Reserve asset management in Asian economies is becoming more and more complex.
There has been a marked shift in the reserve currency asset markets over the last year. Central bankers in developed markets have moved from policy normalization to an easing bias mainly due to macro-economic risks. This has resulted in a downward trend in yield curves of traditional reserve assets, and some asset markets have even sunk deeper into negative yield territory. The stock of negative yielding debt has doubled globally to $17 trillion as of August 2019 from $8 trillion as of December 2018.
The US Treasury market is one the last remaining positive yielding traditional reserve asset markets. Given this environment, reserve managers have ventured into “riskier” asset classes, including equities, exchange traded funds, corporate credits, and commodities for greater diversification and expected returns.
In fact, gold as a reserve asset has regained popularity. According to IMF data, central banks held 34,000 tons of gold as of Q1 2019, making it the third largest reserve asset in the world.
The current environment is marked by economic uncertainty as the effects of deepening trade tensions between the United States and the People’s Republic of China are being felt across Asia. Other risks—including the potential for a sharper slowdown in major advanced economies and rising geopolitical tensions in some other regions—have intensified investor anxiety and increased financial market volatility. This uncertainty has exacerbated the several challenges already faced by reserve asset managers in the previous years.
Foreign exchange reserves are a key component of the monetary and exchange rate policies in most countries. Developing economies have accumulated reserves at an impressive pace, after the global financial crisis of 2008 and 2009. Global holdings of reserves have grown at annualized rate of 4.8% since 2008 and now stand at $12.4 trillion. Asia has accounted for more than 55% of the total growth, mostly because of the trade dynamics in Asia and the importance policy makers place on reserve accumulation.
Traditionally, reserves are kept by emerging economies as a precautionary measure to build confidence in the currency, and as a stabilization mechanism against disorderly markets. However, reserve managers must now balance these with other motives as well. These include supporting the conduct of monetary policy; accumulating assets for intergenerational purposes; or influencing the exchange rate for export competitiveness.
Given the different motivations for holding reserves, the question of reserve adequacy and the associated cost of holding reserves assumes greater importance.
The growth of reserves has brought to the fore risk management issues like liquidity and concentration for the preservation of capital to be balanced with return considerations. Adequacy of reserves must be assessed against each objective and the portfolios segmented to address them.
Sovereign wealth funds, or SWFs, have grown as a structure to segment return objectives and provide the governance structure to achieve them. Globally, as of 2018, assets under management of SWFs have grown to $8 trillion. Governance standards around the management of SWFs have emerged as the Santiago principles set out a common global set of international standards regarding transparency, independence, and accountability for SWFs.
Reserve adequacy must consider assessments of developing risks through forward-looking scenario analysis. Such scenario analysis must consider the evolution of factors that drives reserve needs. However, each country is different. Advanced economies need different adequacy measures compared to emerging economies. The lessons from the global financial crisis has taught us that no country is immune from external or internal shocks. Reserves provide a valuable buffer in these stress events.
Reserve managers face a complex task in investing these resources. With emerging risks clouding the outlook for the global economy, balancing risks with return expectations and with the mandate to provide liquidity during market dislocations has become a more delicate predicament for them.
They must constantly monitor the operating environment as it can change quite dramatically in a short period of time with new challenges such as the emergence of new crytocurrencies. Challenges of reserve adequacy, asset concentration, and risk management will need to be assessed for sound and effective management of reserves. The role of reserve managers will assume even greater importance going forward.
