Core Focus: The drivers of the shift toward non-traditional assets—including excess reserves, prolonged low yields, and changes in the characteristics of sovereign bond markets—and the constraints that limit this shift.
In-Depth Notes:
The expansion into non-traditional asset classes has been driven by several structural factors. The global build-up of reserves, which in part was a result of persistent foreign exchange intervention, has facilitated the shift into higher-yielding assets . However, the shift is not universal, and several constraints limit the adoption of non-traditional assets.
Drivers of the Shift:
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Excess Reserves and Excess Capacity: If foreign currency reserve balances have expanded as a consequence of exchange rate intervention rather than for precautionary purposes, then there is likely to be excess capacity with which to invest in higher-yield assets . Countries with reserves in excess of required precautionary balances have greater scope to invest in higher-yielding and less liquid assets .
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The Prolonged Low-Yield Environment: The prolonged low-yield environment in developed markets has reduced returns on traditional assets, pushing reserve managers to seek yield in non-traditional assets. The recent surge in long-dated bond yields to multi-year highs presents a fresh opportunity to capitalize on valuation dislocations across developed market government debt .
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Changes in the Characteristics of Sovereign Bond Markets: Downgrades in the credit ratings of sovereign bonds from peripheral European countries around the time of the financial crisis reduced the pool of high-quality sovereign bonds available for inclusion in reserve portfolios . This may have caused some reallocation into other high-quality assets, including non-traditional ones. In contrast, the strong credit ratings of Australia and Canada may have increased the relative attractiveness of government debt issued in these countries .
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Diversification Benefits: Research has shown that introducing currencies weakly correlated to the USD (AUD and CAD) significantly reduces portfolio risk, and that expected return is improved through mortgage-backed securities, corporate bonds, and equities .
Constraints on the Shift:
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Market Depth and Liquidity: Alternative reserve assets are often quite small markets, with none larger than US$1.5tn. Moreover, the largest of these—the Chinese treasury market—is difficult for foreigners to access . Central banks managing large pools of official reserves require large and deep markets to avoid significant market impact when transacting.
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Capital Preservation Concerns: Non-traditional assets, particularly equities, can be more susceptible to falls in value, especially in periods of market stress when reserves are more likely to be required . This tension between return enhancement and capital preservation is a central challenge for reserve managers.
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Credit Risk and Liquidity Risk: Non-traditional assets typically carry higher credit risk and lower liquidity than sovereign bonds. Reserve managers must carefully balance the potential return enhancement against these risks.