Divergent monetary policies are top concern for reserve managers in 2016

Divergences in monetary policy between major central banks will probably have the most impact on the work of reserve managers around the world in 2016, according to managers' views submitted to a 2016 Central Banking survey. The impact of divergent policies was viewed as more significant than concerns about either the state of China's economy or volatile oil prices. This was one of the main results from the survey of reserve managers at 77 central banks responsible for foreign exchange (forex) and gold reserves worth $6.04 trillion – or 51% of the world's total.

The survey, published in HSBC reserve management trends 2016, also found that central banks are continuing to invest in alternative currencies and asset classes in a bid to boost yields. And more are resorting to securities lending in an effort to increase returns as well as using derivatives in an attempt to avoid paying interest to park funds. With rates rising in the US but slipping further into negative territory in Japan and the euro area, reserve managers not only face challenges on a day-to-day basis in managing liquidity, but also in the longer term with respect to currency and asset allocation as portfolios are pulled in different directions. Just under half of the respondents, responsible for $2 trillion in reserves, ranked divergent monetary policies as the most significant macro risk.

A reserve manager from the Americas said the uncertainty created by divergent monetary policies makes for volatile markets: "We are in a context of uncertainty. There are doubts about the future [Federal Reserve] decisions and about the evolution of some emerging markets. At the same time, China's reserves are falling. Consequently, there is a lot of volatility, and this has an important impact on investment decisions."

A European reserve manager noted that all the factors were interrelated, "as declining oil prices and developments in China and emerging markets [EMs] are impacting on central banks' actions", but added that they thought "the degree of diverging monetary policy in the US and Europe is indeed the key factor for 2016".

Separately, economic developments in China and other emerging markets comprised the next point of concern, ranked by probable significance of impact, with 30% of respondents ranking it second and 23% placing it third. Concerns centred on the ability of emerging markets to continue contributing to global growth and in particular the influence China's economy has not just on output, but also on monetary policy in other major economies. A fraction less than 20% of respondents, polled during February and March this year, saw this as the factor most likely to affect reserve management in 2016.

A reserve manager from a central bank in the Americas stressed the pervasive influence of China across markets, currencies and macroeconomic policy: "Even though all those factors are somewhat intertwined, it seems that the investment repositioning currently taking place in China tends to seriously affect global perspectives (mainly regarding emerging markets) and commodity prices in the short term, with direct consequences on asset prices, currency volatility and, therefore, on reserves composition."

Falling commodity prices

The decline in the oil price and other commodities was ranked just below concerns about emerging markets in importance, with 27% ranking it second in significance and 26% third. In their comments, reserve managers particularly noted question marks over the ability of commodity-dependent economies to accumulate reserves, even though some commodity prices have recovered from their most recent low levels. An African reserve manager outlined how soft commodity prices would lead to a retrenching of reserve management strategy: "Many commodity-dependent countries are expected to see a decline in forex earnings from commodity exports as prices are projected to remain depressed. This will entail a deceleration in the growth of reserves. Additionally, a slowdown in China's growth will mean a further deterioration in commodity prices going forward. Therefore, these countries will adopt a more conservative management strategy to ensure liquidity availability to meet short- to medium-term contingencies."

A reserve manager from a developing country noted the likely impact on their central bank in particular: "The decline in oil and natural gas prices has significantly impacted the accumulation of reserves in recent times, given that [the country] is an energy-based economy."

In an extended comment, a reserve manager from Europe saw the falling oil price and lower growth in China reducing monetary policy divergence: "Declining oil prices most likely will drive down inflation (expected and real) and may ignite significant spikes in unemployment (oil mining workers can't simply shift their skills to get employed elsewhere), the growth momentum may skew to the downside also due to a significant slowdown in oil manufacturing. China, being the world's second-largest economy, is (most likely) in hard landing already. That's not a constructive environment for their export partners, such as the US. Also, devaluation of the renminbi imposes less incentive for the Federal Open Market Committee to raise interest rates, therefore further monetary policy divergence is less likely."

Falling forex

Changes in reserves levels and exchange rate volatility were seen as relatively insignificant. Nearly half of respondents placed the former fifth out of five, and one-third scored the latter fourth. A reserve manager from Asia noted that "changes in reserves levels will affect both strategic and tactical asset allocation", but added that divergent monetary policies would too.

An African reserve manager said that volatile exchange rates would be most significant because of the impact on the central bank's financial results: "The increase volatility of the exchange rate will be one of the main challenges for reserve managers in 2016, as most central banks report in local currency. Volatile exchange rate could, therefore, result in volatile financial results and foreign reserve levels."

Negative rates

The introduction of negative interest rates has had a far-reaching impact on reserve management strategy among central banks, forcing reserve managers to reassess their traditional aims of security, liquidity and return. This was the view of a majority of respondents that were in this case responsible for $4.6 trillion in reserves. In particular, some said negative yields violate the first axiom of security, as they erode capital value.

To avoid this, reserve managers must look to take on other risks, according to a reserve manager from an EM central bank. "The first priority of reserve management in most cases is security, which implies preservation of capital. Investing in an asset that is known to yield negative returns from the outset is counterintuitive to this priority," the reserve manager said. "However, avoiding negative returns means assuming additional risks in the form of interest rate, credit or currency risk. Depending on their particular conditions, different central banks may have different policy responses – varying from accepting current market conditions as they are to assuming additional financial risks."

A reserve manager from the Americas described a predicament facing reserve management: "There is a dilemma: traditionally, central banks have been conservative investors. Nevertheless, in an environment with lower and lower interest rates, they have [fewer and fewer] options to obtain a better return. Therefore, they have to look for new investment options and, as a consequence, have to be less-conservative investors."

From Europe, a reserve manager offered three potential impacts, with the first two concentrated on shifts in portfolio holdings. The official also highlighted how negative rates could lead to growth in central bank reserves: "There are a few aspects. First, it motivates [central banks] to explore new ideas; how to make some money – and, with distorted swap markets, there are new opportunities. Second, it moves certain limits, for maximum duration, for larger portfolios meant for securities lending, etc. Third, negative rates make clients move their deposits from the market with negative rates to central banks, or even sell that foreign currency to the central bank where rates are zero – and, by doing so, these deposits and forex increase reserves."

At a portfolio level, central banks have taken a number of steps, including withdrawing from the currency where rates are negative, extending duration or looking to new asset classes and currencies where yields are non-negative.

Comments from reserve managers in Europe and Americas summed up the options central banks were mulling over. One from Europe said: "Negative interest rates in some countries are forcing central banks to rethink how much of their reserves to allocate to their currencies. Central banks are cutting the holding of euros, Swiss francs, Swedish kronor and Danish kroner, and this rebalancing is affecting exchange rates between currencies. Central banks are continuously increasing interest rates' exposure by repositioning themselves on the long end of the yield curve where some positive yields can be found. To compensate for the negative yields, central banks are also taking on credit risk and are moving to alternative instruments, such as equities, corporate bonds and infrastructure."

The reserve manager from the Americas noted a general unease towards negative rates: "Central banks are reluctant to invest at negative interest rates. It is our impression that some have reduced their exposure to assets of countries with negative interest rates. Others have lengthened their duration to pick up some yield (this helps to explain the low or negative term premiums in fixed-income markets). Others have added credit risk exposure for the same reason, increasing their exposure to bank deposits, corporate bonds and/or asset-backed securities."

Comments from other respondents echoed these sentiments. A central banker from the Middle East said that negative rates had led to "diversification into riskier assets", while a European reserve manager said: "Reserves have been reallocated to currencies with positive rates. The asset allocation has been enlarged in terms of duration and credit risk."

Another reserve manager, from the Middle East, said there was "caution with regards to exposure to negative rates and negative returns". An Asian central banker said that yen exposure may fall marginally due to negative rates, and a eurozone reserve manager noted that some central banks might reduce their holdings of euro-denominated assets.

Euro and yen holdings cut

The shift to negative rates has led a majority of central banks to change aspects of their portfolio management. Respondents responsible for managing $2.2 trillion in reserves had felt the impact, and provided examples in terms of currency selection, asset allocation (including benchmark), liquidity management and, more broadly, in terms of a greater focus on returns on a day-to-day basis. The most common area for change noted was currency, where, as might be expected, holdings were reduced where rates were negative.

A central banker from a transition country in Europe said they had liquidated their euro investment portfolio, adding that they had "also assessed the probability of similar moves by other central banks". A reserve manager in Africa revealed they had "retired allocations to euro, Swiss franc and Japanese yen".

For a reserve manager in the Caribbean, the decision by the Bank of Japan to introduce negative rates had significant consequences: "We have reduced our exposure to yen deposits. These deposits were initially maintained to meet foreign currency obligations. These obligations are now satisfied via the purchase of currency in the spot market. This has proved beneficial for us thus far. However, we may have to consider using forex forwards if negative deposit rates persist and the volatility in currency markets heighten."

A European reserve manager said they had reduced the share of euros in their reserves, while a central banker in Africa said, conversely, they had extended the tenor of their euro deposits in a bid to escape negative returns.

From the Americas, a reserve manager said they had looked across their currency holdings: "We have reassessed and reviewed the criteria of currency composition in order to incorporate this negative rate environment and the impact it has on the balance sheet as the pillar of capital preservation is being impacted."

For a reserve manager in Africa, there was now a greater onus on monitoring and improving returns in euro and yen portfolios: "Negative rates defy capital preservation objectives, hence encouraging higher risk appetite. There is now more effort targeted towards reducing the impact of negative interest rates in the euro and yen reserves portfolios."

A reserve manager from Europe offered a similar view: "Daily portfolio management decisions are affected by the negative interest rate environment in a way that there is more emphasis on yield enhancement and avoiding capital losses."

Reserve managers favoured the dollar, as the combination of rising yields and economic growth in the US compared positively with the negative rates and malaise of the euro area and Japan. There were concerns regarding EM currencies following outflows, and commodity currencies were felt to be overpriced. There was evidence of a pulling back from EM currencies, with fewer central banks investing in a number of non-traditional reserve currencies (see figure 1). The South Korean won was the notable exception to this.

The number of central banks that reported investing in the renminbi has risen sharply, although they remain cautious about its future. Reserve managers expect the renminbi's share of global reserves to rise to 10% by 2025, although they do not see it challenging the major reserve currencies in the foreseeable future. Thirty-two respondents said they invest in the renminbi – a remarkable increase from the 2012 survey, when only three said they did. However, the pool of those interested in investing in the renminbi did not appear to have grown since last year's survey.

More central banks reported having invested in equities, and more are considering the asset class. Less than half of the respondents said they had no interest in investing in equities, compared with 52% in last year's survey. The trend of dividing reserve portfolios into tranches to meet investment and liquidity needs continued, and some are increasing the number of tranches.

Meanwhile, interest in, and use of, securities lending has grown (see table 2). It appears to remain, however, largely a preserve of developed economies' central banks and large holders. Use of derivatives has also grown further as markets have become less liquid and more volatile. Almost all respondents use derivatives for hedging and duration management, while nearly three-quarters look to derivatives to enhance yield.

This is a summary of "Trends in reserve management: 2016 survey results", by Nick Carver, chapter one, HSBC reserve management trends 2016, edited by Nick Carver and Robert Pringle (Central Banking Publications, 2016). The survey questionnaire was sent to 130 central banks in February 2016. By the end of March, replies had been received from 77 reserve managers, responsible for reserves worth $6.04 trillion (with gold valued at market prices) as of August 2015. Reserve managers took part in the twelfth annual survey on condition of anonymity.