Central Bank of the UAE. Image source: Wikipedia
Over the past decade, we have become accustomed to a relentless focus on central banks as the captains of the global economy and financial markets. Frequently forgotten is that central bankers also operate as investors for large investment pools, particularly foreign exchange reserves. In this regard, central banks have responded to the policy signals of their peers and also moved up the risk spectrum in their own portfolios, mainly by buying equities, corporate credit and asset-backed securities.
The total global pool of foreign exchange reserves hovers between $13 trillion to $14 trillion, making central banks one of the largest investor groups. In reality, the bulk of foreign reserves are designed to simply be able to provide liquidity for foreign exchange and follow traditional rules of prioritizing liquidity, safety and return—in that order. Consequently, high-grade sovereign bonds (e.g. US Treasuries) remain the preferred reserve instrument across the globe, constituting nearly 60% of all reserves. Liquid deposits with the BIS, other central banks or commercial banks make up about 12% and gold holdings slightly less than 10%. In other words, business as usual.
The change has come in the remaining portfolio, with higher risk bonds (mainly corporate bonds and asset-backed securities) constituting nearly 9% and equities over 6% of all reserves. This is a quiet revolution compared to central banking just a decade earlier and reflects a recognition that many economies enjoy excess reserves—i.e. reserves over and beyond what would be needed to simply service worst-case foreign exchange needs.
In the Gulf, most balance of payments surpluses have flowed into sovereign wealth funds. This has led to the counterintuitive result that Gulf central banks have actually pursued a very traditional and conservative portfolio for their foreign exchange reserves. This is eminently logical if one considers the entire sovereign balance sheet holistically, where higher risk assets are managed by sovereign wealth funds specifically designed for that purpose.
In this context, Gulf central bankers deviate from their global peers who have responded strongly to the signals of unconventional monetary policy in the developed world. This has depressed bond yields and raised asset prices, pushing investors to hold riskier assets. In this respect, central bankers have behaved very similarly to other investors, and frankly, have benefited from a long bull market.
One understudied aspect is that central bankers are now major capital market players in certain asset classes. This is less the case for equities or corporate bonds where they own less than 3%. But in high-grade sovereign debt, central banks hold nearly one fifth of the global supply. If one factors in the bond-buying from quantitative easing (QE) of developed economies and other sovereign vehicles, nearly half of all sovereign debt sits on government balance sheets.
In plain English, governments are largely financing themselves from other governments.
This begs the question, what would happen if central banks dropped off as steady buyers of government debt? The reality is that this could contribute to a structural jump in bond yields in order to attract other buyer groups. In fact, in recent years the rising rate environment in the US has led to a drop in foreign official purchases of US treasuries, but this was offset by big demand from domestic retail investors who found short-term rates of 2+% very appealing after a decade of low yields. However, concerns over sovereign creditworthiness could limit investors’ appetite. It is fair to then assume that developed central
banks would not sit by idly but would restart bond purchases in order to push financing costs back down.
The conclusion for most of the Middle East is that financing costs are unlikely to jump sharply as long as oil producers can manage reasonable current account balances and retain credible pegs to the US Dollar. For this, it helps that Gulf central banks maintain credible reserve management, particularly if their sovereign wealth funds cannot provide the necessary liquidity in time of need.
Elliot Hentov is the Head of Policy Research at State Street Global Advisors.