Storm clouds building?

Global financial crisis was the most significant development since the UBS Reserve Management Seminar began 25 years ago, but the world is moving into a new era of trade protectionism.

The global financial crisis was the most significant development since the UBS Reserve Management Seminar began 25 years ago, but the world is moving into a new era of trade protectionism. These disputes have already dampened global growth but any escalation could have a significant impact, according to panelists at the Seminar currently underway in Switzerland, which brings together central bankers and reserve managers from around the world.

Below we outline some of the main points that emerged from discussions on Day 1 of the seminar.

Global Financial Crisis – a watershed moment

The global financial crisis was a watershed moment for central banks in the last 25 years, as it was the moment when their reach extended well beyond monetary policy. Foreign exchange reserves have risen to unprecedented levels, topping USD 11.3 trillion in 2012*. That massive expansion coincided - or indeed demanded - diversification into new assets including equity, corporate bonds and emerging market debt. In some respects, central banks are becoming more akin to pension funds and insurance funds when it comes to asset allocation.

Currency diversification

While the US dollar has remained the dominant and stable currency for reserve managers, there has been diversification at the edges, the most notable of which is the rise of the renminbi, which has risen to about a 2% share of assets under management*. The move into RMB is not sudden, it's slow and gradual. And it’s not about replacing the dollar, but the RMB could potentially rise to the third place behind the dollar and the euro. There are financial reasons related to the Chinese foreign exchange regime that mean RMB is less volatile, with benefits for FX portfolios. And indeed, the USD will more than likely remain the dominant reserve currency for the next 25 years.

Negative yields

With more than USD 12 trillion** of government bonds currently yielding negative returns; this is a very challenging environment for central banks. 50%** of the European debt has a negative yield. There are relatively few options: for instance, even going out longer on the curve means, in the case of Europe or Japan, seeking assets beyond 15 years' maturity. One alternative is China: does the Asian giant require a separate asset allocation? Probably yes, according to a recent paper, Central banks are too conservative when it comes to investing, Max Castelli of UBS Asset Management and Stefan Gerlach of EFB Bank and CEPR note. Since reserves are held for foreign exchange intervention, central banks have prioritized holding safe assets that are liquid during market turmoil. Moreover, reserves were historically small. Only recently have reserves become so large that they exceed what could plausibly be needed for intervention.

Castelli and Gerlach point to a principal-agent problem between the central bank and the Ministry of Finance; the need to ensure sufficient asset management experience among board members and the senior management; and a bias towards a steady stream of profits arising from the profit distribution rules. To offset these problems, governance changes may be necessary.

Embracing volatility?

Volatility has not deterred central banks: they are pressing ahead with diversification. This is likely to remain the case if global interest rates remain in this 'low-for-ever' environment as central banks need to generate a return to protect portfolios in real terms. Any move now will be very careful and progressive because most asset classes are expensive. It is very difficult for a central bank board to decide to go into equities at this stage. There are very few asset classes that still offer sufficient risk premium.

There are challenges with regards to governance. Sovereign wealth funds were created under very different structures that separate political stakeholders from the assets. Some central banks are starting to inject more asset management with more investment expertise, but will this continue? From a sample poll of the RMS audience, 65% say central banks are too conservative and one third say they are fine as they are. Meanwhile, central banks seem to be more worried about the effects of diversifications than about reducing liquidity.

Trade dispute fundamentals behind economic concerns

The global disputes over trade tariffs are the fundamental reason behind the economic concerns reflected in financial markets, and which central banks are having to address. While the first round of tariffs imposed between the US and China have been absorbed, the uncertainty around any escalation is already having an effect.

If the US goes ahead with imposing a new round of tariffs on Chinese goods, the impact could be of the same order of magnitude as major economic events such as global financial crisis or the major global debt crises of the 1990s and 2000s. While global growth is on an uptrend and central banks generally expect interest rates to move up slowly, the imposition of tariffs could lead to the exact opposite: slower growth and central banks cutting rates.

For now, most of the world's central banks are broadly on a monetary tightening cycle in 2020, but if the trade war escalates that will change dramatically, with most central banks embarking on an easing cycle next year, with the European Central Bank (ECB) and Bank of Japan going further into negative territory and the Federal Reserve (Fed) cutting another.

If these supply shocks in the form of trade disputes become a permanent feature of the global regime, then it becomes a permanent uncertainty, which panelists believe puts the global economy into dangerous territory.

The world's major central banks are already paying attention. The steps taken in just the last few weeks by both the ECB and the Fed suggest they are entirely in risk-management mode, premised on the outcome of trade talks. If a tariff escalation were to ensue between the US and China – or the US' other major trading partners – both the Fed and the ECB now stand ready to act. As a consequence of the fallout, and the deep concerns, simply standing still is not enough, and would require action. Both would much rather cut rates and be subsequently proven wrong, than to stand back or hike prematurely.

The US dollar is close to its strongest levels in 20 years, which is entirely reasonable given the strength of the US economy and the position of monetary policy. In terms of probably outcomes, however, the argument may be tilted towards the rest of the world playing catch-up, which would point to a weaker dollar. On the other hand, if growth remains superior and real rates remain high, then the dollar would remain stronger. For bond yields, which are equally rich, there's a similar argument: to think bonds still have value, then the factors that lowered the equilibrium interest rate must remain in place. More likely, bond yields are excessively depressed and in next few years will underperform.

And behind all of this? Politics. The world order since 1945 is undergoing a profound transformation. Three major economic blocks stand out: the US, China and Europe. Each has deep political challenges in many respects. Europe is perhaps in the weakest position, which in many respects reflects its disaggregated, diffuse structure compared to either the US or China. In Western democracies, politicians have, since the financial crisis, hidden all too often behind central banks. If the world goes into another downturn, then politicians will – one way or another – probably be forced into taking action.

Climate risk

Climate risk is possibly one of the greatest, most unique and most far-reaching systemic risks ever encountered, and therefore it has recently come to the top of the agenda of many central banks. However, as the UBS Reserve Management Survey has revealed, central banks still face many challenges when implementing a climate-conscious investment process in their portfolio. These can range from conflicts with the mandate, to more technical challenges like getting clean data to base decisions on as well as benchmarking issues.

The panel explored various options how central banks could solve these issues and discussed the role that green bonds could play in central bank portfolios in the future.

In conjunction with the panel, UBS has published a White Paper 'Central Banks and climate change: taking up the challenge' which explores the challenges of central banks when it comes to Climate risk in detail. Read more

* IMF as at June 2019
** Bloomberg as at 2019