Inflation, global economic slowdown and geopolitical tensions are top of reserve managers’ concerns in an ever more complex macroeconomic landscape. OMFIF’s Global Public Investor 2023 delved into the strategies central bank reserve managers are adopting to counter the pressures they are facing from all sides.
The launch event on 27 June presented the key findings of the report, including the results of a survey of 75 central banks. A panel of experts analysed the multifaceted challenges reserve managers are dealing with, such as concerns about inflation, the need for effective asset allocation strategies, potential shifts in currency dominance and the integration of environmental, social and governance considerations in decision-making.
Stagflation is the top priority
Representatives from Bank Negara Malaysia, Bangko Sentral ng Pilipinas and Narodowy Bank Polski were in consensus about inflation being the foremost concern for reserve managers. Didier Borowski, head of macro policy research at Amundi Institute, echoed the sentiment, adding ‘core inflation is likely to be stickier than people believe’.
But while inflation is a key concern, the report found that stagflation is the main issue for reserve managers. Among survey respondents, 85% see inflation as a top challenge and 69% included a global economic slowdown among their most pressing concerns (Figure 1). Borowski also emphasised that there is a ‘divergence between large emerging economies and advanced economies’, wherein countries from the former group, such as India and Indonesia, are doing well with respect to growth and do not face the same stagflation conditions that advanced economies are.
Figure 1. Inflation and economic slowdown overtake geopolitical tensions as key concern
What are the three most important economic challenges affecting your investment approach over the next 12-24 months? Share of respondents, %
Source: OMFIF GPI survey 2022-23
Geopolitics was another significant concern identified by panellists, although its effect on reserve management decisions was deemed limited. It was the most pressing issue for reserve managers in the wake of Russia’s invasion of Ukraine in 2022 but fell to third this year. While geopolitical events can contribute to volatility, reserve managers find it challenging to act directly on such concerns.
Fixed income is making a comeback
The resurgence of fixed income investments has caught the attention of reserve managers. Borowski claimed ‘bonds are back’ as they are now viewed as a steady source of income, especially in the current environment of higher interest rates. Juliusz Jablecki, director of financial risk management at Narodowy Bank Polski, reiterated the notion, adding that bonds are now a steady source of income that can be acquired at attractive valuations.
The more favourable environment for fixed income ushers in a more challenging environment for diversification. Shahredza Minhat, chief representative for the London office at Bank Negara Malaysia, observed that ‘uncertainties lead you to make decisions about diversification’. He added that as long as ‘diversification improves risk-adjusted returns, it will continue to be a key strategy’.
However, the prospect of higher yields is leading central bank reserve managers towards fixed income. A net 32% of survey respondents intend to increase allocations to conventional government bonds in the next 12-24 months (Figure 2).
Figure 2. Moving towards fixed income
Over the next 12-24 months do you expect to increase, reduce or maintain your allocation to the following asset classes? Share of respondents, %
Source: OMFIF GPI survey 2023
There has also been an increase in allocation to gold, which has historically been considered a safe asset and a hedge against unfavourable market outcomes. A net 14% of respondents intend to increase their allocation to the safe asset. Reserve managers are drawn to gold as it retains its function as a medium of exchange, even in a world increasingly focused on digital assets, explained Jablecki. Gold serves as a hedge against foreign exchange risks, particularly against the dollar, offering reassurance to reserve managers. Given the current positive correlation between equities and fixed income, this makes gold an even more attractive asset for diversification purposes.
Reign of the dollar expected to continue
Representatives from the three central banks agreed that dominance of the dollar as a reserve currency will continue. Kashmirr Ibañez-Camacho, assistant chief reserve management officer at Bangko Sentral ng Pilipinas, noted that the dollar remains an attractive asset with respect to size, depth, liquidity and convertibility of the currency. Minhat agreed, pointing to the fact that the dominance of the dollar becomes ‘more intense’ in times of crisis, as was the case during the Covid-19 pandemic.
While some diversification efforts are being explored, the dollar’s role in global reserves is expected to persist in the foreseeable future. Narodowy Bank Polski’s largest currency allocation is to the dollar, which Jablecki conceded was ‘quite unusual’ for a European central bank. However, as interest rates continue to rise, the ‘tide may be turning’ on the attractiveness of the euro as a reserve currency, he added.
Looking at the renminbi, there is a while to go before it provides significant competition for the dollar as a dominant reserve currency. Reserve managers are taking a cautious approach to China in the short term, but almost 40% of survey respondents intend to increase holdings of renminbi over the next 10 years. However, the renminbi is unlikely to challenge the dollar as a reserve asset in the near future as survey respondents expect it to reach just 6% of global reserves in 10 years, from under 3% currently.
The key challenge to the dollar’s dominance comes from the US itself, according to Mark Sobel, US chair of OMFIF. He stated in his opening remarks at the event that ‘dollar dominance results from the characteristics of the US economy, not a declaration from heaven. America’s challenge is to preserve those characteristics.’
A bright future for ESG integration
To achieve the energy transition in the coming decade, there will need to be increased investment in ESG products, ‘especially green bonds’, noted Borowski. This sentiment was echoed by panellists from the three central banks, all of which have a strategy for integrating ESG into their reserve management frameworks.
The GPI found that investment in sustainable assets is predominantly concentrated towards green bonds, for which the market has grown significantly – especially in Europe. Jablecki emphasised that Narodowy Bank Polski has not felt the problems about size and liquidity of the market for green bonds, underscoring that it has ‘evolved tremendously’.
While ESG integration has come a long way over the past decade, challenges remain. Lack of information and data is the main roadblock to ESG adoption, with 72% of reserve managers citing it as a barrier. This was echoed by both Minhat and Jablecki, who brought up concerns about greenwashing, noting that central banks don’t always have the resources to audit projects directly and have to rely on third-party verifications.
Arunima Sharan is a Senior Research Analyst at OMFIF.