Central banks hold foreign exchange reserves to provide liquidity to foreign exchange markets and, for that purpose, are invested mostly in a narrow portfolio of US treasury bills and notes. Total reserves now stand at about $7000bn, most of which is held by emerging markets central banks. In fact, today the official sector owns more than 40% of all marketable US treasury securities, compared with less than 20% in 2000.
Central banks have also bought more than 40% of Freddie Mac and Fannie Mae’s benchmark securities so far this year and hold more than 12% of total US government agencies’ securities outstanding. Today, US treasury and agencies securities represent about 85% of central bank portfolios. Large central banks – especially in Asia – are estimated to maintain at least 85% of their reserves in US dollars. The risk of the ‘crowded trade’ is real.
Central banks thus rely on an unusually narrow set of securities to execute their intervention mandate. The high concentration implies that it may not be possible to liquidate large positions if necessary without causing substantial distortions in the underlying asset and exchange rate markets. The implied insurance by holding large reserves may therefore have become self-defeating. Recent events have shown that the quest for liquidity can be distressing in the event of a generalised rush – not even the US treasury market is deep enough to accommodate significant surges in liquidity demand.
Broader implications
The high concentration of key government and quasi-government securities held by relatively few homogeneous investors also has broader implications for the functioning of the underlying securities markets. The large share of central bank holdings in US treasury securities may cause effective collusion and distort underlying asset prices with implications for pricing risk overall and the external payment position of the US. The significant accumulation of US securities in central bank portfolios may have unduly kept US treasury yields too low for too long, which may also have contributed to the build-up of large US imbalances in the first place.
The allocation pattern of central banks suggests that the world has run out of feasible reserve assets to provide sufficient scope for liquidation in the event of globalised distress. Central banks should consider whether holding the same securities remains the optimal investment strategy, and may have to look beyond the US dollar and other G7 currencies to attain a reasonable diversification. As the underlying world has been changing into a more multi-polar space, a look at emerging markets currencies seems natural in the light of emerging markets’ increasing importance to the international economy.
Key role
Many central banks have recognised the need to diversify their asset holdings. Even if allocations are most likely to occur at the margin only, central banks are set to play a key role for the direction of strategic asset allocation away from the dollar.
While the claim that emerging markets’ currencies may be adopted as reserve currencies might appear daunting amid current market distress, the strength and resilience of currencies is in large part endogenous to central bank reserve allocation. For many central banks, particularly in emerging markets, the decision on what reserve assets to hold may therefore be key for establishing a post-dollar-dominated world – and essential to ensure the feasibility of current reserve management objectives.
Ousmène Jacques Mandeng is head of public sector investment advisory at shmore Investment Management Limited.
