The markets have always had a healthy respect for, bordering at times on a fascination with, the activities of central banks as they manage their national reserves. In the more distant past, the amount of information that was released into the public domain on these activities was very limited and very strictly controlled, and as a result even trying to determine what central banks had just done was something of an art, while any analysis of what they might be considering doing in the future was extremely difficult and beset with lack of data.
In more recent years, there have been two developments – one helping the analysts, and one perhaps less helpful. Firstly, central banks have in general become more open, both in the reporting of their activities once they have taken place, and even in some cases about giving information on their future intentions. It is now easier for analysts and central bank watchers to determine a pattern in official reserves management, and to debate with more confidence the recent and future activity of these major investors. This is to be welcomed, because the influence that the activities of central bank reserves managers have on the markets they operate in is increasing, and the importance to market analysts of taking these activities, and the central bankers’ future intentions, into account has seldom been higher.
Alongside this move, there has been a rise in the number and wealth of “Sovereign Wealth Funds” or SWFs: large (in some cases very large) pools of national assets held outside the central banks in pure investment vehicles. These funds, which often have their origins in commodity surplus funds, are rapidly becoming very significant, not just because of their size (a combined total probably in excess of $2.5 trillion, and growing fast), but also because they are typically held in more diverse investments than traditional central bank reserves, and finally because they are often at an earlier stage of transparency.
This short essay looks at two of the recent themes, the continued growth in national reserves (whether held at central banks or sovereign wealth funds) and the increasingly diverse range of asset classes that they are being invested in. Neither are particularly new trends: both the rise in national assets and the diversification of their investment have been features of the international financial markets for at least the last 4 years. Nor are the two unconnected: it is largely the pressure of the former, i.e. the greatly increased portfolios, that has led to the latter, i.e. their diversification, as national authorities are forced to consider an ever wider range of asset classes for their reserves.
What is new, however, is the pace at which these changes are taking place, and also the impact they are beginning to have in the wider debate on the role of SWFs in the international financial system: the correct level of transparency on their activities and even the appropriateness of some of their investments. The essay therefore concludes by briefly widening the discussion into these areas.
The growth in official sector assets
The first issue, and certainly the most obvious one even to the casual observer of public sector finances, is the current explosion in official sector (central bank reserves + SWFs) asset growth. From a level of around $1.2 trillion at end 1995, and $2.0 trillion at end 2002, total central bank international reserves now approach $6 trillion. Add in the $2.5 trillion estimated to be in SWFs and the total of official sector assets is well over $8 trillion and rising fast.
Such a pace of reserves accumulation is unprecedented, and has generated considerable comment, not least from the official sector itself. What is especially noticeable is that this reserves accumulation is concentrated in comparatively few hands. Most of the growth is accounted for by less than 10 major holders, mostly from Asia, and indeed no less than 7 Asian central banks now have over $100 billion in reserves. And for the first time, the majority of international reserves are held by developing/industrialising countries.
Several reasons have been put forward for this rapid growth in reserve assets. For some countries it represents a desire to self-insure – this is particularly a feature of policy orientation in Asia, where countries that experienced the turbulence of the Asian Financial Crisis set a goal of rebuilding reserves to levels sufficient to avoid a repetition of the events of 1997/98. Secondly, and more latterly as the initial objective of rebuilding reserves was fulfilled, there has been a desire to maintain given exchange rates – again, this has been a major theme in Asia in particular. Lastly, and of more importance for resource-rich countries, in many cases domestic markets are unable to fully absorb current revenues. Many oil exporters especially find their domestic markets at risk of overheating and choose to keep a substantial proportion of their oil revenues offshore.
What is interesting about the development of reserves accumulation is that in several countries it has moved from being a conscious objective of policy (for example to self-insure) to a by‑product of other policies (for example the desire to stop domestic overheating or a rising exchange rate). As a result, a growing number of countries face the question of when the continued increase in their reserves stops being an undisputed benefit and starts to pose its own challenges – for example in the sterilisation of domestic credit expansion (the counterfactual to the intervention that builds up the reserves), or in the risks to the central bank’s own balance sheet from such large unhedged FX positions. In short, a growing number of governments and central banks are beginning to face two questions which have hitherto very seldom arisen: how much is enough reserves, and can a country actually have too much?
To date only a few countries have taken the step of formally creating separate investment vehicles for reserves that are deemed surplus to monetary policy requirements. More typically, the extra assets are held on the central bank’s books within the official reserves still, though increasingly with a wider investment remit than that for more traditional reserve assets. It is to this that we now turn.
The diversification of national investment portfolios
The second question facing wealthy national authorities is how to invest their greatly increased reserves. Two related issues arise here: firstly, a reliance solely on traditional asset sectors such as money markets and short duration government bonds risks over-concentration in a limited number of securities, and secondly, as reserves levels grow and the need to keep the bulk of the assets fully liquid at all times diminishes, the opportunity arises to seek incremental revenue.
As already noted, neither of these issues is entirely new. And the solution that finance ministries and central banks have adopted, diversification into new asset classes in order both to reduce concentration risk and enhance return, has a long pedigree. But the pace of the diversification, and the range of new asset classes that national authorities have considered for their investments, have increased markedly in the last 2 years or so. In a recent survey of central banks, 80% of those that responded said that they had added a wholly new asset class to their reserves portfolio in the last 24 months, and some of the new sectors that reserves managers have been studying and investing in include Mortgage-Backed Securities (MBS), Asset-Backed Securities (ABS), Corporate bonds and equities.
But for some countries, the discussion is no longer even limited to just investment returns and financial assets. One of the more striking features of the last two years has been the return of the central banking community to the gold market, this time as net buyers. After two decades when any gold broker who received a call from a central bank could safely assume it was for a sell order, a two-way market in central bank gold activity has re-emerged! And official sector investors are also increasingly looking at commodity investments – such as a strategic oil reserve – and even real assets as they seek to increase the diversification of their portfolios.
This has started a debate among reserves managers as to where exactly the boundaries of public sector portfolios should lie. Two questions in particular have come to the fore. Firstly, does the official sector have the skills required to manage increasingly diverse portfolios? As already mentioned, several countries have decided that there is merit in establishing a specialist investment agency to manage non-typical assets, though the exact location of the dividing line between what remains in the traditional central bank portfolio and what is hived off into the new investment portfolios is an interesting question. Other central banks prefer to keep all their assets in one place, but in recognition of the limits to their internal expertise they are increasingly willing to outsource the actual management of the assets to the private sector.
Secondly, the whole question of Strategic Investment has arisen. In an uncertain world, some countries are now looking to secure vital national interests – for example, ownership stakes in crucial companies, access to raw materials, or influence with other sovereign states – by using their plentiful financial resources. This fascinating extension of the debate over what governments should do with national assets has arisen only in the last 2 years or so: the trigger which caught the world’s attention was the attempt by some governments to use national asset funds to buy other countries’ private sector companies outright. This a controversial area with geo-political ramifications, and spice is added to the debate by the fact that – in a reversal of more normal roles – it is increasingly the developing world which is seeking to purchase companies in the developed world.
This has sparked a heated discussion within the developed world about the degree to which SWFs should be allowed to operate in national markets. Two main strands seem to be emerging: that SWFs should be restricted in what they are allowed to do in national markets (and in particular in the sort of companies they can take major stakes in), and that they should be more transparent in what they do.
How much transparency is appropriate?
This issue of transparency is a difficult question on which the received wisdom has moved dramatically over the last 20 years. 20 years ago, it was widely assumed that a central bank needed to maintain an air of secrecy over its operations: this was not limited to its reserves management operations but included monetary policy as well. The 1997 Asian FX crisis caused a reassessment of this assumption: the pressure on the Thai baht in June and July 1997 revealed that the Thai authorities had been covertly intervening in the forward market aggressively, and although their spot reserves were shown as being an almost constant $35 billion or so for the first 6 months of 1997, the forward book had grown from a flat position to minus $36 billion. In other words, the Bank of Thailand had negative $1 billion net reserves. When this became known the pressure on the baht grew to be irresistible, leading to the abandonment of the baht peg and a significant devaluation which had knock-on effects throughout the region.
In the aftermath, the analysis focused on the Thai authorities’ hidden forward book, and the general consensus was that in future it would be best practice not to allow such a distortion to exist unadvertised as a source of surprise to the market. The IMF published a number of papers extolling the virtue of openness, and the momentum in favour of transparency grew to be unstoppable (it was helped by the concurrent move to more independent central banks, with many arguments put forward along the lines of “if central banks are given greater freedom of action, it is only appropriate that we see more clearly what they are doing with that freedom”).
From the high-water-mark of the move to transparency, which was perhaps reached about 3 years ago, there are signs of a reaction and a realisation that not all aspects of central banking and official sector asset management are best conducted in the full glare of publicity. The most obvious recent case of this was the Bank of England’s dilemma in handling the insolvency of Northern Rock: the Bank’s belief that it had to announce to the market what it was doing at every stage of the process clearly affected its operations at the very least, and probably caused the Bank to be more circumspect when speed and decisiveness were the more obvious needs. But even before then there have been dissenting voices; witness the ECB’s determined and principled stance that it will not reveal the minutes of its interest-rate-setting policy meetings (the first president of the ECB, Wim Duisenberg, always maintained that the unity of the ECB was more important than publishing the debate, and that too great a ray of light on the deliberations of the Council would negatively impact on the process of building the consensus the new institution needed).
The latest stage of the transparency debate has sought to force SWFs to provide the same level of openness as central banks. While for the proponents of transparency this would appear to be a logical conclusion to the enthusiasm for openness that has characterised so much of the public debate in the post 1997 world, it has for many commentators merely illustrated the flaws in the mantra of “the more transparency the better” – the arguments in favour of SWFs being more transparent have often seemed somewhat simplistic and have ignored the long history (in some cases decades long) of these official bodies operating with a minimum of fuss, publicity and controversy and yet in harmony with markets and other market participants.
The debate on openness, like so many debates in central banking, does not permit an absolute answer, and some of the more thoughtful commentators sense that the “pro-transparency” ascendancy is on the wane and the pendulum is beginning to swing back. SWFs are legitimately asking western authorities what they mean by “greater transparency”, what information is required (and to whom it should be shown) and why the modus operandi that established SWFs have used for decades is suddenly so unacceptable.
At the moment the discussion on how SWFs should interact with western markets is still at risk of being driven by political populism, and the temptation for western governments to pander to protectionist sentiments is strong. But given that SWFs are by their very nature sovereign institutions, the only way to progress the debate on transparency and involvement is by consensus and dialogue not political posturing, and the debate will only move into the more productive stages when the western authorities engage – as they will inevitably have to in due course – directly with the SWFs themselves.
Whatever the political concerns surrounding this issue, there is no doubt that purely on a portfolio risk management basis, there are legitimate grounds for asset-rich countries to seek real assets in this way, not least to avoid the risk that official sector debtors from the industrialised countries will seek to reduce their (nominal) liabilities through a policy of inflation. It is not yet clear what the consequences of this new investment dynamic will be, and whether it is in fact either optimal or even in some senses legitimate for public sector asset managers to push the boundary of risk‑reward maximisation in this way. But the subject is certain to remain a live one as long as asset-rich states continue to look to diversify their national wealth away from portfolios consisting wholly of securities and paper assets, and as long as governments seek to use all the tools at their disposal – including large financial assets – to pursue their national interest.
Central Banking Publications Ltd (2006): “How countries manage reserve assets”, annual survey published in February 2006
European Central Bank (2006): “The Accumulation of Foreign Reserves”, ECB occasional paper no. 43, available via www.ecb.int
Knight, Malcolm D. (2006): “International reserve diversification and disclosure”, speech to the SNB/Institute for International Economics Conference, September 2006.
Nugée, J.F. (2004): “Developments in Central Bank Reserves Management”, available via www.ssga.com
Rozanov, A. (2005): “Who holds the wealth of Nations?”, Central Banking Quarterly Journal, Vol XV issue 4
Rozanov, A. (2006): “Time to Spend: Russia and the G7”, The World Today, July 2006 issue (published by Chatham House)
 A term now in common use but originally coined by my SSgA colleague Andrew Rozanov; see Rozanov (2005).
 For example the Norwegian Statens pensjonfond (“Government Pension Fund”, but a continuation of the former Petroleum Fund, which was funded by sales of Norway’s North Sea oil), the Chilean copper fund and Middle Eastern national investment funds financed by oil revenues.
 See Nugée (2004).
 As at end October 2007. Source: IMF, various national statistical reports.
 See for example ECB (2006), Knight (2006)
 Singapore led the way in the 1970s and early 1980s, with the creating of Temasek Holdings and (later) the Government Investment Corporation. Other countries, mostly in Asia and most notably China and Korea, are increasingly adopting a similar approach.
 See Central Banking Publications Ltd (2006).
 Though it is interesting to note that the recent injections of capital into some western financial institutions have not been met by any protectionist opposition (except at the margin by a few shareholders unhappy at seeing their investment diluted). Maybe the current financial situation has enabled SWFs to emerge from their latter-day image of aggressive buyers and reassume their more traditional role as conservative and sympathetic long-term suppliers of capital to markets.
This essay was first published by State Street Global Advisors as part of their Insight programme