High level talks at Jackson Hole in August were a reminder of the pivotal role played by the world's leading central banks in formulating monetary policy and coordinating quantitative easing (QE) strategies in support of a balanced and sustainable economic recovery. What is sometimes overlooked, however, is the importance of the judicious management by central banks of their currency reserves as an essential component of their responsibilities as guardians of financial stability.
Christian Deseglise, Global Head of Central Banks Coverage at HSBC, says that much of the build-up in central banks' buffers as protection against instability in financial markets dates back to the aftermath of the Asian crisis at the end of the 1990s. In the previous decade to 2014-15, he says, central banks' reserves rose from around USD1.6 trillion in 1998 to a peak of USD12 trillion in 20141.
Although decreases in China and the Gulf have brought the total down to slightly under USD11 trillion in 2017, the reserves held by the world's central banks remain formidable. Because central banks have a fiduciary responsibility to manage national reserves conservatively, their asset allocation is an important barometer of confidence in the markets and asset classes in which they invest. HSBC's annual Reserve Management Trends Survey sheds important light on appetite for these asset classes by monitoring the attitudes and expectations of reserve managers on central banks' investment strategies. This year's survey polled 80 reserve managers with assets of some USD6 trillion.
Most central banks are either already beginning to make allocations to RMB or are studying the potential of the market. Very few are ignoring the RMB market altogether.
One of the principal trends uncovered in this year's survey, says Deseglise, is the continued diversification and adaptability of central banks in response to the challenges faced by all investors in today's low yield environment. "Although capital protection is reserve managers' number one concern, many are also looking to add more risk to their portfolios to generate an acceptable return," he says. More specifically, Deseglise explains, they have been adding to their exposure of RMB assets, as well as to their holdings of corporate bonds, equities and green bonds.
Appetite for RMB
Perhaps the most striking feature of reserve managers' responses to this year's survey is the growing strength of their appetite for RMB, says Bernard Altschuler of HSBC's Central Banks and Reserve Managers coverage team. However he says that central banks' allocation to RMB today remains very modest. Although some central banks in countries with strong trade links with China have increased their holdings in recent years, the aggregate exposure to the Chinese currency is around 1 per cent.1 This equates to USD89 billion of the allocated reserves among central banks providing a currency breakdown of their holdings. This compares with around 65 per cent in US dollars, 19 per cent in euros and 4-5 per cent in currencies such as the British pound or the yen according to IMF data. Allocations to euros have fallen since the eurozone crisis, from a peak of around 28 per cent in 20091 with central banks' holdings of commodity-driven currencies taking up some of the slack.
Central banks' allocation to RMB looks certain to grow over the next few years, says Altschuler, who says that the number of central banks buying RMB has risen from three to 45 in the last three years. "Most central banks are either already beginning to make allocations to RMB or are studying the potential of the market," he says. "Very few are ignoring the RMB market altogether."
Respondents to this year's survey predict that by 2020, central banks' exposure to RMB will rise to 7.4 per cent, which Deseglise says will equate to annual inflows into the currency of some USD140 billion.
This may turn out to be a significant overestimate. Deseglise points out that there is generally a notable discrepancy between respondents' expectations of their own allocations and their forecasts for the market as a whole, which may be a reflection of reserve managers' natural conservatism. In the case of RMB allocations, their forecasts for their own allocations are just 3.8 per cent, which Deseglise says would translate into additional annual inflows of RMB60 billion.
Drivers of RMB demand
There is ample room for increased allocations to RMB, with demand likely to be driven by several factors. One of these is the Chinese authorities' commitment to the continued internationalisation of its currency. This commitment was recognised in October 2016 when the RMB was included in the IMF's Special Drawing Rights (SDR) basket, alongside the US dollar, euro, yen and British pound. The IMF noted at the time that this inclusion was in recognition of China's "continuing reform progress".
Another impetus for rising inflows into the RMB is growth and liberalisation in the Chinese capital market, which is becoming increasingly accessible to international investors. With some USD9.4 trillion (equivalent) outstanding, the Chinese bond market is already the third largest in the world,2 says Altschuler, and liquidity is fast improving in the government bond sector, which holds a great appeal for central bank reserve managers. International demand for RMB-denominated government bonds will be strengthened when China is added to the most widely-tracked global government bond indices, which is generally regarded as a question of when rather than if.
One example of a central bank that has recently added to its RMB holdings is the European Central Bank (ECB), which recently announced that it had invested EUR500 million (equivalent) in the Chinese currency in the first half of 2017.3 "This is a relatively small amount, but it is an important statement which will give other central banks the confidence to step into the market," says Deseglise. By extension, the imprimatur from the ECB should also encourage other institutional investors to explore opportunities elsewhere in the Chinese capital market – be it in fixed income or equities – underpinning an exponential rise in demand for RMB. HSBC, which is a recognised leader among international banks in the RMB market4, offers central banks, sovereign wealth funds and other institutional investors a range of options for accessing the RMB market across asset classes.
Hunting for yield in non-traditional assets
Another notable trend among central bank reserve managers has been their rising demand for non-traditional investments as a bulwark against low (and sometimes negative) returns in assets historically regarded as risk-free. "Traditionally, central banks' reserves were concentrated in government and quasi-government bonds, and bank deposits," says Deseglise. "Bank deposits fell out of favour during the financial crisis, and the low interest rate environment has led many central banks to adopt a higher risk tolerance."
Another area that is commanding the increased attention of central banks' reserve managers is the fast-growing market for green bonds. Half of the respondents to this year's survey are either considering expanding into green bonds or will do so in the future.
At the same time, Deseglise adds, there has been a change in perception among central banks and other institutional investors of what constitutes an acceptable level of liquidity. It is these shifts in attitudes towards risk and liquidity that have led to an accelerated diversification in central bank reserves, the main beneficiaries of which have been equity and corporate bond markets. Allocations remain relatively modest, with few central banks holding more than 10 per cent of their assets in equities, although the Swiss National Bank (SNB) is a notable exception. Central banks' equity investments are also very conservatively managed, with costs kept to a minimum. "Because headline risk is such an important consideration for central banks, they typically only use passive strategies for their equity investment, either through an external manager or via ETFs in the case of some of the smaller central banks," says Altschuler.
A selective migration from government bonds to corporate bonds is also an increasingly notable feature of central banks' reserve management, although very few are yet ready to look beyond the highest quality, investment grade credits. According to Altschuler, 41 per cent of respondents to this year's HSBC survey indicated that they are already investing in corporate bonds, either internally or through external managers, while 16 per cent are now considering an allocation and a further 22 per cent would consider doing so in the future.
Another area that is commanding the increased attention of central banks' reserve managers is the fast-growing market for green bonds, which first featured in the HSBC survey in 2016. While about 10 per cent of central banks are already buying green bonds, half of the respondents to this year's survey are either considering expanding into green bonds or will do so in the future.
There are at least three compelling drivers for increased allocations to green bonds. The first is the reputational benefits associated with supporting environmental, social and corporate governance (ESG) causes. The second is the absence of any notable differences in prices or yields between green and conventional bonds. A third is the growth of the green bond market both in terms of size and diversity of borrowers – sovereigns, supranationals, other public sector entities, corporates and financial institutions from a wide range of countries. Green/Social/Sustainability Bond issuance for 2017 as at 18 August had reached c.USD70 billon (197 deals) compared with USD54 billion (126 deals) at the same point in 2016 , representing a YoY increase of 30 per cent (Source: HSBC Green, Social, Sustainability Bond database – based on Dealogic, CBI, Bloomberg data as of 18 August 2017).5
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1 IMF Data, August 2017
5 HSBC Green, Social, Sustainability Bond database – based on Dealogic, CBI, Bloomberg data as of 18 August 2017
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