Central banks may put more reserves into equities, less into bonds


By Jamie McGeever
Tuesday, January 9, 2007


LONDON -- Central banks around the world are looking to invest more of their $4.75 trillion foreign exchange reserves in equities at the expense of bonds, but the implications for currencies are far from clear.

The issue of reserve diversification re-emerged late last year as the dollar fell against major currencies, hitting multi-year lows against the euro and sterling.

The International Monetary Fund also published its latest snapshot of global reserves at the end of December.

Of the $4.75 trillion total, the currency composition of $3.151 trillion is known. And of that, $2.07 trillion is in U.S. dollar-denominated assets.

Central banks are starting to behave more like yield-hungry, market-savvy institutional investors and many are setting aside chunks of their reserves for specific investment vehicles.

With the dollar share of reserves -- where currency allocation is known -- broadly steady at 65.6 percent, the focus for investors and central bank watchers has become the asset composition of these reserves as much as the currency breakdown.

David Bloom, head of global currency research and strategy at HSBC in London, notes that central banks are so flush with reserves that they barely know what to do with them. They are buying a wider range of currencies than ever and diversifying across a wider range of asset classes than ever before too.

"Everybody's at it -- they all want stability. It's a natural progression," Bloom said.

Yet the implication of this asset shift on currencies, particularly the dollar, is murky.

Stephen Jen, head of currency strategy at Morgan Stanley, said: "There are plenty variables ... and no set rule of thumb."

"But there should be some relationship between asset allocation and currency," he added, pointing to the global share of individual market capitalizations as a clue to how asset shifts could impact the foreign exchange universe.

For example, Jen reckons the U.S. accounts for around 40 percent of all the world's leading equity market cap values, the euro zone 18 percent, Japan 13 percent, and the UK 9 percent.

For leading global government bond market caps, the U.S. accounts for around 35 percent, Japan 27 percent, the euro zone 20 percent, and the UK barely 3 percent.

This suggests that a shift by central banks into equities, based purely on these market cap weightings, could benefit the dollar.

But, as Jen points out, Asian central banks seeking higher returns may be more likely to invest in regional emerging market equities than the United States.

Given Japan's relatively low share of global equity market cap, the yen could benefit from, say, the People's Bank of China setting aside investment destined for Japanese stocks, Jen said.

"I don't believe it is a dollar versus euro tug of war, but more a major versus minors and bonds versus equities story," he wrote in a recent note. "Though China has not begun to have exposure to equities, I suspect this may be the next step."

Jim O'Neill, chief global economist at Goldman Sachs, agrees that "the clearest implications" of central banks seeking higher returns on their ballooning stash of reserves is "good news for equities and risky assets at the expense of more liquid ones."

But he reckons the dollar could suffer as a result.

Although the implications for currencies aren't clear, "presumably it's not great for the dollar, as most of these (liquid) assets are in dollars," O'Neill said.

What analysts agree on is a broad shift in central bank behavior to reflect a more aggressive investment profile.

Norway's Government Pension Fund, which saves the country's oil wealth for future generations, grew to 1.712 trillion crowns in the third quarter, or about $265.6 billion.

Norges Bank, which manages the fund, has said it wants to shift the allocation of that money to 60 percent equities and increase exposure to property and private equity. The fund is currently invested 40 percent in stocks and 60 percent in bonds.

Russia has proposed expanding the list of sovereign bonds in which it can invest its $83 billion budget stabilisation fund to include not only AAA-rated debt but riskier and higher yielding A-rated paper. Russia's oil-driven reserves are $283 billion.

The monetary authorities of Singapore, South Korea, and the United Arab Emirates are also thought to be considering raising the risk profile of their existing investment vehicles.

"I know there's been talk going on for some time in these places, but it gets back to the question of why they haven't done this before. This is the nations' money, so they have to be sure they're doing the right thing," said O'Neill at Goldman.

This broad trend comes against the backdrop of key developments concerning the world's reserves behemoth: China.

Reserves held by the People's Bank of China have topped the staggering $1 trillion level. PBOC Governor Zhou Xiaochuan has said the bank is looking at diversifying that stash across currencies and asset classes.

The composition of China's reserves is unknown but many observers reckon around 70 percent is in dollars, almost all of that probably in Treasuries and T-bills.

With global reserves now at such massive levels, a few extra percentage points of return can mean billions for central banks.

For example, a 5 percent return on Asia's near $3 trillion reserves from holdings of top-rated government bonds swells these countries' coffers by around $150 billion a year. A return of 10 percent, say, from equity, property or private equity investments would yield around $300 billion a year.

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