Asian state institutions face major challenges over what to do with their ever-expanding pools of capital, meaning central banks, sovereign wealth funds (SWFs) and the like are increasingly diversifying into new asset classes. But they face numerous issues in doing so, not least due to their sheer size.

Close to half of the total reserves of Asian central banks are now viewed as excess reserves, says Jay Arya, Asia head of the sovereign institutions group at BNY Mellon in Singapore. “Given how large reserves have grown since 1997, I can believe that,” he adds. “The largest part of that [excess] figure is in Japan, followed by China.”

It’s a good thing to have excess reserves, points out Arya, as has been demonstrated recently by Japan pumping liquidity into the economy following the earthquake and tsunami on March 11.

SWFs, in particular, are accumulating assets faster than any other category of investor, including hedge funds and private equity firms, says Peter Burnett, Asia chairman of global capital markets at UBS in Hong Kong.

This is mainly because of big inflows from high commodity prices, given that many were set up to invest excess capital derived from petroleum exports, but Asian growth and industrialisation generally is also having an effect.

The global mutual funds industry stands at around $27.3 trillion and is growing by about 8% a year, but UBS forecasts annual asset growth for SWFs of 18% a year going forward. That's slower than before the global financial crisis, but still faster than other investors.

However, the cost for governments of sterilising these excess flows will rise as local interest rates go up, since doing so is cheaper and easier in a low local-currency interest-rate environment, says Arya. As interest rates rise, he adds, central banks issuing bonds in local currency will need to let their currencies strengthen or seek higher returns on investment, or both.

Hence, to help mitigate the cost of surplus reserves, central banks have been increasingly looking at diversifying into different, higher-yielding asset classes, such as emerging-market and even local-currency debt, says Arya.

Some central banks have also ventured into alternatives through their SWF arms, and certain entities are even looking at very-high-quality corporate debt at the margins, he adds. Korea Investment Corporation and Government of Singapore Investment Corporation are two examples known to have done so.

For SWFs, the most pronounced moves are into alternative investments, he notes. “But the question is: how fast will they be able to grow these assets, because they have to be able to manage both the risk and the operational side, and that doesn't happen overnight.”

Demand for alternative investment services such as accounting, fund administration and middle-office functions is growing fast, with enquiries increasingly coming more from asset owners such as SWFs and state pension funds, says Arya. Sovereign institutions are looking at either building or outsourcing these capabilities, he adds, but the former is a longer process and could slow the expansion of their core investment capabilities.

Meanwhile, transition management is becoming more important in the sovereign segment, given the sizeable amount of mandates that are approaching maturity, says Arya. Five years ago, some central banks started to experiment with external fund managers, he explains, and now that they have higher performance expectations, they are looking at transitioning into different markets.

The recent appointment of a panel of transition managers by Korea's National Pension Service demonstrates the growing shift towards using specialists for this function.

UBS’s Burnett makes the point that SWFs are very good managers of managers; the biggest ones in particular drill down in extreme detail into asset management firms. However, they tend not to specialise in portfolio-type investments, he adds.

He points out that it’s easier to fire external fund managers that don’t perform well than lay off 20 internal employees. As a result, the vast majority – some 80% – of SWFs' portfolio investments are outsourced.

Another method for SWFs to invest their capital is to take direct stakes in companies. This has been a sensitive area politically in the past, notes Burnett, but it is less of a concern now than it was pre-2008, since such liquidity is in high demand.

Moreover, SWFs tend to invest with a financial – rather than political, or other – motive, he adds, and they tend to take minority stakes and not seek board seats.

“It’s highly political question,” he says. “The point when people get exercised about what sovereign wealth funds are doing is when there’s an issue in their home market.”

Burnett cites as an example the fuss made in the US over Dubai Ports World’s move to acquire ownership rights to certain American ports. The objections were, he says, politically motivated because the US was in the midst of mid-term elections.