Like other asset owners in recent years, even central banks have struggled to achieve their (relatively low) target returns. Now the prospect of interest rates being depressed for years to come to support Covid-hit economies seems to have accelerated moves by reserve managers into riskier assets such as emerging market stocks and private equity.

“[The market environment] is making [central banks] realise that they have to change their mandates or guidelines quicker than before,” said Jahangir Aka, head of official institutions at US fund house Neuberger Berman. “Whether that’s to allow private equity or derivatives or whatever it might be, every single one of them is having to loosen up their guidelines in some way.”

Jahangir Aka,
Neuberger Berman

This is a trend among the “top tier” of central banks, London-based Aka told AsianInvestor: those with substantial surplus reserves that in many cases have already allocated beyond traditionally safe fixed income assets.

In Asia, that would include the likes of Bank of Korea, the Hong Kong Monetary Authority, Monetary Authority of Singapore, Bank of Thailand and Bank Negara Malaysia.

A growing number of central banks are investing into Chinese bonds, and some of the top-tier banks are buying stocks in China and other emerging markets, Jahangir said. Some of those that already have exposure to listed stocks are even “tiptoeing into” private equity via fund-of-fund strategies, he added, declining to identify any institutions.

“Reserves remain large, yields continue to drop, so reserve managers need to do something,” agreed Gary Smith, managing director at London-based consultancy Sovereign Focus.

Those that moved into equities soon after the 2008 financial crisis “have done pretty well”, he added. “Plus equity markets have bounced back very impressively after the Covid crisis, which has given people the confidence to continue the diversification move.”

In fact, one central bank in Europe has even allocated to a real estate fund a few years back, Smith said, declining to provide a name.

ACCELERATING DIVERSIFICATION

Such portfolio diversification has been a trend for a while, said Aka, but it has accelerated under Covid, given the expectation that rates will be lower for even longer than had been expected at this time last year.

“Some of these central banks – those with bigger balance sheets – have core cash flow, so can now invest,” he said. “They won't go longer duration on fixed income because that's not being rewarded. But they can get longer duration by going into alternatives, and that's starting to happen.”

A few reserve managers are going to run a barbell investment strategy, Aka said – that is, some passive or active equity exposure combined with alternative assets.

Of course, some countries have sovereign wealth funds they can rely on to invest their public assets in a less limited fashion, but others either do not or prefer to retain some of the surplus reserves within the central bank.

Gary Smith,
Sovereign Focus

In any case, a consistent pattern across Asia is that central banks are “having to broaden their [investment]  guidelines”, said Jahangir.  “They're all having to think about... how they’re going to loosen up a little, whether that’s by allowing the use of derivatives or longer duration – both of which have traditionally not been allowed – or allowing [bonds] two notches below investment grade, which has not always been allowed.”

Moreover, achieving more relaxed guidelines is no simple task, and it doesn’t tend to happen quickly – even for less constrained institutions such as pension funds, which are also facing major performance challenges.

For example, Thailand’s Government Pension Fund wants to invest more into alternatives and equities and is trying to do away with the legal requirement that it must have at least 60% allocated to investment grade bonds.

NEGATIVE RATE CHALLENGE

One major driver of the central bank diversification trend is the fact that a large chunk of the world now has negative real interest rates – where inflation is higher than the nominal interest rate.

A central bank’s priorities for its reserves are preservation, liquidity and return – in that order, said Jahangir. Based on expectations of 1.5% to 2.3% US dollar inflation, central banks may be earning negative absolute yield, he added. “Unless [they] can actually beat that 1.5% to 2.3%, [they’re] not achieving [their] first objective of preservation. ”

An even bigger problem is negative nominal interest rates, argues Smith: “Some central banks can’t cope when interest rates go negative; they have a real problem with it. This then makes any other diversification option more attractive.”

The European Central Bank and the central banks of Denmark, Japan, Sweden and Switzerland have all started experimenting with negative interest rates, and the UK is toying with the idea.