Korea Ministry of Strategy and Finance and Korea Development Institute, Seoul 22-23 June 2015
Ousmène Jacques Mandeng
Central bank capital markets interventions through foreign exchange reserve allocations have become critical determinants of national and international capital markets developments. However, many economies, including in particular most emerging markets economies largely lack central bank capital markets participation. The asymmetry in central banks’ reserve allocations may induce undue biases in the distribution of international capital markets volatility. The relationship between reserve accumulation and volatility biases would suggest that emerging markets may be an important source of capital markets volatility. At the same time, the relative stability of central banks’ asset allocation suggests that broader based allocation of central bank capital markets intervention may represent a major capital flow volatility mitigating measure.
The present note focuses on recent developments in international portfolio liabilities, in particular debt securities, to highlight and by simple conjecture discuss the implication of significant central bank international reserve accumulation for capital flow stabilisation. The role of official reserves has been considered mostly with regard to mitigating capital flow volatility through direct foreign exchange market interventions and the effect on investor behaviour.1 The impact of central banks’ asset purchases has been reviewed largely with regard to central bank reserve accumulation and the level of asset prices (“Greenspan conundrum”) and central bank unconventional monetary policies and the direction of capital flows (“taper tantrum” and “currency wars”).2 Very little if any attention has been paid to the relationship between foreign exchange reserve accumulation and international capital flow volatility.
International portfolio liabilities excluding official reserves more than tripled since the early 2000. International portfolio liabilities, cross-border portfolio investments in equity and debt securities, increased from US$14.1 trillion (41 percent of world GDP) in 2002 to US$46.5 trillion (60 percent of word GDP) in 2014 and debt securities increased from US$9.3 trillion to US$25.7 trillion.3
The global financial and economic crisis caused a significant decline in international portfolio investments. Total liabilities dropped from US$39.7 trillion (68 percent of world GDP) in 2007 to US$31.1 trillion (49 percent of world GDP) in 2008 of which debt securities dropped from US$22.1 trillion to US$21.2 trillion. International securities holdings in emerging markets excluding China declined from US$5.8 trillion (38 percent of emerging markets GDP) in 2007 to US$3.7 trillion in 2008 (21 percent of emerging markets GDP) of which debt securities declined from US$2.1 trillion to US$1.6 trillion. Official reserves have maintained a continuous upward trend from US$2.4 trillion (7 percent of world GDP) in 2002 through 2008 declining for the first time modestly in 2014 to US$11.6 trillion (15 percent of world GDP) (Chart 1).4 Emerging markets central banks’ hold about US$4.0 trillion of reserves and China US$3.7 trillion in 2014.
Investment allocation patterns differ significantly between official, assets held as reserves, and non-official, assets not held as reserves, portfolio liabilities holdings. Official reserves are allocated almost exclusively in international government debt securities issued by a narrow group of countries.5 Official reserves have maintained on average investments predominantly in France, Germany, Japan, the U.K. and the U.S. representing as estimated 79 percent of total international debt securities investments in 2014.6 Non-official holders maintain international debt securities allocations to the same group of countries of 48 percent in 2014 (Chart 2).
The decline in total international portfolio liabilities in 2008 affected disproportionately equity securities and emerging markets. The share of emerging markets excluding China in total portfolio liabilities declined from 15 percent in 2007 to 12 percent in 2008. During 2013 emerging markets were also adversely affected by the “taper tantrum.” The capital flow reversal was reflected in significant increases in government bond yields affecting emerging markets to a significantly greater extent than advanced economies. Emerging markets government bond yields increased from an average of 7.1 percent in 2007 to 8.4 percent in September-November 2008 (Chart 3).7
Central banks’ asymmetric capital markets allocation represents a critical bias in the distribution of stable investments in international capital markets. Official reserves represent an important stabiliser of capital flows for advanced economies with stability provided directly through steady asset allocation and indirectly by giving market participants comfort that asset prices benefit from central bank support.8 While central banks intervene almost exclusively in government debt securities, the importance of government securities as benchmarks and to price other fixed income securities suggest important broader effects from official capital markets interventions for other asset classes and the exchange rate.
The high level of official reserves may risk unduly diverting volatility towards emerging markets causing and reinforcing “currency war” effects. The important bias in central banks’ securities holdings may induce significant adverse relative value effects that may bolster “safe haven” trades in situations of market distress. In normal times, the stability of official reserves may reduce average volatility levels and help develop and deepen national capital markets, that is, the U.S. treasury securities market is attractive in large part due to the People’s Bank of China’s holdings of U.S. treasury securities.
Official reserves remain largely underutilised. While central banks’ adopted national asset purchases to stabilise national asset prices, international asset purchases have been mostly regarded as a hedge against adverse exchange rate movements but not to affect international capital markets volatility and hence stabilise national asset prices. Even in the aftermath of the Lehman Brothers collapse use of central bank foreign exchange reserves remained very limited and concentrated in a small number of countries. The benefit of holding large official reserves amid a perceived fear of intervening is ambiguous. The mobilisation of central banks’ reserves to help establish somewhat greater balance between asset support for advanced economies securities and emerging markets securities may constitute an important complement of conventional capital flow management measures.
The asymmetric allocation of central bank reserves may have contributed to a biased distribution of international capital markets volatility. Consideration should therefore be given to alter the composition of central banks’ official reserve holdings to rebalance asset support across a broader range of countries. Central banks have started to diversify official reserve holdings but total allocations to new countries remain small. Given the short-term destabilising effect a significant reallocation of central bank reserves implies, a coordinated approach among central banks—given the distribution of official reserves requiring participation in particular of China and emerging markets–-would be preferable. The diversification of central bank reserves would help create positive international externalities from reserve accumulation diffusing the stability properties of reserves more evenly. This may contribute to a significant decline and more balanced distribution of international capital markets volatility and allow especially emerging markets to establish more of a level playing field in terms of capital flow stability. China and emerging markets are therefore themselves both a source of international capital flow volatility and stability.
* Prepared for delivery in session 5. Financial spillover and capital flow management measures, 23 June 2015
1 See e.g. Alberola, E. et al, International reserves and gross capital flows: Dynamics during financial stress, Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute, Working Paper No. 110, March 2012; Reinhart, C. and Reinhart, V., Capital inflows and reserve accumulation: The recent evidence, NBER Working Paper no. 13842, March 2008.
2 On the impact of official reserves and capital markets, see e.g. Higgins, M. and Klitgaard, T., Reserve accumulation: Implications for global capital flows and financial markets, Federal Reserve Bank of New York, Current Issues, volume 10, number 10, September/October 2004. See also .e.g. Fratzscher, M. et al, A Global Monetary Tsunami? On the Spillovers of US Quantitative Easing, mimeo, 19 October 2012, available at SSRN: http://ssrn.com/abstract=2164261. On the “Greenspan conundrum”, see e.g. Craine, R. and Martin, V., Interest rate conundrum, mimeo, January 2009, http://eml.berkeley.edu/~craine/2009/conundrum_final2009revison_complete%282%29.pdf. On currency wars, see e.g. Korinek, A., Capital controls and currency wars, mimeo, February 2013, http://abfer.org/docs/track1/track1-capital-controls-and-currency-wars.pdf.
3 Portfolio liabilities data from IMF CPIS through June 2014.
4 IMF COFER allocated and unallocated official foreign exchange reserves through December 2014.
5 E.g. Hong Kong Monetary Authorities and Swiss National Bank are exceptions.
6 Estimates based on IMF CPIS Table 9 securities held as reserve assets by investments by country.
7 JP Morgan Government Bond Index-Emerging Markets Global Diversified. Constituents are: Hungary, Malaysia, South Africa, Poland, Mexico, Philippines, Chile, Brazil, Turkey, Colombia, Peru, Romania, Russian Federation, Nigeria, Thailand and Indonesia.
8 International reserve allocation are also reinforced by central banks’ national asset purchases. National central banks have become major holders of national government securities with the adoption of quantitative easing. The Bank of Japan holds about 35 percent of straight Japan Government Bonds (JGBs), the Bank of England holds 35 percent of conventional gilts and the Federal Reserve holds 20 percent of U.S. Treasury marketable securities (April 2015). On the importance of central banks’ lending to governments, see e.g. Mandeng, O., May Newsletter