Central Banks Invest in Equities as Foreign Exchange Reserves Swell
Investors are not the only ones searching for higher yields in a low-inflation and low-growth environment. Challenging market conditions have prompted central banks to rethink how they invest their official foreign currency reserves.
The Official Monetary and Financial Institutions Forum (OMFIF) estimates 30 to 40 central banks worldwide are investing, in one shape or form, a portion of their foreign exchange reserves holdings in equities.
The trend towards riskier assets looks set to continue. A recent survey of reserve managers by Central Banking Publications and HSBC indicated that more central banks envisage adding shares or exchange-traded funds (ETFs) in their foreign reserves portfolio.
The challenge for central banks is to implement a dynamic reserve management strategy that effectively balances liquidity needs, safety of capital and return on investment.
Holding Official Reserves
Most countries hold official reserves of foreign exchange, and do so as a precaution—in case they need to intervene in the foreign exchange market to stabilize exchange rates, or to provide foreign currency liquidity to domestic financial institutions in times of financial crisis. Reserves are also held to provide liquidity to support fixed exchange rate regimes.
The Bank of Canada, as the fiscal agent of the Government of Canada, manages the country’s foreign exchange reserves. It intervenes in foreign exchange markets on a discretionary basis and only in exceptional circumstances to counter disruptive short-term movements in the Canadian dollar, rather than target any specific level.
The last time the Bank of Canada intervened in foreign exchange markets to affect movements in the Canada-U.S. exchange rate was in September 1998. In March 2011, the Bank of Canada collaborated with central banks in the U.S., Europe and Japan to stabilize the Japanese yen in the aftermath of Japan’s earthquake and tsunami. Prior to this action, these four countries had coordinated their efforts to support the euro in September 2000.
Sharp Increase in Holdings
Global official foreign exchange reserves have almost quadrupled in the last 10 years, reaching the equivalent of US$11.9 trillion in the first quarter of 2014. The rapid growth in the international reserves of emerging and developing countries is particularly striking. They have amassed US$8.0 trillion in reserves (or two thirds of the total), more than double the amount held by advanced economies (US$3.9 trillion).
China has the largest stock of foreign exchange reserves in the world (equivalent to US$4 trillion), and it accounts for an important share of the buildup in emerging market reserves. Japan holds US$1.3 trillion in reserves—the world’s second largest after China.
Canadian Dollar’s Prominence
International Monetary Fund (IMF) data indicate that prior to the global financial crisis, foreign exchange reserves were invested almost entirely in five currencies: the U.S. dollar, the euro, the British pound, the Japanese yen and the Swiss franc. Since the crisis there has been increased diversification in terms of currency composition.
The share of U.S. dollar-denominated assets in reported global foreign exchange reserves fell from 65.1 per cent in early 2007 to 60.9 per cent in the first quarter of 2014. Over the same period, the euro’s share declined modestly—from 25.0 per cent to 24.5 per cent. The pound sterling saw its share of global foreign exchange reserves dip from 4.6 per cent to 3.9 per cent.
By contrast, the share of reserves invested in Japanese yen-denominated and Swiss franc-denominated assets increased, albeit from a low level—in the case of the yen, from 3.1 per cent to 4.0 percent, and in the case of the Swiss franc, from 0.2 per cent to 0.3 per cent.
All “other currencies” combined accounted for just 2.0 per cent of total reserves in early 2007. However, by the first quarter of 2014, “other currencies” accounted for 6.5 per cent of total reserves reflecting the increased importance of the Canadian dollar and the Australian dollar as non-traditional reserves currencies. The Canadian dollar accounted for 1.9 per cent of reported global foreign exchange reserves and the Australian dollar for 1.7 per cent in the first quarter of 2014. Both currencies were essentially neck and neck in terms of the value of official reported holdings at US$117.4 billion and US$107.2 billion, respectively.
The popularity of Canadian dollar-denominated assets among reserves managers reflects Canada’s relatively strong mix of domestic fundamentals—a stable economy, sound banking system, triple-A credit rating, its natural resource wealth and somewhat higher yields than found in traditional reserves currencies. Australian dollar-denominated securities have enjoyed a similar rise to prominence for similar reasons.
The IMF figures are based on responses of foreign reserves managers representing US$6.2 trillion, or 52 per cent of the total US$11.9 trillion in official foreign reserves worldwide. The currency composition of the remaining 48 per cent—the so-called unallocated reserves—is not known because not all foreign reserves managers respond to the IMF’s request for data. Additionally, some countries may report their total foreign exchange reserves, but not disclose the actual currency composition of those reserves.
Taking into account both reported and unreported official foreign exchange reserves, the Bank of Canada estimates that Canadian-dollar denominated holdings among central banks stand somewhere between US$172 billion and US$219 billion. Most foreign reserves investments denominated in Canadian dollars are in government bonds. Emerging economies account for a little more than half of foreign holdings of Canadian dollar-denominated debt.
The Bank of Canada concluded that increased demand for Canadian government securities may lead to higher bond prices and lower yields, thereby reducing the financing costs for the government. But, it may also decrease market liquidity reflecting the fact that foreign reserves managers tend to be as patient, buy-and-hold investors. The Bank reckoned that reduced liquidity may “eventually translate into higher yields, since investors will demand additional compensation for entering illiquid markets.”
Jump into Equities
Central banks have typically invested their foreign exchange reserves (or a portion of their reserves) in short-term, highly liquid and secure foreign government securities that they can always realize in case of crisis.
While these assets provide insurance against a loss of access to international capital markets, they generally yield relatively low rates of return. And the larger the reserves portfolios, the greater the overall opportunity cost of these low returns compared with returns on alternative uses of the funds.
According to the OMFIF, central banks around the world have foregone US$200 billion to US$250 billion in interest income as a result of the fall in bond yields in recent years.
To compensate for lost revenue on their reserves portfolios, the OMFIF notes that “central banks around the world, including in Europe, are buying increasing volumes of equities as part of diversification by official asset holders that are now a global force on international capital markets.”
According to the OMFIF, China’s State Administration of Foreign Exchange (SAFE), the governmental agency in charge of administering the country’s foreign exchange reserves, has become the world’s largest public investor in equities. Other central banks that hold stocks in their reserves portfolios include the Bank of Japan, the Bank of Korea, the Swiss National Bank, the National Bank of Denmark, the Bank of Italy, the Bank of Israel and the Czech National Bank.
The Swiss National Bank (SNB) has increased the share of equities in its foreign currency investments to 15 per cent, which appears to be at the high end in terms of allocation to equities in central bank reserves portfolios. The SNB has a globally well-diversified equity portfolio of roughly 6,000 individual stocks. The Bank of Israel has eight per cent of its foreign currency reserves invested in equities and plans to increase this to 10 per cent. Some other central banks that have diversified their holdings to include equities appear to be targeting a 10 per cent equity allocation in their reserves portfolios.
For the most part, central banks are passive investors in the stock market—they basically do not select individual equities, but invest in a very broad equity universe. This strategy aims to minimize the impact on the markets.
Debt Securities of Sovereigns
Canada’s holdings of liquid foreign exchange reserves total the equivalent of US$62.4 billion and consist primarily of highly rated fixed-income securities issued by the U.S. government and European sovereigns, their agencies and supranational organizations.
Finance Canada data indicate that 69.0 per cent of reserves (US$43.1 billion) are invested in U.S. dollar-denominated securities, 29.1 per cent (US$18.1 billion) in euro-denominated securities, 1.2 per cent (US$756 million) in yen-denominated assets and 0.7 per cent (US$443 million) in pound-denominated assets.
Canada has three investment objectives with respect to its official foreign exchange reserves: to maintain a high standard of liquidity (i.e. hold reserves that can be sold on very short notice with minimal market impact); to preserve capital value by holding a diversified portfolio of high quality assets; and to achieve the highest possible level of return, while respecting the liquidity and capital preservation objectives.
Central banks have common functions, but each operates in distinct ways. In this regard, a central bank has to choose an appropriate strategic asset allocation of the foreign exchange reserves consistent with its general circumstances and policy objectives. Inclusion of non-traditional asset classes within a central bank’s portfolio may not be appropriate for everyone.
In general, central banks with large reserves have the capacity to broaden their investment universe and expand into non-traditional asset classes. As they take on more risk, calls for more effective communication and transparency with respect to policy actions are likely to intensify.
Tina Kremmidas, Economics Contributor