Central banks have moved heavily into higher-yielding investments since the 2008 financial crisis, according to new research, and industry experts see that trend continuing, led by Asia.
Some 15% of central banks’ holdings now sit in “unconventional” reserve assets – with 8.7% in return-enhancing bonds and 6.2% in equities – says a report by US fund house State Street Global Advisors and the Official Monetary and Financial Institutions Forum (see graph below).
The research is based on analysis of 30 of the balance sheets of the 35 biggest central banks, which jointly account for $10.7 trillion (some 80%) of the $13.3 trillion in global reserves. That group includes those of China, Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.
“While safety and liquidity [of reserve assets] remain the clear priorities, the focus on return has increased in recent years, contributing to the diversification of central bank reserve portfolios,” noted the report, which was released on Monday.
As interest rates and thus bond yields fallen to ultra-low levels in recent years, so even these most conservative of investors have sought higher yields by moving into riskier assets, beyond high-grade government and quasi-government bonds.
Anecdotal evidence suggests that before 2008, only five or six central banks held such investments, said the report. As of end-2017, 17 of the sample of 30 held return-enhancing bonds and 11 held equities.
Despite limitations – including rules that prohibit many central banks (such as the Reserve Bank of India) from holding equities and non-sovereign bonds – there has been “substantial evolution, if not revolution, in reserve management”, added the paper.
ASIA LEADING RISK BUILDUP
Asian central banks have generally moved quicker to adopt more risk in their reserves management because they hold by far the most excess reserves, said Pierre Ortlieb, London-based economist at Omfif and a co-author of the report. They built up a surplus of reserves after the 1997/1998 Asian financial crisis, he told AsianInvestor.
For the same reason, “they have adopted risk in higher quantities than in developed market central banks”, he said. For instance, Denmark is a fairly significant developed market holder of corporate bonds, as is Singapore, yet the Monetary Authority of Singapore eclipses the holdings of Danmarks Nationalbank in quantity and share of such assets.
And the trend towards building risk and diversifying into new assets is likely to continue, Ortlieb said. “In the prevailing low-yield environment it’s difficult to envision returns becoming less important to reserve managers.”
That’s particularly the case in Asia, given both the excess reserves there and the tendency among some central banks in the region to use their funds to support their currencies.
Gary Smith, London-based head of sovereign wealth funds and official institutions at asset manager Barings, echoed Ortlieb’s point: “I see this trend [to move into higher-yielding assets] continuing. There’s a great ‘follow my lead’ pressure in this space.”
Central banks don’t have clear individual liabilities like those of pension funds and insurance firms, so what their peers and regional neighbours do is more influential for them than for other asset owners, Smith told AsianInvestor.
He cited an example: “The reserve managers that have moved into equities in the past few years have done pretty well – and that creates pressure on the laggards.”
There is certainly scope for substantial further risk taking. Bank of Thailand in March 2017 received approval to invest into equities, said its latest (end-2017) annual report, while others in the region have not yet reached that point.
To make such moves, central banks are likely to use external fund managers for new asset classes, said Smith. “Asking a central bank’s government bond team to invest in corporate bonds is one thing; asking them to cover equities is quite another – that’s a big jump. For the first step, they will probably require external help.”
Meanwhile, there are variables that could affect the allocation of reserve managers. For instance, Asian central banks – particularly those along the Belt and Road route – have been building up their holdings of gold, Ortlieb noted; China and Kazakhstan are two notable examples.
This may be because China’s Belt and Road infrastructure initiative and the trade flows that accompany it are positive for the renminbi as a reserve asset, he said, so it also makes sense to hold gold as a safe haven or reserve asset.
Another potential factor could be opening up of China’s bond market to foreign investors, which will have a major impact on global holdings of Chinese debt, Ortlieb said. “It will be interesting to see how this affects the composition of reserve assets.”