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Reforming FX reserve and macroeconomic management for ESG

Reforming FX reserve and macroeconomic management for ESG

Arnab Das, global market strategist, Europe, the Middle East and Africa, at Invesco explores why central banks must play a role in environmental, social and governance (ESG) risk mitigation, management and prevention, as they are expected to during wars, pandemics and other major shocks.

The ESG revolution may challenge central banks even more than other market participants or public institutions. How central banks respond could make all the difference for two of their key roles in society – as guardians of economic and financial stability through monetary policy, and stewards of national wealth and insurance as reserve managers.

The range of perspectives and policies across the panel of policy-makers who took part in a roundtable convened by Central Banking crystallises the issues and debate: a mix of similarities, varied approaches and, in practice, opposing views on whether central banks or government bear responsibility for ESG imperatives and therefore how central banks conduct monetary policy and foreign exchange reserve management.

Perhaps the most fundamental way to think through these central banking ESG conundrums is to go back to the basics – the principles of modern monetary policy. The idealised vision of central banking has become minimalistic over decades, until recent crises. Central banking increasingly focused on specific goals, ultimately boiling down to the pursuit of price stability defined by an inflation target.

This specialisation was pursued on the basis that central banks should have no more goals than instruments they can deploy. Furthermore, such a singular, transparent goal would provide a clear metric for economic analysis and its synthesis into judgement and policy decisions – as well as accountability to the public. Thus, central banking could be independent of political, economic and financial cycles, and even of changes in the structure of the economy, society or the world as whole, yet would still represent a major element of the social contract – central banks would remain at arm’s length.

This rethink of central banking followed the Great Inflation of 1965–82, when the independence of the US Federal Reserve was repeatedly challenged; macroeconomic policy in the US was particularly expansionary and governments were very active in the economy throughout the world; the US dollar and, by extension, other currencies were severed from gold; and inflation was not only high and persistent, but volatile and rising. That is, modern central banking was remade after economic policies contributed to far worse economic performance than was tolerable.

The elegance of this reform of monetary policy in a fiat currency regime gained enormous credibility during the Great Moderation from the mid-1980s until 2007 – two decades in which inflation subsided but real growth proved resilient, with rising productivity growth. As a practical matter, defining these goals implicitly focused on the policy interest rate on central bank liabilities – money, specifically bank reserves. After the effective lower bound on policy rates was reached, the focus shifted to the size of domestic assets via quantitative easing programmes.

The analogy on the asset side of central bank balance sheets was also direct and clear: FX reserves are held to support monetary policy in pursuit of price stability (or currency stability, for central banks that had exchange rate targets, before most moved to inflation targets). Hence, the hierarchy of reserve management – liquidity, safety and capital preservation – works to ensure that reserves are sufficient, sellable and stable in case of need, when called upon in extremis.

This combination of precise goals, defined instruments and easily measured accountability on the face of it collides with the ESG revolution, at least for many purist central bankers and academics. Aligning monetary policy and reserve management with climate risk mitigation, transition risk management, inequality or corporate or public governance goals poses insurmountable obstacles: not only would it dilute central banks’ missions, it would also blur the lines between independent central banks and the much greater scrutiny and accountability imposed on explicitly political policies – fiscal, regulatory, structural policies that are best allocated to legislative and executive branches.

However, since the global financial crisis that began in 2007–08 and the eurozone financial crisis since late 2009, financial stability mandates have been reintroduced and inflation targeting has been reoriented to be more flexible and averaged over time, rather than aiming for a single point. These reforms amount to an enhanced central banking mission in a global economy and financial system that can arguably be much better aligned with ESG imperatives.

A world facing climate and other ESG risks is one in which central banks will have to change how they think about maintaining macroeconomic and financial stability, even though it may leave them exposed to purists’ fears of politicisation and accountability for outcomes beyond their control.

Price, currency and financial stability can be relatively easily assessed. When such relatively pure macro targets are essentially achieved, all is well, but if not, change can be instituted. Difficulties with exchange rate stability anchored by gold, for example, paved the way for a shift to fiat currency. The Great Inflation contributed to the development of inflation targeting, supported by central bank independence, monetary policy committees and new communication strategies.

In contrast, making central banks even partly responsible for ESG goals could also render them at least partly accountable for outcomes that lie beyond their capacity to manage. For example, if central banks take on exposure to firms or governments through large-scale asset purchase programmes in domestic monetary policy, they may be providing indirect financing to economic agents that do not deliver on their commitments or, even if they do, climate change targets are still missed. Who would then bear responsibility?

Even so, there’s no escaping the threats to economic and financial stability posed by climate change itself, transition risk and by efforts to address these risks. Climate change could threaten economic activity worldwide. The Covid‑19 pandemic brought this into sharp relief: lockdowns worldwide led to a tipping point in economic activity and financial stability, then causing a worldwide ‘dash for cash’ in late March 2020. Economic and financial stabilisation were essential to sustaining lockdowns in a massive, coincidental – rather than co‑ordinated – effort to restore public health. It fell to central banks to provide monetary liquidity to meet the demand for cash, which eased monetary policy.

Emerging market central banks faced capital outflows and initially liquidated large portions of reserves. The pandemic thus crystallised ESG risks – most clearly climate risk, but also other environmental challenges, such as deteriorating biodiversity or social stresses due to environmental flashpoints, inequality, severe commodity or food inflation – all of which could threaten economic and
financial stability.

Equally, a ‘greenium’ on financial assets deemed to be ESG-desirable could combine with a ‘brownium’ – relating to the deterioration of non-ESG assets – to cause relative price shifts that affect growth or inflation. Climate change itself could precipitate a global economic tipping point.

For reserve managers, the message may be that liquidity tranches should be far more customised and resized to reflect national ESG exposures, in addition to traditional metrics such as trade or debt flows in the balance of payments, even as investment tranches are redirected to be better protected against ESG risks. On the whole, central banking may need to adapt in both monetary policy and reserve management to factor in the increasing importance to macrofinancial stability of climate risk, transition risk and associated effects on balance sheets and income flows throughout the economy in the corporate, banking, household and public sectors – including those of central banks themselves.

In short, central banks as reserve managers, macro policy-makers and financial regulators will need to play a role in ESG risk mitigation, management and prevention, just as they would be expected to in wars, pandemics or other major shocks. 


This feature forms part of the Central Banking focus report, ESG for central banking 2021


Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information
This article is for Central Banking only and is not for consumer use. Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
Issued by Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.

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