46.50) failing to reflect the true supply-demand dynamics. This approach focused on minimizing costs to inflate paper profits, conflicts with the BoM’s mandate of ensuring price stability.

Capital Gains, Interest Income, and the Profit & Loss Statement

In a recent letter to L’Express, former First Deputy Governor Mr. Kona defended the income-based strategy with key statements: capital gains are excluded from the profit and loss account; bank profits may not increase despite favorable market conditions; marked-to-market gains are allocated to the Special Reserves Fund (SRF); and the strategy aims to protect Mauritius’s sovereign credit rating.

However, Mr. Kona seems misinformed. Both Moody’s and the IMF raised concerns about the BoM’s independence, MIC’s asset values, and their impact on the BoM’s balance sheet. Fair value gains on investments are transferred to the Profit and Loss account, and Rupee depreciation is allocated to the SRF. Remaining paper profits of MUR 3.3 billion transfer to the General Reserve Fund (GRF) under the Bank of Mauritius Act. Both GRF and SRF form part of the BoM’s equity, and the BoM no longer distributes profits to the Government. What matters is total return, reflecting interest income, dividends, and Rupee value changes minus expenses, and the BoM’s ability to ensure monetary and exchange rate stability.

Inflated MIC Asset Values and the BoM Balance Sheet

The BoM holds various assets in the Mauritius Investment Corporation (MIC), and there are legitimate concerns about their valuation. These include busted convertible bonds with zero equity sensitivity, inflated land values, and an Air Mauritius stake via AHL with significant negative equity—posing risks to the BoM’s financial position. A mark-to-market evaluation by an independent and international expert could reveal substantial fair value losses, undermining the BoM’s reported level of equity.

Solutions for the Bank of Mauritius

The Bank of Mauritius must revamp its investment strategy, moving away from an income-driven focus to one that better aligns with its mandate and to its liabilities. The tail risk budget of the portfolio should be approved by the Board and be actively managed. The reserves portfolio should include more growth assets to increase reserves and equity over the market cycle. A review of the strategic asset allocation framework is necessary, as is an assessment of the accounting framework and business model.

Additionally, the BoM must adopt a dynamic approach to tactical asset allocation and control risk levels through overlays. The annual report should include a new section on Reserves Management, detailing portfolio performance and risk attribution.

Finally, the BoM must address its internal challenges. The Bank has lost many talented individuals due to its lack of attractiveness as a workplace and given a deep resistance to change by too many within the permanent establishment. Global markets won’t wait for the BoM to evolve. Public pension funds are also suffering in Mauritius because of poor management.

To better manage all the country’s public assets, a separate structure a la Norges Bank Investment Management, should be established as a subsidiary of the BoM away from internal dynamics and constraints. This would attract top global talent and be a professional manager of all public assets through segregated mandates. It is high time for policymakers to now deliver on the meaningful changes people voted for.