Central banks working against one another was a key problem during the crisis, a panellist at a CentralBanking.com web seminar focusing on reserve management on Wednesday.
"The most confusing thing for me during the crisis was that some central banks were intervening to try and support certain asset classes, the Fed and ECB in particular, and at the same time, other central banks were sellers of the same assets," said Gary Smith, the head of the official sector group at BNP Paribas.
"I'm not trying to apply perfect hindsight to criticise what central banks were doing, and I understand central banks wear two hats and reserve management is not the same as market regulation," added Smith, who then questioned whether this "problem of central banks working against each other" would be repeated if another crisis were to come along.
"Or have central banks spoken about this 2008/2009 problem and devised a strategy to avoid that kind of confusion happening again?" he asked, stating this was very much an issue for more developed economies.
The lessons for developing countries to learn after the crisis were slightly different, Smith said.
"First, I would say for many developing countries, the lesson was having a lot of reserves was better than too few; second, the role of the dollar should not be underestimated; third, having access to a swap line with the Fed proved very useful."
Michael Hart, head of FX strategy at Roubini Global Economics, said: "What we have seen is central bank managers have taken what they thought were the lessons from the Asian crisis in 1997 and insured themselves against sudden reversals in capital flows by accumulating reserves."
The problem with this was the inherent differences between the two crises, he said. "Then, what we had was a lot of speculative attacks on the currencies. This time, the issue was really the refinancing, and drying up of liquidity in wholesale markets that were fuelling the private sector."
Panellists agreed that countries needed to try and work in a more co-ordinated fashion. "What may be individually rational for a particular country can lead to sub-optimal outcomes, in that it exacerbates global imbalances that have bedevilled the global economy over the past decade," said Hart. "There has been a co-ordination failure."
Responsibility within the central bank
Turning the discussion to who within the central banks should be responsible for making the decisions about reserve management, Luděk Niedermayer, former vice-governor of Czech National Bank, said this is an issue "that must be assessed by the board, the top managers of the central banks".
He said countries wouldn't necessarily need to change their legislation to allow central banks to make better decisions about reserve management. "Most central banks have sufficient freedom in most cases to set structure of reserves," he said.
Smith said this was an issue of "mission clarity". "A lot of central banks lost sight of mission clarity because they were hit with a catastrophe," he said. "We've spent many years reading about central bank reserves being divided into a liquidity tranche and an investment tranche, and that these two did slightly different things. During the crisis, it is clear to me these definitions were wrong. People had way too much in investment tranche and not enough in liquidity."
Now, he said central banks must "go back to the drawing board and decide exactly what they want to hold reserves for. There needs to be greater clarity in terms of the job a central banker is supposed to be doing."
Preparing for the next financial crisis is a tough job, as central banks have no idea when it will happen or what might be the root cause of it. The panellists noted that this uncertainty had interesting implications for how reserves should be invested.
"Liquidity is king, it remains the paramount objective," said Hart. "Currency diversification, which has been pursued by several central banks, aggressively in some parts of the world, is of no benefit in a crisis. That will of course mean there will be some underperformance from a portfolio point of view during normal times, but that perhaps is the cost a central bank has to bear to achieve the cushion needed."
"The question of what is really safe and what is really liquid is a difficult one," said Niedermayer. "I am a big believer in the German economy these days, but if I buy German bonds, I am not buying German currency, I am buying the euro. If I look to the US, the level of debt is extreme and I don't see a clear commitment to bring it down. You don't know what are safe assets and if these will perform poorly in the future."
The discussion on equities concluded that they were generally a suitable asset class for central banks to invest in.
"In my experience, they are [looking at investing in equities]," said Smith. "The central banks doing this are the ones seeing the most rapid increase in the size of their foreign exchange reserves. It's not a liquidity-driven decision, it's a decision to try and grab more yield and fight against the negative carry-cost of holding reserves."
"It makes more sense to reconsider equities than to buy some structured products," said Niedermayer who stressed that whatever investment decisions are made, the central banks must be honest about what and why they are investing.
"Transparency in asset management is very important," he said. "[Central banks must] disclose the details of how reserves are invested, what is the rationale behind it, what is the strategy."
Hart said there was a relationship between the size of the reserves and the allocation of the reserves. "After you pass a certain threshold or have achieved a comfort that liquidity needs are being satisfied, you can then look to enhance performance," he said.
The question of how to quantify excess reserves caused a conundrum for the panel.
"I cannot begin to tell you what adequate reserve levels are," said Smith. "But neither can anybody else. All the old models are wrong, that is clear. The way I would approach this is that you probably need more than you used to think you needed, but it's interesting to think about the level of reserves from a relative perspective rather than an absolute perspective. Think about what other countries have, aim to have more than them. There is typically a league table of vulnerability, you want to be higher up that of course."
"The problem with that sort of categorical imperative is that it's not scalable," said Hart. "It is not something you can apply to every central bank."
While Hart said it is "impossible to insure against all sorts of contingencies", he said something that would help a central bank compete in the "arms race of reserve" are the swap lines the Fed and several other central banks provided during the times of crisis.
"To prepare for the next battle, if not war, is to make that institutional arrangement [the swap lines] more permanent rather than an ad hoc feature."
Flight to safety
The flight to safety action of many central banks no doubt perpetuated the financial crisis.
Panellists expressed surprise that countries did not try to act in unison, rather than in such a disparate way. Niedermayer suggested that perhaps the Bank for International Settlements could provide the forum for more co-ordinated approaches, because "at home, each central bank is fighting its own fight".
The subject of the dominance of the dollar as a reserve currency led to an interesting debate. Panellists agreed any change to the status quo would be slow. "The dollar is so dominant that a change to that would take a long time to engineer," said Smith.
"Reserve currencies will not change overnight," agreed Niedermayer.
The internationalisation of the Chinese currency, the renminbi, was of great interest to all three panellists, who said the political strains could affect the process. "I think the difference in power between the dollar and the renminbi [and the political pressure this creates] could allow greater internationalisation," said Smith.