Public policy lines blur: implications for reserve managers

Crisis-fighting has pushed central banks into new forms of risk-taking, which is impacting reserve managers

Swap lines in dollars and renminbi may facilitate investment in risk assets

It was not much more than a decade ago when the overriding objective of most central banks was relatively simple: maintenance of the value of money as evidenced through price stability. Governments endowed central banks with independence to protect this mandate from potential political interference. And, by every measure, central banks have been largely successful.

Whether they have been a victim of their own success or they have been captured by a broader corporate trend of more holistic measures of success is unclear. What is clear, though, is that central banks are now taking on multiple objectives – from market stability and climate risk to financial inclusion. And this is occurring across disparate central bank functions: research, monetary policy, currency issuance, bank supervision and reserves management.

Before turning to reserves management, consider central bank balance sheets as a whole and the domestic portfolio in particular. These balance sheets traditionally held risk-free domestic and foreign government bonds on the asset side and money on the liability side. Domestic bonds were purchased as part of the central bank’s monetary policy operations and foreign currency bonds were held, in part, to stabilise the external value of money or the exchange rate.

During the Great Financial Crisis, the major reserve currency central banks loosened their credit restrictions on the quality of domestic bond purchases as part of quantitative easing and price stability. But, under Covid-19, such practices have become more common to protect market functioning and help governments sustain the private sector during lockdowns. Market stability, as distinct from price stability, is now driving domestic corporate bond purchases to help the government keep businesses and the economy afloat.

The acceptance of credit risk on the central bank’s domestic portfolio cannot help but lower central bank resistance to taking on credit risk also in the foreign currency reserves portfolio, particularly in today’s interest rate environment. With negative rates on government bonds, central banks can achieve their capital return objectives only by extending investment horizons and expanding eligible asset classes, including the assumption of credit risk, and managing total exposure on a portfolio rather than single-asset basis.

To a certain extent, the ability to invest foreign currency reserves in risk assets has been facilitated by yet another central bank innovation – central bank liquidity swaps – introduced by the Federal Reserve in 2007 but expanded in size and scope by both the Fed and the People’s Bank of China in 2020. In addition to traditional assistance by the multi-laterals, major central banks are now stepping up to backstop global liquidity and shore up foreign currency reserves in systemically important countries, potentially alleviating liquidity concerns.

With negative rates on government bonds, central banks can achieve their capital return objectives only by extending investment horizons and expanding eligible asset classes

In what is perhaps the biggest challenge to reserve managers, many are now being asked to invest “responsibly” in addition to investing on the basis of capital preservation, liquidity and ever more vaporous investment returns on traditional reserve assets. This additional mandate is coming from central bank policy-makers, rather than central banking law, and as a natural extension of central banks’ consideration of climate change and other societal goals in monetary policy formulation and bank supervision.

While surveys show upward of a quarter of central banks have diversified into corporate assets, the bulk of central bank reserves remain invested in bonds issued by government and multi-lateral organisations. While the latter have responded to central bank demand with dynamic green bond issuance programmes, the size of central bank reserves dwarfs their total annual borrowing programmes. Whether governments will be rated on the basis of environmental, social and governance (ESG) factors remains an open and intriguing question. In the near term, however, central bank reserve managers are faced with resolving mutually exclusive expectations of conservatism, return and contributing to positive societal outcomes, or at least not financing negatives ones.

How might reserve managers resolve this conundrum over time? The first reaction has been to outsource the problem, either by including ESG criteria in an external asset manager mandate or allocating a portion of reserves to the Bank for International Settlements’ green bond fund, the size of which is ultimately limited by the relatively small size of the underlying market.

For countries that are able to diversify portfolios beyond high-grade government debt, the answer is more obvious, if incremental, as the calibre of ESG benchmarks and ratings improves over time. For the bulk of the reserves, however, investment is likely to be dictated by the central bank legislative mandate and the cold logic of the size of reserves relative to the size and liquidity of investible capital markets. Thus the ESG profile of the reserves will be determined, ultimately, by government policy in the US, Europe, Japan and China.

Jennifer Johnson-Calari is an expert in reserves management, having created and led the World Bank’s Reserves Advisory and Management Program (Ramp). Working with the International Monetary Fund, she helped set global best practice for sovereign asset and liability management. She most recently co-authored with Dr Adam Kobor a series of White Papers on reserve management for Invesco. She also chairs annually Central Banking’s Nalm conference. 

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