Geopolitical risks continue to loom over central bank FX reserves

LONDON, May 19, 2024 – Two surveys of central bank foreign exchange reserve managers have been published in recent weeks – both of which highlighted that geopolitical risks were now considered to be the primary investment challenge. Russia’s invasion of Ukraine, war in Gaza and political tension between the US and China are just three episodes that have played a role.

A precautionary reaction will follow, according to the surveys. In such a scenario, we believe that central banks will allow and encourage their FX reserves to grow. The challenge will then be to manage those reserves in a transformed fixed income investing environment. The survey data suggest that core fixed income strategies will be the first to benefit.

A Central Banking Publications survey of 87 central banks identified geopolitical risk as the number one concern for the next 12 months, while a survey of 73 central banks in OMFIF’s Global Public Investor report also revealed that 80% of respondents expected geopolitical risk to be the most significant factor impacting their long-term investment strategy.

Unlike a concern about the future direction of US Federal Reserve policy, which would impact all central banks in a similar manner, adjusting for geopolitical challenges will not. Every central bank will have a different playbook driven by their own government, legacy international relations and alliances. For some nations, it may mean getting closer to the US and the dollar. For others, it may mean getting closer to China and the renminbi.

There may be implications for the choice of trading counterparty, external manager and security custodian as well as an impact on asset class and currency choice. However, every central bank will be aligned in one key aspect – they will all have a desire for a larger quantity of FX reserves.

Conserving reserves

One simple way to keep FX reserves high is to not deploy them. On the topic of deployment thresholds, the OMFIF survey found that approximately 65% of respondents would not spend more than 15% of their total reserves for market intervention. The conservation of reserves is a key route by which growth can be fostered.

This corresponds with the feedback that there is a desire to conserve reserves to fight the next crisis. The required firepower to deal with the next unknown crisis would be substantial. As one central bank official told me recently: ‘If it is a geopolitical crisis, double the number that you first thought of’. For many Asian nations, the bitter memories of the currency crises of the late 1990s are seared on the institutional psyche. Self-insurance is best.

At the International Monetary Fund annual meetings in 2024, Reserve Bank of India governor Shaktikanta Das was happy to explain the approximate doubling in FX reserves to around $600bn that has occurred since 2016. The decision to allow reserves to grow during a period of capital inflows was ‘to build buffers against possible future capital outflows’.

For a non-aligned nation such as India, self-insurance is an attractive tool, particularly in a world where economic and geopolitical uncertainties have multiplied. The governor did not mention negative carry costs, but instead asserted that the current level of reserves ‘gives confidence to domestic financial players’.

In recent years, it is rare to hear central banks mention carry costs. Historically, this cost was cited as a reason to not hold large FX reserves. However, FX reserves are a form of self-insurance and insurance has a cost.

How much is enough?

One Asian central bank spokesperson declared in the GPI report that, ‘in the event of a crisis, there is no level of reserves that is adequate’. Traditional metrics such as import cover ratios are seen as too narrow and simplistic. Although the IMF published a multi-factor model in 2016 – the ‘Assessing Reserve Adequacy’ metric – this has been widely criticised by practitioners.

There is an absence of a credible measure of FX reserves adequacy. The consequence is that the default position is often to allow reserves to grow. Moreover, when neighbouring nations are achieving growth in FX reserves, emulation pressures soon mount. The history of previous crises [especially the 1997 Asian crisis] is that market pressure falls first on nations that have the weakest coverage ratio.

Bilateral swap lines are not a substitute for FX reserves. Perhaps the only swap line that will succeed in a period of stress is a swap line with the US. The granting of these lines by the Fed has been unambiguously influenced by geopolitics. Only friends of the US need apply.

In terms of currency choice, the two most likely currencies to be purchased over the next 12 months will be the dollar, followed by the euro. We suspect that this is an expression of hope that FX reserves will grow, rather than an asset allocation switch in favour of the two largest reserve currencies. In simple terms, an increase in FX reserves will be mapped on to the existing currency allocation. In most cases, the biggest position will be in dollars, followed eventually by a diversification into the euro, and then other currencies.

The final piece of the jigsaw relates to intended investments. Almost 90% of respondents in the GPI survey expected to increase or maintain exposure to government bonds, 80% to quasi government bonds and 55% to corporate bonds. This is unlikely to represent an intention to switch out of equities but should be regarded as simply a mapping of where inflows will be directed to. Global aggregate anybody?

Gary Smith is Client Portfolio Manager of Fixed Income at Columbia Threadneedle Investments.

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