Nalm 2013: Debate rages over how to manage expanding reserves

Central banks enter into new asset classes and alternative currencies but Bank of Israel’s Andrew Abir rejects value of renminbi as a reserve currency
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The renminbi does not "meet the conditions of a reserve asset", and increasing holdings of renminbi reserves by some central banks is more likely a political statement than a genuine reserves asset allocation, according to Andrew Abir, director of market operations at the Bank of Israel.

Abir was discussing the rebalancing of reserve portfolios in the post-crisis world, alongside Feiran Long, a portfolio manager at the Bank of Finland, and Rajendra Pandit, director of foreign exchange management at Nepal Rastra Bank, at National Asset and Liability Management 2013.

His comments came following a presentation by Gary Smith, head of central banks, supranational institutions and sovereign wealth funds at BNP Paribas Investment Partners, who extolled the benefits of investing in the renminbi and said the Chinese unit of exchange would become a major reserve currency in the not-too-distant future.

The composition of the Bank of Israel's reserves has changed since the crisis, Abir explained, with the central bank diversifying around 10% of its reserve portfolio into smaller, less liquid, currencies. However, this does not represent a fundamental shift in investment policy, he stressed, as it only involves reserves that are "not needed in the day-to-day activities" of the central bank.

But this is not always the case. The Bank of Finland, for example, has split its management framework into separate portfolios for ‘liquidity reserves' and ‘investment reserves' – with different objectives for each – as its reserves have grown.

Abir acknowledged the benefits of using separate tranches, but said the Bank of Israel does not possess enough excess reserves to extract the benefits of such a policy – despite its reserves growing from $28 billion in 2007 to a current $78 billion. Splitting a central bank's reserves, he said, has the effect of removing "one degree of freedom" from its investment strategy, and given the size of the Bank of Israel's reserve holdings, it makes more sense to operate one portfolio under separate liquidity and loss constraints.

But Abir revealed the Bank of Israel started investing in equities last year – partly to hedge against interest rate risk. "It was a reasonably difficult process to get it into the portfolio," Abir said. "[The potential for] headline losses were a concern."

However, The Bank of Israel invests in equities through an index, and Abir said it is easier for the public to accept an index falling than it is to accept the default of a company in which the central bank holds corporate bonds. For this reason, the Bank of Israel does not invest in corporate bonds.

When choosing which assets to invest in, the relevance of rating agencies has decreased, according to Long. Their debt ratings are receiving less attention in central bank investment decisions, a trend he said "will probably continue".

Abir suggested, however, that while rating agencies have made some notable mistakes, there are few alternatives available. Central banks are unable to compete with rating agencies' superior resources, he explained, and there is an absence of practical and affordable alternatives.

Another consideration when allocating reserves is whether to employ external managers to help handle the growing portfolio.

Pandit revealed the Nepal Rastra Bank, which invests in both renminbi and Indian rupee assets, employs external managers to invest some of its reserves, but warned "you have to be careful how much they handle". External managers can provide a combination of experience and independence, he said, but central banks must ensure they follow the investment guidelines, he stressed.

External managers' expertise is most valuable when moving into new assets, Abir said, and there are also economies of scale to exploit, particularly in IT investment. However, he said, the knowledge transfer is "pretty minimal" as it is not in their interest to lose their competitive advantage.

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