By Taimur Ahmad
Seven years ago, former US Treasury Secretary Lawrence Summers
proposed what, at the time, seemed to many people a radical
Summers, then president of Harvard University, suggested in
a lecture that a portion of the wealth being rapidly
accumulated worldwide by central banks - chiefly in the
emerging markets through their foreign exchange holdings -
should be invested in more productive and higher-yielding
assets, rather than ploughed into low-yielding US Treasury
"6% would not be an ambitious estimate of what could be
earned" by investing reserves domestically in infrastructure or
in a "fully diversified way" in global capital markets, he told
an audience at the Reserve Bank of India.
Accumulated reserves were far larger than what could be seen
reasonably as self-insurance against adverse shocks, Summers
said. Moreover, the risk composition of assets in which these
"excess reserves" were invested likely implied a "zero real
return measured in domestic terms". Simply put: a "substantial
The total central bank reserve pool he was referring to in
early 2006 was a staggering $4.3 trillion.
Today, it's $11 trillion. It was spawned and fed in recent
years by vast global external imbalances between surplus and
deficit countries and by sustained high commodity prices. In
the last year alone it grew by $725 billion, according to IMF
What Summers didn't know when he gave his address in Mumbai
was that a financial crisis would strike a year later which
would snowball to engulf the entire global financial system and
which would ultimately leave developed economies ravaged by an
explosion in public sector debt and facing sovereign crises of
But what was perhaps even less foreseeable was that official
sector demand for US Treasuries would nevertheless continue
unabated - even after its sovereign debt lost its triple-A
rating, after the Federal Reserve resorted to three rounds of
emergency bond buying and despite the negative real yields on
Doomsayers had long predicted an investor revolt against the
US Treasury market. Yet government bonds were boosted by a
global flight to safety; and investors, in particular foreign
central banks, have not shied from piling into US
"The markets and the activities of reserve managers have
been very uneven, in large part because the environment has
been very disorienting," says Terrence Keeley, head of the
official institutions group at BlackRock, the world's largest
asset manager. "Given their preoccupation with credit and
default risk, they have even bought negative yielding
Times are changing
Today, the debate is heating up anew over how the central
banks of major surplus nations, including in Latin America,
should manage their reserves - as uncertainty looms over the
global economy as well as over the returns offered by
conventional investment strategies.
BlackRock estimates that historically low nominal rates in
the US, UK and Japan are costing the holders of $11 trillion in
foreign exchange reserves some $250 billion a year versus
Many central banks in emerging markets - some of which have
relied on foreign exchange reserves to generate up to 80% of
their total income - are now facing "unsustainable financial
trajectories," the asset manager says.
Just like pension plans, insurance companies and other
institutional savers, official sector funds are being forced to
change their investment strategies to replicate the historic
returns they once earned just from government bonds.
In an interview with LatinFinance in March, Yi Gang, head of
China's $3.44 trillion State Administration of Foreign Exchange
(SAFE), the world's largest reserves holder, expressed his
concerns over the deteriorating financial performance of
Chinese state wealth.
Yi, deputy governor of the People's Bank of China, resolved
to press ahead with efforts to diversify his country's foreign
currency holdings into higher yielding assets, including
emerging market currencies and bonds. He said expectations of
continued poor returns from developed markets had prompted the
central bank to "continue to diversify our reserve
"Everybody knows that recently [quantitative easing] policy
has driven down the interest rate so that bond yields have
decreased for years. That means a lot of challenges if you
invest in this market," he said. "We really have to have a
diversified and balanced portfolio."
The People's Bank of China, like many other central banks,
is increasingly investing in a wider range of non-core and
riskier assets, including Latin and other emerging market
sovereign debt and equities, as yields on developed world
sovereign bonds remain subdued.
The growing presence of official sector capital in private
markets represents a shift in the global economy - and one with
significant implications for asset valuation, financial
stability and growth.
That shift, if it happens meaningfully, could also represent
one of the most profound opportunities yet for the capital
markets of Latin America and other emerging regions - in
particular for the development of local bond markets, which
depend critically on central bank foreign exchange reserve
Capital markets promise
"The big capital markets innovation in the waiting, that
would be the greatest source of capital markets reform and
change, is central bank reserve allocation to the emerging
markets," says Ousmène Mandeng, a former IMF official
who was, until recently, head of public sector advisory at
Central banks could help by providing "anchor money to allow
more liquidity and help the development of local capital
markets," he says. "It's a sensible argument to make: a lot of
currencies are so attractive and liquid because central banks
are investing in them. That's certainly true of the main
markets and that logic could be applied to the emerging markets
This would require central banks moving beyond the status
quo in the international monetary system and towards a multiple
reserve currency system- incorporating leading emerging market
currencies including those of China, Brazil, and Mexico, among
others. Chile's central bank and the Reserve Bank of Australia,
for example, are among a handful of China's trading partners to
have already diversified a portion of their reserves into
Mandeng advocates establishing a framework, similar to
central banks' existing gold sale agreements, by which monetary
authorities constrain allocations to new reserve currencies.
The limit could be 15 percentage points of total foreign
exchange holdings over the next five years, for example.
"This would help mitigate undue volatility of the main
reservable and new reservable asset markets, help guide market
expectation, support desired orderly reserves diversification
and provide critical support for the development of local bond
markets," he says. "Central banks would be guided, similar to
the central bank gold sales agreements, by making purchases of
new currencies not in excess of an agreed limit and during an
agreed time interval."
Such a mechanism could help develop long-duration, local
currency fixed income markets in Latin America, which - despite
important progress over the past decade - are still small and
illiquid by international standards.
The potential for such development is not lost on Yi.
Emerging markets as an asset class are not large or deep enough
for meaningful investment by official investors. But, he says,
strides already taken in developing Latin America's bond
markets are "very positive".
"I think [the] emerging markets asset class in the future
will deepen its scale and volume and liquidity will be better.
It has tremendous potential though right now it's not very
How much is too much?
Today, there's a growing belief among central bankers
themselves that reserve levels have surpassed useful limits and
that the cost of maintaining them is now too great. This raises
the possibility of a greater allocation of reserves as
Summers' argument hinged on the notion of excess reserves,
which he put at $1.5 trillion in 2006. This raises the
question: what is the appropriate level of foreign exchange
reserves for a nation to hold? One theory, the
Greenspan-Guidotti rule for the adequacy of reserves, says they
should equal external debt maturing within 12 months; that is,
enough to cover a sudden reversal in short-term capital.
For China, whose reserves stockpile is $3.44 trillion, the
answer is clear. Says Yi: "We already have large enough
Safety, liquidity and return, he says, are the three guiding
principles of reserve managers - in that order. Reserves should
first be about self-insurance against shocks. "The most
important function of foreign exchange reserves is increasing
confidence of the market," says Yi. "If you pursue safety and
liquidity and a little bit of return, the US Treasury market is
a major market."
But, he adds: "For the reserves it is not the case of the
larger the better. At the margin the benefit of continuing to
increase reserves is diminishing. So that I think right now we
have large enough reserves already."
China's central bank buys dollars to prevent its currency
from appreciating sharply, to keep its exports competitive. To
do so, it sells yuan domestically and then issues local
currency bonds to soak up any excess and prevent inflation. The
cost to the central bank of this sterilization is the
difference between what it earns on its reserves and what it
pays to its bondholders.
In a world of negative real yields on US Treasuries, that
cost is significant - not just to China, but to any foreign
central bank loading up on the dollar. "They will get their
principal back, but they have had to pay for the privilege,"
says BlackRock's Keeley.
But therein lies the opportunity, experts say: the global
stock of foreign exchange reserves is excessive - and a
percentage of such reserves could be used for more productive
purposes at higher yields.
"There's $11 trillion in reserves. That's far more than what
is required globally to maintain exchange rate stability," says
Keeley. "The reserves are not invested optimally. In the
aggregate, too much is invested in government bonds that yield
nothing and do nothing for global growth."
Excess reserves could be put to more productive uses, such
as investment in public goods like infrastructure, or in
corporate debt that leads to private hiring, he says. "There's
an opportunity for central banks globally to invest for better
macroeconomic outcomes, for example in infrastructure bonds.
From a policy perspective, to have excess reserves languish in
low yielding securities rather than solving the pressing
problems of our times is unacceptable."
Such an approach is being pioneered in Africa, for example,
where the African Development Bank is poised to issue a $22
billion pan-African infrastructure bond in which the region's
central banks would invest 5% of their hard currency
The idea of central bank investment in infrastructure is one
that Latin central bankers are willing to engage with - even if
they remain publicly cautious about the practicalities of such
Peru's central bank governor Julio Velarde tells
LatinFinance that while "it's good to build more infrastructure
and increase investment, you have to be conscious about the
macro effects of too big an increase in domestic demand,
including of course public expenditure."
He adds: "Reserves have a counterpart which are liabilities.
It's not assets without liabilities. We have to consider that.
Many times what's not taken into account is that public
investment tends to grow too fast which increases the prices of
projects. That is happening around the world and many countries
are still facing strong domestic demand."
But central banks are nevertheless ideally placed to offer
needed payments, custody and settlements infrastructure to
allow best practice access to local bond markets for other
central banks. In Latin America, says Mandeng, agreement on
common standards, possibly within the framework of bilateral
swap agreements, "would help to lower the barriers of entry for
Brave new world
There is another argument in favor of greater reserve
diversification: the evolving structure of the world economy
itself. Experts say emerging markets' growing share of global
output should be represented by more diversified global reserve
The IMF forecasts emerging economies will comprise 48% of
total global GDP by 2018. "That continuous shift in the real
economy we have been observing for quite some time and which
the crisis has actually brought forward - that still has no
equivalent in the monetary sphere," says Mandeng. "There's
still this fundamental asymmetry between reserve holdings and
currencies and the shifts in the real economy."
While US Treasuries offer advantages that emerging sovereign
and currency markets can't match in terms of depth and
liquidity, Mandeng says: "we have to be realistic, central
banks don't need that much liquidity. They have shown in this
crisis that they don't need that liquidity and they're not
using those reserves.
"Emerging markets are becoming very important and yet if you
look at their currencies, EM currencies are so far nowhere to
be seen. It's changing - but only slowly."
Capital flows, trade and investment between emerging regions
are greater than ever. But Mandeng acknowledges that both in
terms of reserve currency diversification and investment
strategy "one should not assume that central banks would be
leading these trends. They are lagging a trend that we already
Not so fast
A shift in currency allocation and investment strategy by
central banks - which would include channeling reserves towards
an orderly expansion of local bonds markets - is proving more
complicated than many, especially in the private sphere, would
Data on central bank reserve holdings and their composition
is limited. But available IMF figures suggest that reserves and
allocation policies remain, in the main, highly homogenous and
concentrated in a narrow range of asset classes.
Central banks continue to pile into government securities,
principally US Treasuries, as well as dollar and
euro-denominated bonds issued by other advanced countries. The
US dollar dominates strongly, with 62% of foreign exchange
reserves denominated in the currency in 2012. This is followed
by the euro with 24%, down from a 2009 high of 28%, and the yen
and pound accounting for 8% of total reserves.
Although a risk-free rate for sovereign bonds post-crisis
may no longer exist, for many central banks and institutional
money managers, US Treasuries still remain the closest proxy
for a safe asset.
This is especially true for Latin America's central banks,
which are widely considered to be among the most conservative
anywhere. The case for reserve diversification by the region's
monetary authorities might be naturally constrained by their
smaller size. On average reserves in the region account for
some 13% of GDP, according to Moody's. This contrasts with
emerging Europe, where the median is 20% of GDP, and China,
where they represent 40% of output; in Latin America, only
Bolivia's reserves ratio is comparable.
Still, the region's reserve wealth continues to grow. Brazil
now has $378 billion in foreign exchange reserves as its
disposal. In Mexico, that sum is $166 billion, having expanded
by 14% in 2012. Peru's reserves increased by 24% in the year to
February, to $67.6 billion. Colombia's reserves are valued at
$39 billion, the same amount as Chile's. Uruguay has also
continued to accumulate reserves, reaching $12.7 billion by the
first quarter of this year.
But in general, the diversification of reserves away from US
dollar securities has been slow across the region. "Latin
central banks have been resisting that sort of change quite a
bit. It's changing, but you look at a region that is a laggard
when it comes to currency diversification of reserves, with two
or three exceptions," says Mandeng.
Peru and Chile are widely acknowledged as being among the
most innovative of the Latin reserve managers. Peru's Velarde
says that when it comes to reserves diversification, "the
problem is that all assets are expensive now. Probably if we
had diversified more before the crisis [that would have been
preferable]," he says.
"Before Lehman we were already diversifying our portfolio.
After Lehman, there was an increase in the purchase of dollars.
Now we have started to diversify again, for example into
commodity currencies. For example, the Australian dollar: we
had very little before now we have an important quantity."
Velarde points out that many central banks have legal
restrictions on where they can put their money. "In our case,
we cannot buy corporate bonds, for example. But we have been
increasing the number of currencies we buy, public bonds,
public agencies, multilaterals."
Nevertheless, he says, the case for further diversification
is tempered by uncertainty over the dollar. "The dollar has not
been doing so badly in the last two years compared to other
currencies. In spite of what is said about the weak dollar, we
see the dollar actually as having been strong. In 2012 it was a
little bit slow but still appreciating. And it has been strong
Similarly candid about diversification efforts is Chile's
central bank governor, Rodrigo Vergara, who tells LatinFinance:
"We have already done that - we have already diversified our
reserves." The bank has shifted strategically into Canadian and
New Zealand dollars, Swiss Francs and Chinese renminbi, but
still has 40% to 50% of its reserves in US dollars, Vergara
says. Still, he says: "we've had a very conservative
Yet at the same time, the big central banks, led by Brazil
and Mexico, remain reluctant to move.
Indeed, recent moves towards diversification have ended in
tears for many. Having loaded up on gold in the years following
Lehman, central banks - including those of Mexico, Brazil,
Colombia, Venezuela and Paraguay - lost a combined $560 billion
following the recent collapse in prices of the metal.
Says John Nugée, head of official institutions at
State Street Global Advisors: "I don't know what the effects of
the current shake out is going to have on official sentiment.
But people have been moving out, it does appear to be a genuine
change in sentiment towards the metal."
Since the crisis, the most important source of reserve
growth - global imbalances - has been shrinking as the US
deficit and China's surplus, respectively, grow smaller. A
rebalancing of China's growth model to prioritize domestic
demand over exports will slow reserve expansion in the world's
biggest foreign exchange accumulator.
"We will make the trade surplus of China smaller, although
we may still have a trade surplus but we will have a very small
trade surplus as a percentage of GDP," Yi says. "So we pursue a
balanced balance-of-payments situation. In that case, we won't
have a rapid accumulation of reserves."
Meanwhile, reserve growth in many instances - especially in
Latin America - is now being driven by emerging countries
buying dollars to combat rapidly appreciating currencies that
accompany massive capital inflows.
Arnab Das, head of research and strategy at Roubini Global
Economics says the implication of moderating global imbalances
is a tendency not to diversify reserve currencies.
"It's less of an investment strategy or return optimization
strategy by central banks and more of an intervention-oriented
strategy, which requires liquidity and currency matching. You
want that currency diversification and that reserve pool at the
central bank to match the original source of capital inflow,"
he says. "All of those things point to reasons for less
Indeed, despite the rhetoric, the process of reserve
diversification has in recent years followed an extended rally
in core bond markets, says Jan Dehn, co-head of research at
Ashmore Investment Management.
"The crisis has been a setback for reserve diversification,"
he says. A US Treasury rally, a deterioration in the
risk/return of emerging markets currencies and elevated levels
of uncertainty, among other factors, have "significantly
slowed" diversification away from the dollar.
The more profound worry today, however, is over the
soundness of prioritizing the US dollar at a time of great
uncertainty about the trajectory of the economy and policy.
Much of that concern is about the likely path of interest
rates once US economic activity picks up. But analysts are
today increasingly split on how that will unfold.
A view is taking hold in the mainstream debate that
conditions are ripe for another dollar rally: the deficit is
shrinking as a proportion of GDP, employment is picking up and
the housing sector has stabilized. Meanwhile, risk appetite is
As Velarde points out, the dollar has gained about 4% since
the start of the year, on a trade-weighted basis, in line with
riskier assets such as equities. The euro, sterling and the
Japanese yen have retreated.
But another, more alarming scenario could be underway.
Ashmore's Dehn says it is implausible that policy could shift
from today's ultra-low interest rates and slack growth to
higher rates and output "without having to go through a major
macroeconomic adjustment". This is especially so given the
trillions of dollars the Fed has pumped into the banking system
since the 2008 crisis.
"We're only a couple of years away from the point where US
household deleveraging ends and consumption rises," says Dehn,
who predicts a significant pickup in US domestic demand by the
first quarter of 2016. "When that happens, inflation will rise
too…we have the potential for quite a significant
explosive evolution in inflation given where monetary policy is
today, should demand come back."
His argument is that the US Federal Reserve will face a
choice between allowing a sharp rise in interest rates to their
long-term average of 6.5% or engineering a gradual rise in
rates. The former would trigger a "bloodbath" in the bond
markets and lead to another financial crisis, whereas the
latter entails a slow exit from quantitative easing - and an
associated decline in the dollar of "at least 25%".
"If 10-year Treasuries went to 6.5%, it would wipe out 35%
of global fixed-income," he says. "Given the enormous negative
wealth effects, the Fed won't allow it. They will unwind QE
extremely slowly." That will keep real yields negative.
Dehn says this scenario challenges the received wisdom of
many central bankers. "It confronts them with the possibility -
I would say likelihood - that their existing allocation is
introducing risk into their reserves. This is something that
will be experienced by all central banks that are heavily
invested in Treasuries.
"This is beginning to appear on the radar screens of many
reserve managers, who are now much more concerned about whether
they have the right currency allocation in their
Dehn is not alone in anticipating a slow exit from QE. While
he declines to comment on the likely direction of the dollar,
SAFE's Yi says that despite "a lot of market anticipation" and
what he sees as "minor voices" within the Fed arguing for an
earlier exit, extraordinary monetary stimulus will not be
"I think [Fed chairman] Ben Bernanke's and [vice chair]
Janet Yellen's message is very clear," he says. "The US dollar
is still the main reserve currency. I would like to see a
The only way is up
BlackRock's Keeley says reserve managers must now "be
vigilant of the hidden fractures in the global economy. These
could easily lead to further stresses on sovereign debt markets
that have long been the mainstay of the reserve management
The solution? Diversify. For Dehn, that means central banks
should invest in emerging market local currency sovereign
bonds. Why? Because the result of dollar weakness will be a
rally in all major local currencies - in Latin America, the
Brazilian real and Mexican peso, in particular. The challenge
will be coordinating this diversification so as not to trigger
a sudden realignment of global currencies, but the underlying
trend is inexorable, he says.
There is compelling evidence, both anecdotal and factual,
that central banks are now shifting away from the dollar and
towards a broader portfolio of currencies and assets. And if
Dehn is right, and if new reserve currencies are adopted
wholeheartedly, the local bond markets could be on the cusp of
precisely the boost so many would like to see.
But as Chile's Vergara points out: "It's a lengthy process,
we don't know other [non-core investment and currency] markets
He adds: "There's a lot of learn in the process of