Reserve managers weigh the risks amid the Ukraine crisis

Central bank reserve managers could increase investments in commodity and energy-linked assets to help deal with higher inflation, according to panellists at Central Banking’s Spring Meetings in late March. This might allow them to deal with some of the risks stemming from the Russian invasion of Ukraine, some panellists thought. However, if they did that then central banks would need to accept the trade-off involved in higher exposures to more volatile assets.

In the weeks following the beginning of the war on February 24, the prices of oil, gas and agricultural commodities such as wheat have risen rapidly. Both Russia and Ukraine are major exporters of these commodities. Russia is also a major oil and gas exporter.

This has contributed to push inflation way over central bank policy targets. In Germany, the federal statistical agency expects inflation to have risen by 7.3% year-on-year in March, the highest level since 1981. The European Central Bank aims to have eurozone inflation at 2% over the medium term. High inflation depreciates the relative value of reserve portfolios.

Portfolio options

Such rising inflation requires that central banks devise hedging strategies to protect the value of their assets, and if possible to also reap benefits. “Thanks to innovation and technology, it has just become much easier over the years to build exposures to asset classes that tend to do well in inflationary regimes,” said one participant from a central bank in Europe. “You can access them through an ETF [exchange-traded fund] at very low cost. And you don’t even have to enter into lengthy legal negotiations for passive mandates. There’s public infrastructure, exposure to energy or mining and metals,” this panellist noted.

The most traditional way that reserve managers protect from higher inflation is through Treasury inflation-protected securities (Tips). These are “probably the easiest, or most straightforward inflation hedges that one can think of,” added the panellist. “Although operationally it is more complex.”

Investing in energy and mining stocks to hedge inflation risks would require a methodology to distinguish between expected and unexpected inflation. Energy-linked and mining stocks tend to overperform in the kind of unexpected inflationary shock the global economy is currently going through. However, in more normal circumstances reserve managers would have to accept the risk that these assets tend to perform below central bank benchmarks, added the panellist.

In addition to volatility, some reserve managers could be required by their boards to explain whether higher exposure to these sectors is in line with environmental, social and governance (ESG) principles.

Reserves to the front line

For neighbouring countries, the war has caused added many challenges, with one of the clearest examples being in Poland. Around 3.8 million people have fled Ukraine, with more than 2 million of them now being in Poland. The National Bank of Poland has joined the efforts of other Polish authorities in supporting Ukrainian refugees, and on March 18 the NBP reached an agreement with the National Bank of Ukraine to allow adult Ukrainian refugees to exchange up to 10,000 hryvnia ($400) per person for zloty.

Against this backdrop, in the first two weeks of the war the Polish zloty depreciated 12.5% against the US dollar. To stabilise the currency, the NBP has carried out foreign exchange interventions. In turn, to support the Polish financial system, on March 28 the European Central Bank approved a new €10 billion ($11.1 billion) swap line with the NBP, which will remain active until January 15, 2023. The Polish central bank confirmed in a statement that the swap line allows it to “borrow up to €10 billion from the ECB in exchange for Polish zlotys. The maximum maturity for each drawing will be three months.”

In response to Russia’s aggression, governments have imposed hefty financial sanctions on Vladimir Putin’s regime. This has included the confiscation of the Bank of Russia’s foreign currency denominated assets placed at other central banks, an act that has hampered the Russian central bank’s efforts to stabilise the rouble, which plummeted in the days following the invasion.

Alternatives to the dollar?

Some observers have claimed these actions erode the international monetary system, which would accelerate efforts by emerging economies to diversify reserve assets away from the US dollar. “This is a unique situation due to the size and the importance of the central bank that has been sanctioned,” said one panellist from a South American central bank. “But it wasn’t just the dollar that was seized, it was dollars, euros, yen and so forth – basically all G7 currencies.

This panellist also stated that these sanctions cannot be taken as a precedent, and should not undermine the credibility of the international monetary system. “The reasons why the assets were seized were well known, transparent, and to a certain degree agreed upon by the international community. So it wasn’t like it was something that was done because of one particular country’s political interest.”

Another panellist, from a central bank in Europe, pondered what other options international reserve managers have beyond the dollar or the euro. “Where else are you going to go? If you have sizeable reserves portfolio, then the question is, ‘where are you going to put it?’” In his view, the debate may not centre on whether the war will accelerate the decline of the dollar as the world’s reserve currency. Instead, it could be on whether it is going to speed up the adoption of crypto assets among traditional investors, including even reserve managers.

However, a South American official warned that “even if crypto is something that is popular, and people do want to associate with crypto or some variants of crypto in the future, are you going to withstand the volatility that crypto exposes you to?” Another panellist pointed out that large emerging market central banks are among the top reserve holders worldwide, and they could have an incentive to move away from the dollar. However, many of these jurisdictions “are outlawing the use of crypto, or restricting at least the use of crypto in their own domestic financial systems.”

He went on to explain this as due to there being “a significant risk of substitution away from the domestic currency. So crypto might be quite interesting, but might also be quite challenging from that point of view.” The South American panellist added: “That’s why you are always pretty much stuck with the type of portfolios that we manage, that we have been managing for a long time.” He conceded: “We have shifted around currencies a little bit, we have shifted around durations a little bit. Some people have invested in riskier asset classes like equities, and corporates, and mortgage-backed securities. But US Treasuries remain the undisputable main asset.”