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COMMENTARY: Shifts in reserve management priorities

We interacted with many stakeholders at a central bank reserve management conference last week. Our key impression from the event was that while core mandates remain broadly unchanged, central banks are reacting, on the margin, to profound shifts in geopolitics, financial technology, and asset returns outlook.

Central banks’ mandate to manage reserves prudently revolves around three key factors: safety, liquidity, and returns. We consider these factors in the context of ongoing global developments.

Safety

Hard currency sovereign issuance by high income economies has always been the standard for safe assets. No one doubts the capacity of US or European authorities to pay back USD or EUR denominated debt, but additional concerns have begun to rise about orderly settlement and return of capital. What if a debt holder falls foul of the creditor country’s sanctions policy? What if payment rails controlled by the US are cut off? What if the act of selling a country’s debt is seen as a hostile act during periods of market stress?

Few, if any, reserve managers worried about such eventualities a decade ago, but today they don’t consider them utterly outlandish. Wars, aggressive use of sanctions, and extra-territorial overreach across payment rails have generated a level of unease previously non-existent. Large pools of developed market debt will remain a part of central bank portfolios, but slowly, they are likely to increase allocation to non-Western debt and securities, in our view



Liquidity

Central banks should be looking at reserves with a long-term lens, but they cannot escape short term liquidity considerations. Dealing with terms of trade shocks and associated currency volatility requires having some dry (but liquid) powder. Managing capital inflows, shifts in foreign portfolio investor positioning, and swings in international interest rates also can require occasional use of reserves, underscoring the need for liquidity.

But concerns around safety have begun to get intertwined with liquidity. If a bond market long considered safe begins to have issues around liquidity, would it still be in the safe category? Events like ratings downgrade, rate increase cycle, policy dysfunction in dealing with debt and deficit, financial repression measures, and political unrest could cause some liquidity to evaporate and spreads to widen. Most of these developments, especially in the realm of policy and political dysfunction, were long considered hallmarks of emerging market economies, with investors demanding a risk premium. Should they begin to do the same for developed market sovereign issuance as well?

Returns

Central banks can avoid mark-to-market risks by holding bonds to maturity. But that capacity does not negate the risk of losing out on real returns due to inflation and currency volatility. Perhaps the currency aspect can be managed through hedging, affecting returns nonetheless, but loss associated with inflation will remain unaddressed.

Is the mandate for the central bank to protect the real purchasing power of reserves or should they target a return threshold like sovereign wealth funds? Should they buy inflation protected bonds? What about increasing allocation to gold? Are there uncorrelated currency pairs available that can reduce excessive exposure to one currency?

If the currency in question is USD, then the data show that not many DM currencies can offer a quantitatively durable hedge to the greenback’s fluctuation. This is largely since most developed market economies face similar and synchronised shocks. In the past year, Chinese currency and China’s government bonds have been the ones offering low correlation and good return. Moving to British, European, or Japanese bonds would have brought in no gains in portfolio value.

From stablecoins to cryptos, gold to large company credit, EM equities and currencies, central banks are looking at a wider array of assets than they have done in the past. They are not going to ditch the dollar or load up on gold, but they are quite likely to buy less of the former and more of the latter. Central banks are inherently cautious and slow to move on their portfolio allocation. But their direction of travel toward more diversified holdings is clear.

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