Like other asset owners in recent years, even central banks have struggled to meet their (relatively low) return targets. Now, the prospect of depressed interest rates for years to come to support economies affected by Covid appears to have accelerated movements by reserve managers into riskier assets such as emerging market equities and private equity.
“[The market environment] is doing [central banks] realize that they need to change their mandates or their directives faster than before, ”said Jahangir Aka, head of official institutions at the American fund house Neuberger Berman. “Whether it’s allowing private equity or derivatives or whatever, each of them needs to relax their guidelines in some way. “
This is a trend among the “first ranks” of central banks, said London-based Aka. AsianInvestor: those with substantial excess reserves which in many cases have already been allocated beyond traditionally safe fixed income assets.
In Asia, this would include the Bank of Korea, the Hong Kong Monetary Authority, the Monetary Authority of Singapore, the Bank of Thailand, and Bank Negara Malaysia.
A growing number of central banks are investing in Chinese bonds, and some of the leading banks are buying stocks in China and other emerging markets, Jahangir said. Some of those who are already exposed to listed stocks are even going into private equity through fund-of-fund strategies, he added, declining to identify any institutions.
“Reserves remain high, yields continue to fall, so reserve managers need to do something,” agreed Gary Smith, managing director of London-based consultancy Sovereign Focus.
Those who took action soon after the 2008 financial crisis “did pretty well,” he added. “In addition, the stock markets rebounded in a very impressive way after the Covid crisis, which gave people the confidence to continue the diversification movement. “
In fact, a central bank in Europe even allocated a real estate fund a few years ago, Smith said, declining to give a name.
Such portfolio diversification has been a trend for some time, Aka said, but has accelerated under Covid, as rates will be lower for even longer than expected around this time last year.
“Some of these central banks – the ones with bigger balance sheets – have basic cash flow, so they can now invest,” he said. “They won’t go for a longer term on fixed income because it’s not rewarded. But they can get a longer duration by going for alternatives, and it is starting to happen. “
A few reserve managers will implement an investment strategy at the helm, Aka said, that is, passive or active exposure to equities combined with alternative assets.
Of course, some countries have sovereign wealth funds that they can rely on to invest their public assets on a less limited basis, but others do not keep or prefer to keep some excess reserves in the central bank.
Either way, a consistent trend across Asia is that central banks “need to expand their [investment] guidelines, ”Jahangir said. “They all need to think about … how they’re going to slack off a bit, whether that’s by allowing the use of derivatives or of a longer duration – which have traditionally not been allowed – or by allowing [bonds] two notches below the investment category, which has not always been authorized.
Moreover, achieving more flexible guidelines is not a simple task, and it does not tend to happen quickly, even for less constrained institutions such as pension funds, which also face challenges of major performance.
For example, the Thai government pension fund wants to invest more in alternatives and equities and tries to remove the legal requirement that it must have at least 60% allocation in investment grade bonds.
NEGATIVE RATE CHALLENGE
One of the main drivers of the trend towards central bank diversification is the fact that much of the world now has negative real interest rates – where inflation is above the nominal interest rate.
A central bank’s priorities for its reserves are preservation, liquidity and yield – in that order, Jahangir said. Based on the US dollar’s inflation expectations of 1.5% to 2.3%, central banks could get a negative absolute return, he added. “Unless [they] can actually beat this 1.5% to 2.3%, [they’re] not to reach [their] first preservation objective. “
An even bigger problem is negative nominal interest rates, says Smith: “Some central banks cannot cope when interest rates go negative; they have a real problem with that. This then makes any other diversification option more attractive.
The European Central Bank and the central banks of Denmark, Japan, Sweden and Switzerland have all started experimenting with negative interest rates, and the UK is playing with the idea.