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03 June 2019

Where the giants place their funds

Speaking exclusively to Banker Middle East, Elliot Hentov, Vice President, Head of Policy and Research at State Street Global Advisors, provides a comprehensive view of how central banks and sovereign wealth funds in the region invest.


A 2017 study by State Street Global Advisors (SSGA) on central bank asset allocation for its reserve portfolio found that central banks have to perform a number of different functions, and one of them is related to the foreign reserves they hold. The core investment assets of central banks stem from the official reserve portfolio.

How do central banks differ in the way they invest?

The core investment assets of central banks stem from the official reserve portfolio. In line with the liquidity and safety objectives, high-grade sovereign bonds issued in reserve currencies, gold and deposits have usually been the classic reserve instruments.

They still constitute the bulk of the global reserve portfolio (almost 82 per cent), and even among the group of the 30 largest security-holders, our analysis focuses on, 16 invest nearly exclusively in these liquidity instruments. Both external and internal factors make a central bank differ in how they invest. However, what makes them significantly different is the purpose of reserve assets--investment purposes or for policy purposes.

We believe the diversification of reserve assets is fully underway and the official reserves portfolio is becoming increasingly complex. Around 20 to 30 years ago, all central banks investors had their reserves in the same way. The basic question is how to have ready (foreign currency cash) reserves, and how to invest in foreign currency cash.

Banks usually keep foreign reserves mainly denominated in US dollars, Euro, and Chinese yuan, as well as in liquid forms such as short-term treasuries. In recent years, instances such as the Asian financial crisis taught big lessons to central banks.

The biggest lesson was central banks need to have more reserves so as to better cope with the crisis as and when it happens. A number of emerging markets, especially crude oil producers, deposited huge foreign reserves into central banks and a part into sovereign wealth funds (SWFs) in order to ensure adequate cash in hand in terms of any eventualities.

Today we see about two or three types of central banks In terms of investment patterns of their foreign reserves holding:

  • Diversified central banks investing a large part of their portfolio the way any long-term investor would invest;
  • Conservative central banks, still doing what they were doing 20 to 30 years ago.

Our report is an update on the last two years and shows how rapidly central banks are adding both riskier assets (something that is not a government bond) such as corporate bonds, asset-backed securities, and equities, unlike in the past from they were largely holding cash.

There are many who hold the common perception that central banks are policy makers. However, this is a very narrow definition. In fact, central banks’ scope of work also involves much more than that. While some central banks such as the US, in recent years went for quantitative easing (QE), other banks such as European Central Bank (ECB) and Bank of Japan, in contrast, delayed QE and kept interest rates on hold.

 In other words, central banks as investors have responded to the policy signals of other central banks and have sought out higher-yielding assets in the era of QE. There are also some central banks on the other side of the spectrum, which are involved in investing their reserves.

The whole idea behind quantitative easing was that big central banks wanted investors to go out of safe assets, treasuries, bonds and get a little bit into riskier assets. Our report shows how the central banks have done that. Overall, as our report finds, now there is a greater diversity of asset classes and broader use of risk assets, with roughly 15 per cent (that is $2 trillion out of total $13 trillion) in unconventional reserve instruments.

Which central banks have implemented a diversified investment strategy more aggressively and actively? I would say it’s a mixed bag, as not all banks are transparent. There are some central banks which we do not even know exist.

However, we do know that some large central banks, such as Japan’s, have stayed conservative. It may sound confusing to understand how Japan’s central bank does it. However, the basic point to understand is that it remains in treasuries, which is a huge reserve pile despite everything. Another example is the Swiss central bank, which has started to actively diversify.

As for central banks in the Gulf, the region is different from other oil producing regions in the world. The central banks in East Asia, for instance, have sovereign wealth as their core but not oil wealth. On the basis of the investment pattern, there are three broad investment patterns: In the Gulf, for instance, central banks have acknowledged the existence of sovereign wealth funds.

Additionally, they are into sophisticated industries and are investing for the long term, which does not necessarily need to be done with their forex reserves. This means Gulf central banks’ foreign reserves are there for policy purposes, i.e., to provide liquidity for external reasons.

This is the classic type of central banks--meaning they have sovereign wealth funds and are doing everything including the most advanced techniques of investment.

  • This category includes oil producers such as Russia and Kazakhstan that have expressed their willingness to diversify away from the US dollar. Due to geopolitical reasons, they have expressed reservations about staying with the US dollar, whether in the form of corporate bonds or mortgage backed securities. However, these banks must bear in mind that if they want to diversify, US dollar-denominated assets or investments cannot be ignored. Both Russia and Kazakhstan have diversified their holdings into gold, which for them is a stable asset and easily convertible, acceptable everywhere in the world and it gets them out of US sanctions radar.


  • The third trend is visible in the South East and East Asia. Central banks in Hong Kong, Greater China, Singapore and other emerging markets in Southeast Asia have been on a diversification drive. Although they have sovereign wealth fund vehicles, they also have a large portfolio, a large part of which they are not diversifying into different assets. So, these are basically the three trends that we have been seen across the world.

In this regard, what trends do you see emerging in the Gulf?

In the UAE, the central bank is a purely focussed on its core domain, meaning it doesn’t hold sovereign wealth reserves and it is the same in Kuwait.

In Saudi Arabia, the situation is a bit different as the central bank traditionally manages the sovereign wealth fund’s money as well. However, in recent years, we have seen this changing and the Kingdom’s central bank is gradually transferring or is splitting up the money that is not purely foreign reserves into the Public Investment Fund (PIF), pension system and other sectors where it belongs so to speak.

So, when I say Middle East central banks and including Saudi did not have classic central bank structure, I am talking about the money that was really kept for foreign reserves. Within the classic portfolio, the holdings are mainly in US dollars. It’s difficult to give exact proportion, but as per estimates at least 90-95 per cent of holdings are dollar-based, either in the form of the US government paper or any other government paper that they can hedge back into dollars.

What about other GCC countries like Oman and Bahrain?

Bahrain’s reserves have shrunk because the economy has been into deficit for quite some time. As a result, their reserves are small, and it is just basically a liquid pool. Oman is in the same economic situation as Bahrain. If you think of high-quality government bonds, such as those of European governments, almost half of the world’s government bonds are owned by other governments but 12 years ago it was about 15 per cent.

Can you elaborate more on the factors that are taken into consideration when central banks place their funds?

It is a mix of factors that involves foreign reserves buyers, quantitative easing, large sovereign wealth funds and public pension funds.

Even if they are not buying large quantities of assets, this doesn’t mean they can’t as they are multi-trillion groups. That said, there are two key things that are worrisome:

  • First, the significance of having foreign reserves is to ensure not only stability and security of the domestic economy but to also have adequate liquidity. One of the main goals of buying US Treasuries by central banks is to maintain liquidity and safety. However, this way how to remain liquid and safe has become one of their prime objectives.
  • Secondly, it also creates a lot of awkward relationships between governments themselves and between central banks and central governments.

While safety and liquidity remain the clear priorities, the focus on return has increased in recent years, contributing to the diversification of central bank reserve portfolios.

How do they mitigate their exposure?

People are worried about the global debt crisis, primarily because debt levels are rising fast. The only way to avert any potential debt crisis is to have lower rates. This is because, one, rates are controlled by the central banks.

Secondly, central banks are also the holders of debt thereby creating a conflict of interest. The reason is they are not only rate-setters but asset holders and investors too at the same time. It is not an imminent concern but at some point, in time, it could grow too much, thereby generating the conflicts of interests.

Theoretically, it prevents central banks from raising rates because it has the potential to damage their own portfolio. Globally, central banks hold around $800 billion (six per cent of their portfolio) in equities and over one trillion (nine per cent of their portfolio) in return-enhancing bonds (mainly investment-grade corporates and asset-backed securities) compared with close to zero at the beginning of the century.

In total, equities accounting for around six to seven per cent of the global equity market value are held by government investors, of which the majority rests with the pension and sovereign wealth funds. Central banks own just one or two percent of the global equities. For corporate bonds, the share is around 10 to 11 per cent for government assets.

Finally, we are seeing the rise of the Renminbi in the Gulf as one of the reserve holdings of central banks. While the amount of money being put into the Renminbi is still very modest, we are seeing more and more banks are investing in it. Ten years ago there were less than five central banks that had Renminbi in their portfolio, today it’s almost 75 to 80 central banks.

Though the number has grown a lot but the share of the portfolio is still pretty small--going from one per cent two years ago to close to three per cent now. China is the second largest economy in the world, it has the second largest bond market in the world and it is the biggest trade finance centre in the world. This could lead one to think the currency to eventually become number two globally.

However, in reality, it’s not. Nevertheless, we are seeing preparations are underway.

Do you think it’s because of how China has grown over the past 10 years?

The Renminbi is used widely and across the Gulf because of the Special Drawing Rights (SDR), which is the IMF currency. The IMF used to have four currencies that it used as reserve currencies and they used to say you must have this percentage if you want to maintain the accounts the way they do.

The IMF added China around two years ago and that was kind of green light for everybody to do so. The Gulf countries are active investors in China across the board but not in the central banks. One can speculate why it is like that.

Gulf’s sovereign wealth funds buy liquid assets, Chinese equities as well as hard assets and companies’ shares. This apart from partnering with Chinese companies and the Chinese government as investors, which show the links are very strong.

How does global trade issues affect MENA?

There has been a slowdown in 2018 and markets were very nervous about it at the end of the year. Then there has been a bit of policy reversal by the US Fed. I expect in the next few months, the news on the global economic front will get better and we could see a bit of a recovery in Europe, and China.

When I say a bit, I mean it will hit the bottom and pick up again, a bit of a rebound. We see a bit of a resolution of the China-US dispute that will be very positive. But markets have already priced it in. The Fed has turned lucent and the easy policy stance will also see a bit of rebound in the US.

I expect the next two quarters or so to be pretty good. However, it would be somewhat a temporary rebound, because overall the global economy is slowing down across the board, and it looks like 2020 will be much of a slower year than this year. It might not be technically a recession but it’s quite a slowdown, the whole world will be growing slow next year.

Partially this will be because China is not growing the same way it used to 10 years ago. China accounted for 40 per cent of global growth in the last decade, and over a third of global growth was led by China.

However, China’s growth potential is dropping, its economy is having debt constraints. As the growth is coming down, it has a ripple effect on the global trade, and commodities are facing the knock-on effects. The fact is that China is a massive engine of the global economy; but since it’s slowing down, that is going to inevitably hurt everybody.

Secondly, the US growth was flattered by taxes, deregulation and very low interest rates until recently. That effect is partially affecting the US and as a result, growth will be a little bit lower. Overall you have structural forces that are going to fall down the economy, again not negative but slower than what it has been in the last two to three years.

How do you see things picking up?

Our view of the 2020s is a bit dark. Frankly, I am not going to lie, a bit somber. The reality is we do not see any fundamental growth drivers that are very strong and positive. This means we think governments and policy makers will step in to drive the recovery in the 2020s and the only way they can do that is they can even do things that are even more unconventional.

If you are a markets person you do not like unconventional stuff because you want markets to be working the way markets work. But we expect that there will be a lot of intervention by the governments that is going to make markets work.

Maybe this will be good for the economy but not great for markets in the 2020s. I do not know when the recession will come to end. But I do care about what will happen after the recession, that is, the recovery will not be normal, but governments will start doing things that are very unconventional. There are always winners and losers for investors, but markets will not operate the way they used to in the past.

What are your views on the geopolitical crises we face?

Geopolitics plays a big role; geopolitical factors are either at a backburner or are sometimes in the front. We think governments are going to bring back financial controls and industrial policies in the 2020s at least in the developed economies, something they have not done in the last 40 to 50 years.

In the 1970s, governments came up with industrial policies when the governments felt like they can steer the economy. We think some of that will come back and this is where geopolitics comes in. Think of what has happened under the guise of China, in Europe and America in the last two to three years. For example, the US changed the rules of inward investment, disallowing Chinese companies to buy an American firm.

Another example is Germany that changed the percentage of foreign ownership foreigners can hold in certain sectors. They have laid down rules about which Europeans companies can merge and cannot merge, all under the guise of competing with China.

During a recession, people are pissed off because they are losing jobs. In this scenario, what do you think governments will do with those types of tools?

They will decide which companies should merge, which sectors and companies to provide support and financing, which sector, region or company will change the rules to help you a little bit.

It will be like you bringing the government back to manage the economy. We see this happening under the guise of geopolitics right now. The US is talking about all sorts of measures about who can own what and who can control what because they say they are protecting themselves from the China threat. In a few years, it will no longer be about China, but something more profound.

It will be like the return of the states to the market economy. That is why the future is so bleak and it’s a return to the 1970s partially. Regression is going back a little bit, and that’s why geopolitics matters because they have set a stage.

For example, in America if it was not for China for the government to say this is okay or not okay, citizens will question what the government is doing in terms of protecting the American workers. This means ‘America first’ but it is under that guise the state is taking the larger role. The same is true in case of much of Europe.

What is your outlook on things at the moment?

In the short term, we expect the next few months are going to be fine. Things should start rebounding a bit. I am hopeful we will see a lot of tech innovation spilling over into productivity for many years, in terms of improving processes and workflows, boosting productivity and that will boost economic growth.

I am positive about the Middle East and the GCC region, as oil prices will be stable. There might be ups and downs here and there but structurally, the regional economy will remain strong in the medium term. It’s better to remain calm than boom because a boom could cause all sorts of misallocations.

Secondly, Saudi Arabia is one of the few places in the world that is doing reform. Things are actually changing on the ground. You cannot say anything like that about any other place in the world. Saudi’s financial sector reforms have been meaningful, fast, impactful and if they can do what they have done in the financial sector across the economy I am quite positive about the future.

In the UAE, Dubai is exposed to world trade that is facing headwinds. The silver lining is that the Emirate is attached to the Indian subcontinent which has been growing strong for the last few years, regardless of the global scenario.

That is a positive sign. Another positive factor is Expo 2020, no matter what happens after that, it is a stimulus for the domestic economy. The UAE has incredible financial stability and has very comfortable savings position. Kuwait is also in a very comfortable position. Its oil production costs are low that is something positive.




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