AsianInvestor: Asian central banks consider new asset classes

Asian Investor, May 2013

Asia’s central banks have emerged from the global financial crisis with a modest but growing sense that there is more to life than US Treasuries. Naturally, the vital business of stability and liquidity still dictates the vast majority of central bank reserve management. But increasingly, where there is a surplus, they are considering new asset classes, new locations and new models of risk.

This is both a global and a regional trend. A survey of 60 central banks, 10 Asian, announced by RBS and Central Banking Publications in April, garnered the views of institutions that account for $6.7 trillion of reserves – more than half the global total – and found that 13% of central banks were invested in equities, with a further 10% planning to do the same in the next five years. More than three quarters of respondents had moved beyond dollars and euros and were invested in Australian or Canadian dollars, or planning to do so. Generally, the survey cited “considerable appetite” to expand the range of currencies in central bank portfolios, and said a “growing minority” saw a place for equities in their portfolios.  Asian central banks known to have equity exposure include the Hong Kong Monetary Authority and the Bank of Korea, while several more do so through sovereign wealth funds.

This is a big shift. Equities never used to be even considered in central bank allocations, yet the institutions in this survey that said they did or soon would invest in the asset class hold over $2.5 trillion of reserves – a powerful bloc.

So what’s happening, and why? After all, during the financial crisis, all capital flight appeared to be in the opposite direction. “During the financial crisis, the immediate rush was into US treasuries and gold, and perhaps away from euro government bonds, with central banks pulling in their horns if they had been experimenting with other countries or asset classes,” says Jervis Smith, Asia Pacific head of client sales management for securities and fund services at Citi in Hong Kong. “What’s happened in the last year or so is with all the quantitative easing that’s been going on, there has been a lack of return from the safer assets, and they are looking to inject a degree of growth.”

Bankers and fund managers agree that there hasn’t been a wholesale change in central bank management technique; to do so would be reckless in view of recent experience. “During the financial crisis, although most central banks in the region did not have currencies under tremendous pressure, there were one or two where pressure did build,” says Michael Paulus, head of public sector coverage for Asia Pacific at HSBC. “They were reminded that safety and liquidity are the bread and butter of what they need to do, and there has been a swing to more safe and liquid asset as a consequence.” Prior to the financial crisis, Paulus estimates that dollars made up 58-59% of all central bank reserves, and that today the figure has risen to 63-64%. “You might say 5% is not much, but 5% on $10-11 trillion is a lot of money.”

But at the margins of this trend, we are now seeing a bolder approach. “Some central banks have accumulated considerable reserves. And since the financial crisis there seems to have been a more rigorous review of how much they really need for safety and liquidity,” Paulus says. The funds that need to be safe have stayed in mainstream dollar assets – “during the crisis, when everything was falling apart, one thing central banks learned was that they could still sell as many US treasuries as they wanted” – but where there is a surplus beyond that, “they are beginning to look more broadly at other assets they might invest in.”

Fund managers are clearly seeing this in the mandates that are starting to appear from central banks. “We see government entities [a term that includes central banks, national pension funds and sovereign wealth funds] increasing their riskier asset investments since the last quarter,” says Hao Sun, in institutional sales at Alliance Bernstein in Hong Kong. “We are seeing them increasing their exposure in global credit and in emerging markets, including emerging market corporates.” He says he is also seeing some clients revising their guidelines to allow managers to invest in lower rated securities, “such as from single A down to BBB-.” And he agrees that equity mandates are starting to appear. “We do see some equity RFPs or manager selections from the region. Previously those types of clients only invested in fixed income, but now they are starting investment into equity and other non-fixed income assets. Meanwhile we see some product discussion in real return assets like commodities, real estate and other alternatives.”

Why? The most obvious answer is lack of returns. “It is a genuine search for yield that is the issue,” says Smith. “If you’re earning close to zero, let’s say .15%, in US treasuries, and you’ve got inflation running at 2 or 3%, then you’re really losing money on your investments. Banks have to think about getting a big more juice on their returns without in any way being too risky.” Which, in this environment, is easier said than done. “There is risk at every turn on the path: the world’s economy isn’t a happy place.”

Ironically, central banks are themselves part of the reason that they are having to look further afield for growth. “Central banks are playing two roles in this discussion,” notes Smith. “If you think of the main activity of a central bank, it’s not investing their reserves, but managing monetary policy and the liquidity of their nation. So they are often creating the quantitative easing that they also have to respond to in investing their surplus cash.”

Sun at Alliance Bernstein says there is “a common consensus that there is too much duration risk” and believes investors no longer expect attractive returns from the high-grade fixed income markets. Like Smith, he notes the pressure of inflation outreaching returns on safe assets. “Clients have fears about inflation and know the current yield for fixed income definitely cannot beat that inflation expectation. So they like to increase inflation-sensitive assets, or better return assets.”

Paulus, though, argues other reasons for the shift. “It’s not really so much about returns, but diversification, and to learn about other markets,” he says.

“If you are a central bank, you don’t normally invest in equities, but you might be interested in having your staff understand equities. So you might hire an asset manager to manage an equity portion for you, and as part of the contract, you say: we require you to take two of our people for one week each in one of your offices each year.” In some cases, he says, “it can be months: almost a secondment. It creates additional expertise within the central bank.”

Pinning down exactly where this is happening is trickier, since asset managers are unwilling to discuss individual mandates, but market commentators do point to some specific institutions. “Some Asian central banks have been allocating to higher risk assets for several years now, including commodities and equities,” says Bee Ong, Director at Cerulli Associates. “The Hong Kong Monetary Authority, for example, has been diversifying into emerging market equities and bonds, private equity and real estate, among other assets.” She sees this as a continuing development, driven by several factors: “All institutions, including central banks, are redefining the risk-return landscape; and central banks are gradually growing more comfortable with assets beyond G-20 government bonds, partly because they have been watching sovereign wealth funds invest.”

But, as Ong says, “central banks’ raison d’etre differ from SWFs,” and the HKMA is perhaps a special case as it has characteristics both of a central bank and a sovereign fund. The HKMA’s Exchange Fund has two components: a backing portfolio, which holds US dollar denominated assets to back the monetary base of Hong Kong; and a separate investment portfolio which looks much more like a sovereign wealth fund. The Exchange Fund’s asset allocation is not disclosed, but its most recent annual report did say that it employs external fund managers in “over a dozen international financial centres” to manage about 20% of the fund’s assets, “including all of its equity portfolios and other specialised assets.”

The line between central bank investment and sovereign wealth funds is a little blurred when reserves are seconded from the central bank to a sovereign fund; or when reserves that might otherwise have gone to the central bank are instead diverted to a sovereign fund.

There are various permutations of this around the region. In Singapore, the Monetary Authority of Singapore is the central bank, but foreign exchange reserves are managed by the Government Investment Corporation of Singapore (GIC), considered one of the smartest sovereign funds in the world with a renowned track record in private equity, infrastructure and real estate, among other things. The China Investment Corporation sovereign fund was created in 2007 by diverting funds that would otherwise have gone to the People’s Bank of China. And in Korea, the Korea Investment Corporation sovereign funds gets its money partly from the finance ministry and partly from the Bank of Korea, an arrangement that has involved no shortage of political fractiousness since the two institutions have quite different views on risk tolerance. Korea also shows the perils of trying to understand outsourcing accurately: Bank of Korea outsources 15% of total reserves (particularly for equities, corporate fixed income, mortgages and China investments), but the biggest external manager is the KIC itself, which accounts for 7% of total foreign reserves (and which in turn then puts a large amount of that money out to its own group of external managers).

Bank of Thailand, to take another variation, has talked about setting up a separate entity to diversify investments and improve returns on foreign reserves, but with the central bank maintaining ownership and control of the corporate entity rather than allocating to a new sovereign wealth fund. It abandoned the idea of a sovereign fund in 2011 but, anecdotally, has allocated a modest proportion of its reserves into higher-risk assets than has historically been the case.

Looking at pure central banks, Bank of Korea (see separate article) is an interesting example of growing appetite for RMB assets. Bank of Korea applied for qualified foreign institutional investor (QFII) status to invest in RMB assets and received approval in early 2012 with a quota of $300 million; it also received approval to join the interbank bond market. Choo Heung-Sik, director general of the Bank of Korea’s reserve management group, says BOK has hired a mixture of Chinese, global and Korean managers for its quota, including two managers for A-shares.

Although the days of the RMB as a reserve currency to rival the dollar and euro are still some considerable difference away, it is the most significant trend in Asian central bank diversification today. “In our FX business we are seeing some diversification away from the dollar and euro, and into some more unusual currencies for central banks to be investing in,” says Smith. He recalls the Swiss national bank investing in Australian dollars and Swedish kroner, and says other central banks have invested in New Zealand dollars, Singapore dollars and Korean won. “But the biggest story is the RMB.”

Bank of Korea is not alone in having sought RMB exposure. The HKMA, as might be expected, has a $1 billion quota (as do Singapore’s two sovereign wealth entities, Temasek and GIC); but on top of that, Bank Negara Malaysia has a quota of $400 million and Bank of Thailand $300 million.

And what of China itself? China’s total external financial assets reached $5.17 trillion by the end of 2012, according to the State Administration of Foreign Exchange, about 65% of it in the $3.4 trillion of foreign exchange reserves. Clearly, a change in investment style among this preposterous amount of capital would have far-reaching consequences.

There do appear to be changes in China, but they represent a drop in the ocean compared to the overall quantum of reserves. “In China it’s difficult to say whether it’s SAFE or one of the other entities, but we are certainly seeing interest in alternative investments and in particular private equity,” says Smith. “You’re talking about tiny amounts relative to total reserves, but it’s there as a diversification and long-term play.”

Any shift to riskier assets is good news for asset managers in Asia, since this is precisely the sort of work that will be outsourced. Cerulli research from June 2012 found that central banks and quasi-government organizations contributed the largest chunk, 39.7%, to asset managers’ institutional AUM in ex-Japan Asia, so any shift to more active and high-fee allocations in that group could be very lucrative. “There is definitely a trend towards outsourcing active management while at the same time increasing their levels of passive allocation,” says Smith. “It’s still unusual to outsource domestic fixed income, but if they diversify out of their own country, they probably will outsource, apart from direct investment.”

Bank of Korea, for example, uses 30 global asset managers apart from KIC; Choo says last year it hired two domestic asset managers for RMB investments, for example. In 2011, equities accounted for almost 6% of Bank of Korea’s overall funds, and this was largely allocated externally, as were mandates in corporate debt and mortgages.

There is a challenge, though, for any major central bank that does wish to diversify in a meaningful way. There has been much discussion about Asian central banks investing in one another’s markets, rather than automatically heading to the US as soon as they leave their own borders. But it’s not entirely practical. “Very much on the margins that happens, but it is on the margins for several reasons,” says Paulus. “One, the bulk of money has to go to assets that are liquid, particularly in a crisis. Two, for entities managing a lot of money, they can’t put a lot into emerging markets because it can drive prices against them and cause other problems. And even if central banks wanted to, there’s only a certain amount they could put in these countries: if you’re managing several hundred billion dollars, how much can you really invest in many Asian emerging markets without owning a significant portion of the market?”