September 16, 2010 / 8:41 AM / 9 years ago

Analysis: Yield search fans cyclical risks for FX reserves

LONDON (Reuters) - Central banks, having spent the past 10 years gradually diversifying reserves, are facing fresh pressure to expand into new assets and currencies as the cost of managing more than $8 trillion in reserves rises.

While that pressure could soon generate new demand for equities, credit, derivatives and other assets, greater risk-taking by reserve managers could also aggravate herding in global markets and cause greater shocks during crises.

What is prompting a new wave of diversification is the returns on government bonds in major economies, whose benchmark yields are falling further below risk-free rates in emerging countries, which hold the bulk of the world’s reserves.

This means they are paying more at home to sterilize — issuing bonds to neutralize the monetary impact of reserves — than they get from investing in U.S. or euro zone bonds.

“If anything, from a purely economic perspective, the pressure to mitigate (sterilization) costs may be higher now compared to the pre-crisis period,” said Andrew Rozanov, head of sovereign advisory at Permal Investment Management.

“However, we want central banks to be guarantors of financial stability. Therefore, when they manage FX reserves, we don’t want them to be acting in a pro-cyclical way. That’s why monetary authorities need to consider very carefully the options available to them for managing excess reserves more efficiently, while also maintaining financial stability.”

The sheer scale of global reserves — which rose $127 billion a month in the past year — means managers can still keep a liquid component of reserves as a liquidity insurance for a crisis while buying more risky assets.

Franklin Templeton, which manages $43 billion of assets for around 30 state clients, expects some central banks to invest up to a quarter of reserves in equities in the next five years.

Those who do hold equities, tend to allocate something like 10-15 percent of reserves to stocks now.

PROCYCLICALITY

In an example of central banks aggravating problems in the financial markets, reserve managers pulled around $500 billion of deposits and other investments from banks to avoid default risks through the world financial crisis, according to estimates by the International Monetary Fund.

“Reserve managers may have contributed, albeit unintentionally, to the funding problem in some banks, and have forced an even stronger policy response by authorities in countries issuing a reserve currency,” the IMF said in a report.

Benchmarking is also playing a big role in changing the mindset of risk-shy reserve managers. The IMF cites an example of performance rankings of euro zone national central banks which manage reserves for the European Central Bank — potentially increasing pressure on them to generate returns.

“Clearly, this type of competition among central banks creates an environment which puts more emphasis on return ... and stimulates creativity for return-enhancing investment strategies,” it said.

The use of derivatives to hedge the exposure of reserves would help preserve capital during a currency crisis. A survey of 115 reserve managers, conducted earlier this year by Central Banking publications, showed one in three viewed derivatives as more attractive than before.

Gary Smith, head of central banks, supranationals and sovereign wealth fund business at BNP Paribas Investment Partners, said derivatives actually help increase the value of reserves during a crisis.

“Imagine the power of being able to announce during a currency crisis that FX reserves had received a positive impulse from the successful crisis management strategy of owning call options on gold, or put options on the S&P 500,” he said.

UNNATURAL?

The new wave of diversification is also rippling into some countries on the receiving end of central bank investment.

China spent more than $7 billion in buying short-term Japanese bills in July, extending a record buying spree this year. At the same time, it has pared back its U.S. debt holdings by nearly $30 billion this year.

Japanese Finance Minister Yoshihiko Noda has said he felt a bit “unnatural” about China’s bond buying — which could be contributing to the recent rapid rise in the yen.

China’s buying of Korean bonds also shot up this year.

Some countries like China and South Korea are transferring excess reserves to sovereign wealth funds, whose mandate is to buy illiquid and risky assets to deliver long-term returns.

“SWFs can help redesign and restructure reserve portfolios to make them more robust and resilient to the reform of the global reserve system. That is, by exposing reserve managers to a more diverse mix of currencies and asset classes,” an Asian Development Bank report said.

Editing by Mike Peacock

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