Balancing reserve management objectives in the current economic and financial environment

Speech by Mr Agustín Carstens, General Manager of the BIS, at the Regional High-level Reserve Management Conference, Riyadh, Saudi Arabia, 29 April 2024.

Good afternoon distinguished guests. Let me thank the Saudi Central Bank (SAMA) for co-hosting this event with the Bank for International Settlements (BIS) and commend them for their hospitality.

I will frame my remarks today around some of the broad challenges reserve managers have faced in recent times. I will discuss these in the context of three long-standing reserve management objectives – liquidity, safety and return – as well as a new one – sustainability.

Pursuing the three traditional objectives – liquidity, safety and return – has always been a delicate balancing act for reserve managers. The increasingly nimble use of foreign exchange (FX) reserves as a policy tool amidst a rapidly changing financial environment has increased the challenges. More recently, the emergence of sustainability as an additional objective has sharpened the trade-offs for many reserve managers.

Let me expand on these points, before concluding with a few words on how the BIS's banking services can support reserve managers in their pursuit of these objectives.

The three traditional objectives of reserve management are grounded in the conventional uses of reserves. These include FX intervention and hedging foreign liabilities.

Recent events have seen many central banks deploy reserves for these purposes, often in the context of financial market volatility and US dollar appreciation. One of the clearest examples took place in 2022, when the start of monetary policy tightening in the United States saw central banks draw down on their reserves to limit the speed and extent of exchange rate depreciation. Although central banks have since started to rebuild their FX reserves, the total amount of global FX reserves, at around USD 12.3 trillion, is still lower than at its peak in early 2022.

The experience of 2022 highlights the imperative to hold sufficient reserves in safe and liquid form. Reserve managers may need to deploy reserves at a moment's notice, often in times of stress or crisis. They need to be able to transform their underlying assets into cash quickly and at good prices, even when trading conditions are choppy. That is why most continue to hold the bulk of their reserves in the most traditional asset classes, such as US government bills and bonds. The "flight-to-safety" quality of these assets provides reserve managers with comfort that their capital can be quickly deployed and will hold its value over time.

But there is a cost to holding reserves in liquid form: the returns are often low. And returns have become more important for reserve managers of late. The growth in the size of reserves and the persistence – until recently – of a low interest regime contributed to this increase in emphasis.

A desire to strengthen returns has led many central banks to diversify their reserves into a broader array of asset classes. Examples include corporate bonds, mortgage-backed securities and – in some cases – equities.

Diversification involves trade-offs. To balance these, many reserve managers earmark their assets into multiple asset tranches. The safest is the working capital or liquidity tranches, consisting only of the safest assets. This is complimented by an investment tranche, which includes riskier and less liquid assets that deliver higher returns. We at the BIS estimate that around two-thirds of all reserve managers employ some form of tranching to construct their portfolios, with the practice being more common among central banks in emerging market economies.

The recent historic rise in global interest rates has changed the environment for reserve managers. For one, it led to significant valuation losses for fixed income investors. These losses affected riskier fixed income securities and the most traditional reserve assets alike – particularly those with long duration. There was nowhere to hide.

Over the longer term, however, higher interest rates imply much more appealing fixed income returns for reserve managers. Meanwhile, changing correlations between asset classes raise questions about the extent to which less traditional assets will continue to deliver meaningful portfolio diversification.

Take as an example the correlation between fixed income and equity. Many of the 20–25% of reserve managers that have added equities to their portfolios did so in an environment where bond and equity returns were essentially uncorrelated – as was generally the case in the decades before the Covid-19 pandemic. This has shifted in the past couple of years, with the correlation between the two asset classes becoming meaningfully positive. In other words, fixed income and equity prices have moved together, removing some diversification benefit from holding both asset classes.

So, with an inverted yield curve and positive cross-asset correlations, why wouldn't a reserve manager simply scale back, invest in short-dated fixed-income and call it a day?

I think we all know the answer here.

Reserve managers cannot act rashly. Nor should they base their strategic decisions exclusively on returns over short horizons.

Practical considerations also apply. It can take time for reserve managers to add new asset classes to their portfolios, given the necessary approvals and need to ensure operational readiness. So once those assets are in your portfolio, there are costs to removing them.

Reserve managers are thus much more likely to suggest holding steady – or scaling back allocation size – rather than disinvestment or removal of eligibility altogether. This preserves flexibility for future strategic allocation adjustments, particularly when there is so much uncertainty as to which market environment will prevail in the future.

Indeed, our sense from interacting with central banks is that reserve managers are not doing away with their diversification practices. Instead, the pace of these diversification trends seems to have levelled off, suggesting a healthy equilibrium may have been reached.  

But the story does not stop there. Many reserve managers have recently had to grapple with a fourth objective – sustainability. We estimate that around half of central banks see this as a relevant consideration for their reserve management decisions.

Sustainability is a broad term. It can include many concepts, including environmental, social and governance-related objectives – as in the famous ESG acronym.

In practice, I suspect that for most reserve managers, environmental considerations – particularly those related to climate change – are the most relevant.

Reserve managers have adopted sustainability as a factor in decision-making for at least two reasons. The first is because of the implications of climate change itself. This can come either through the physical damage that results from larger and more frequent weather events, or the so-called "transition risks" associated with efforts to address climate change. The second is to influence climate outcomes themselves through their investment activities.

For investors with longer investment horizons, sustainability objectives may be justified from a pure risk management perspective. For others, where mandates allow, influencing climate outcomes may also be a relevant goal.

But how do reserve managers actually pursue a sustainability objective?

Investing in green bonds has been the most popular way of expressing a sustainability objective. Indeed, green bonds may be the only tool for those with a more restrictive list of eligible assets.

Why is this the case? Attempting to embed sustainability more comprehensively into a traditional reserve portfolio can give rise to difficult trade-offs.

Take as an example the measurement of a reserve portfolio's carbon footprint. This is an increasingly common practice among investors and one some central banks have adopted.

But reserve managers tend to hold a large share of their assets in sovereign securities. And the currency composition of their reserves is, in significant part, a function of their policy objectives. Reserve managers would thus generally start from the position of measuring the carbon footprint of their sovereign holdings. On this basis, managing towards a lower sovereign carbon footprint may require adjustments to the composition of reserves away from certain major reserve currencies linked to carbon-intensive economies. But those currencies may be key to achieving their core policy goals.

Few reserve managers would be willing to make such a compromise.

Sustainability is more easily pursued in relation to diversification assets, such as corporate bonds and equities. Here, the trade-offs are more manageable and there is greater scope to differentiate amongst private sector issuers.  

With this in mind, some reserve managers have begun managing their corporate bond or equity portfolios against climate-aware benchmarks. These allow investors to manage those portfolios with a defined decarbonisation trajectory, helping to meet a sustainability objective.

But even this will require difficult – and potentially controversial – decisions. Examples include whether to follow indices that exclude certain industries, such as those relying on fossil fuel-related activities for revenue generation, altogether. Some stakeholders may prefer a different approach, such as limited investment with active engagement, rather than outright exclusion.

Reserve managers will also want to know whether there is a compromise between pursuing sustainability and earning returns. The jury is still out on this question.

In theory, one might expect a climate-aware portfolio to deliver lower returns than the broader universe, as it is protecting against climate-related risks. Given that taking risks should be rewarded with compensation in the form of risk premia, moving away from those risks should, all else held equal, lower returns.  

But perhaps the more relevant question may be the impact on properly risk-adjusted returns. Perhaps reserve managers would be happy to accept a small reduction in return for a commensurate reduction in climate-induced risk, particularly if the strategy helped achieve a sustainability objective. 

Short data histories make it difficult to take a firm position on any trade-off in this regard, which – at this stage – requires a degree of conviction. But this should become more evident over time. 

This raises the issue of measurement and disclosures. While managing towards a lower carbon footprint portfolio has its challenges, more and more investors are choosing to report their exposures – including some central banks. Recommendations put forth by the Task Force on Climate-related Financial Disclosures and, more recently, the International Sustainability Standards Board have provided helpful standardisation.¹

That said, there is still some way to go. One issue is that even reporting presents challenges – including political ones. One example is the choice of whether to include the carbon footprint of sovereign holdings in any disclosures. Another challenge is cross-asset class aggregation, which may not be possible, given the differences in metrics and data available for different asset classes.

In sum, central banks continue to evaluate ways of integrating sustainability in ways that suit their mandates and motivations, but trade-offs and constraints will continue to be a challenge.  

Let me close with the reminder that the BIS stands ready to assist reserve managers in pursuing all four of their reserve management objectives.

BIS investments are among the safest available to reserve managers, a reflection of the top credit quality of the institution. Indeed, the BIS's banking operations are underpinned by an unquestionably strong capital position and a prudent financial risk management framework.

Therefore, we are well placed to offer a suite of products that emphasise liquidity, while still offering a favourable risk-return trade-off. This includes tradable instruments across the major reserve currencies, namely fixed-rate investments at the BIS, or FIXBIS, and medium-term instruments, or MTIs. These products are designed to mimic the features and market conventions of their respective government bill and bond markets, while offering a return pickup relative to these reference instruments. And all that at fixed or even zero bid-ask spreads, offering impeccable liquidity.

We also offer FX services to assist central banks with their foreign exchange needs. This includes advanced electronic FX trading capabilities to offer the most efficient execution possible.

Our gold services include transactions and physical services, such as quality upgrading, refining and location exchanges.

We recognise the importance of being able to access liquidity in all market conditions for reserve managers. We strive to provide best-in-class options there, including through access to bilateral liquidity facilities against high-quality collateral.

Finally, our third-party asset management services allow clients to invest in both traditional mandates and a variety of mutual fund-type structures – so-called BIS Investment Pools, or BISIPs. These include two BISIPs denominated in onshore renminbi, one in Korean won and a few others dedicated to asset classes such as inflation-linked or corporate bonds.

In line with the sustainability topic discussed before, recently, we have placed particular emphasis on our sustainable product offerings. These include a range of green bond funds, with investors receiving an annual impact report detailing the environmental benefits expected from the associated projects. More BIS products increasing reserve managers' ability to pursue environmental sustainability objectives are on the way.

Let me conclude.

Safety and liquidity remain as important as ever for reserve managers, though pressures to generate returns have grown over the last decade or two. The latest tightening cycle may have ushered in a new era for reserve managers, though diversification practices are likely to remain an important part of reserve managers' asset allocations, despite higher sovereign yields. Integrating sustainability has become a new challenge for reserve managers, and the associated trade-offs can be challenging, particularly for reserve managers holding mostly traditional reserve assets. The BIS stands ready to help central banks address these challenges with a range of product offerings designed specifically for their objectives.

Thank you for your attention.

¹        See Task Force on Climate-Related Financial Disclosures (2017): Recommendations of the Task Force on Climate-related Financial Disclosures.