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 bills.
"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 data.
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 their own.
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 those securities.
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 securities."
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
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 investment".
"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 as well."
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 renminbi.
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
"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
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 large."
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 investable assets.
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
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 reserves.
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 moves.
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
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 currency holdings.
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
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
"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
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 like.
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 management."
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
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
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 currency diversification."
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
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 removed soon.
"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 stable dollar."
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
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 that
He adds: "There’s a lot of learn in the process
of diversification." LF