Emerging markets economies have resumed accumulating international reserves after the three-year hiatus which followed May 2013’s ‘taper tantrum’, when the US Federal Reserve implied it would slow its rate of bond purchases. This resumption speaks to emerging markets’ resilience, and is proof of the success of self-insurance policies based on floating currencies and high stocks of international reserves.
However, as only a small fraction of international reserves was used to protect these economies from the global shocks of the last 10 years means that emerging markets are over-insured. Existing stocks of international reserves far exceed the levels which would provide what most practitioners perceive as their main benefit, namely the ability to smooth domestic absorption in response to sudden stops of financing.
In the light of rising stocks of international reserves, currency diversification has become an increasingly important allocation decision for policy-makers. While security is paramount, an increasing number of central banks are including return objectives in their reserve management procedures. But managing the trade-off between security and returns is a difficult task. Varying international reserve holdings away from the dollar could lead to large drawdowns in returns that prove difficult to recover.
An optimal portfolio for a central bank should provide maximum returns in times of crisis. Currency diversification is key to achieving an optimal allocation of reserves.
That being said, the cumulative return of an optimal portfolio of currencies tends to underperform significantly a dollar-based portfolio in times of stress or sudden stops.
Over time, central banks which hold an optimal currency-diversified portfolio would outperform purely dollar-based portfolios, but at the expense of experiencing greater volatility during periods of market stress. Moreover, it could take more than a decade for an optimally currency-diversified portfolio to recover from the drawdown experienced during a sudden stop. This is a clear disadvantage which, in some cases, could prove to be politically untenable. In the long term, however, the positive attributes of a diversified portfolio should supersede such short-term evaluations.
Adding emerging markets’ inflation-linked currencies to central bank reserve allocations may improve the return potential of portfolios without causing a sizeable deterioration in their safety characteristics. These securities can provide insurance against nominal currency depreciations, thus reducing the large drawdown in returns which are typical of global currency markets. Emerging market inflation-linked bonds can, too, represent a superior investment to a set of liquid emerging markets currencies.
The varied impact of global shocks on different countries calls for differentiated optimal allocations of international reserves by their central banks. One factor which they should perhaps all share, however, is the inclusion of more inflation-linked securities to enhance optimal portfolio returns without meaningfully increasing underlying investment risks.
Ricardo Adrogué is Head of Emerging Market Debt at Barings.