Ahead of the Curve: Low rates challenge central banks
The low-interest-rate environment is forcing central banks to take more risks in their asset allocation to meet capital preservation objectives, writes Alex Millar
Central banks’ reserves account for more than $10trn (€9.4trn) of assets and represent a substantial pool of investable capital. Their approach to investing this capital is, however, being challenged by the low-interest-rate environment.
Reserve levels have increased substantially over the past two decades (having stood at $1.6trn in 2000). A large portion of these new reserves were accumulated by emerging market central banks to support exchange rates and mitigate the risk of financial crises. They were also designed to provide stabilisation at times of uncertainty.
Meeting this stabilisation objective is linked to central banks’ reserve adequacy. This is a metric that compares the actual level of central bank reserves with likely scenarios in which the government would need to draw down on these reserves.
However important, stabilisation is not the only objective for central banks. Nor is it, by their own assessment, the most important. In our 2016 Global Sovereign Asset Management Study we asked 18 central banks to rank the relative importance of stabilisation, capital preservation and investment returns as objectives. Capital preservation came out on top.
As central bank reserve adequacy positions have improved, they have become more confident that reserves are sufficient to meet their stabilisation objectives. Ample reserves, however, do not negate the risk of losses, especially when central banks’ universe of investable assets is traditionally confined to low-risk assets. Central banks typically define capital preservation as “no absolute losses at portfolio level” or as “no portfolio losses in real terms”. The current low-return environment means that, in reality, central banks are struggling to meet their capital preservation objectives.
This brings into focus that third, arguably neglected, objective – investment returns. Central banks are realising the need to adjust to this low-rate environment in their asset allocation if they are to avoid negative returns and compromise their capital preservation and, as a result, stabilisation objectives.
Several banks expect to shift assets from low-yielding asset classes (such as gold or bank deposits) in favour of higher-risk assets. Some 80% of central bank reserve managers surveyed plan to increase their allocation to equities and 43% predict higher allocations to corporate debt.
Low returns on traditional government bonds were the main catalyst for this growing diversification into other assets, according to 80% of central banks. This challenge is particularly acute for central banks where the currency composition of reserves is heavily weighted towards the euro. Where central banks measure capital preservation in real terms, the hurdle is even higher, given the negative real returns on dollar and euro government debt.
Allocating to new asset classes has also forced central banks to reconsider the structure of their reserves. To avoid conflicts while managing multiple objectives, central banks are splitting their reserves into ‘tranches’ to allow for these distinct, if interlinked, objectives to be pursued. Central banks are operating up to four tranches – the liquidity tranche, hold-to-maturity tranche, cash or working-capital tranche and investment tranche.
The liquidity tranche is typically the largest, holding low-risk assets (AAA-rated, short-duration government bonds) and primarily responsible for stabilisation objectives. The hold-to-maturity tranche holds longer-term fixed income which is held to maturity to generate return and guarantee capital preservation. The cash or working-capital tranche represents cash balances required for operational purposes. It is in the typically still even smaller investment tranche that central banks are pursuing investment returns and holding riskier assets such as corporate bonds and equities.
Although every central bank surveyed had an investment tranche, the creation of these tranches is a relatively new phenomenon. Many were in the process of designing or testing their allocations and there was no clear consensus on the target size for the investment tranche or the underlying asset allocation. There was also little clarity on how these allocations related to risk-adjusted returns and volatility. Central banks also did not rate their capabilities in asset allocation highly and attributed limited allocations to corporate bonds and equities to inexperience rather than an evidence-based view of strategic asset allocation.
While an early phenomenon for many, this trend looks set to grow. Central banks are continuing to feel the pressure to take more risks in their reserve management to ultimately avoid losses.
Alex Millar is head of EMEA sovereigns & Middle East and Africa institutional at Invesco