Executive summary

HSBC Reserve Management Trends 2023, the 19th annual edition, is published at a time when reserve managers face an uncertain market environment, geopolitical tensions and the sharpest monetary tightening cycle in over four decades. The book reflects on the challenges posed by a longer period of higher inflation, high policy rates and yields. But it also analyses the ideas that central banks are implementing to preserve, and, if possible, boost, the value of their reserve portfolios.

One thing is already clear: reserve departments are continuing to become increasingly sophisticated and innovative teams. They are carrying out changes to their portfolios, from duration recalibration to asset and currency diversification. Simultaneously, they are building new relations with external managers, implementing the adoption of SRI investment, and improvements to risk management frameworks.

2023 survey findings

The first chapter presents the results of a survey carried out in February and March 2023. It collates the opinions of 83 reserve managers, which jointly manage over $7 trillion in assets. These central banks highlight above-target inflation as the most pressing risk they are facing in 2023. Following Russia’s invasion of Ukraine in February 2022, geopolitical risks have also become increasingly relevant for these institutions.

As a way of preserving the value of their holdings, most participants say they reduced their portfolios’ duration. However, because policy rates are higher than previously expected, some managers have increased duration in response to higher short-term sovereign bond yields.

A majority of participants believe market volatility will either accelerate asset diversification or have no impact in this process. A smaller number of institutions expect volatility to slow down the adoption of new asset classes and currencies in reserves portfolios. Most participants say they expect central banks will continue to increase their gold holdings.

Regarding the impact of monetary policy normalisation on reserve currencies, the end of negative interest rates in the eurozone has boosted the euro’s attractiveness as a reserve currency. In contrast, the Bank of Japan’s more accommodative approach has reduced the yen’s allure. Similarly, instability in the UK’s sovereign bond market in late 2022 has damaged sterling’s standing. Regarding the renminbi, most participants think it will gain a larger share of international reserves through the rest of this decade. Nonetheless, this increase is expected to be gradual, and would maintain the Chinese currency at levels much lower than the US dollar.

A large majority of reserve managers think risk management frameworks have worked effectively to face the set of risks central banks have encountered over the last three years. However, a significant share of them intends to modify these frameworks over the coming two years.

Reserve managers identify the three main goals in their relations with external managers. The first objective is the adoption of new asset classes, the second the introduction of active management, and the third entering new markets.

The role of gold in central bank reserves 

The second chapter analyses how geopolitical risks, high inflation and economic uncertainty boost reserve managers’ interest in gold. In fact, central bank gold purchases in 2022 were at the highest level since at least the 1960s, when the global financial system still operated under Bretton Woods.

James Steel, chief commodities analyst at HSBC (with specific responsibilities for precious metals), argues there is a positive association between gold prices and increased geopolitical risk. In circumstances of heightened tension and uncertainty, gold tends to outperform other commodities. In fact, it has a history of rallying independently from other commodities during periods of risk aversion. “This supports gold’s status as a global safe-haven asset,” writes Steel.

The author provides an overview of the forces boosting central banks’ demand for this metal, and why this is likely to remain the case in the future. Among these, Steel stresses that gold can serve as a portfolio diversifier, reducing the risk of holding currencies and debt instruments of other nations. Gold also reduces risk because it does not have counterparty risk. This is especially relevant, says the author, because authorities can deploy this metal when facing a balance of payments crisis.

For instance, this happened during the 1997–98 Asian financial crisis. Gold can be used to cover essential imports or shore up a domestic currency, and it can also serve as collateral for loans. Additionally, in times of national emergency or conflict, when national currencies might not be redeemable, gold can be mobilised.

These characteristics may be especially important for large economies opposed to or not closely aligned with the US-led international order. For countries such as China, Russia, Iran and Venezuela, gold holdings may be especially alluring in order to mitigate the impact – or risk – of sanctions. “Sanctions may limit or cut off access to US dollars. This can lead to the utilisation of gold in its place,” says Steel. In this regard, a number of central banks in large emerging economies have significantly increased their gold holdings since 2000, he says.

Will the dollar remain the world’s reserve currency?

The third chapter reflects on the US dollar’s role as the world’s reserve currency, and to what extent this central position could be challenged by other currencies in the future. For instance, some experts and officials stress the importance of the sanctions on the Bank of Russia following that nation’s invasion of Ukraine. “Reserves management has been used as a weapon. That is undeniable,” says the head of reserves of a major emerging market central bank. The use of the dollar as part of the US’s foreign policy arsenal may prompt some central banks to somewhat reduce their exposure to the US currency.

Since the Bretton Woods conference in 1944, the US’s share of the global economy has declined, as has the country’s role in international trade. And over the last four decades, China has transformed itself from an economic backwater into the world’s primary exporter and the second-largest economy. However, the renminbi represents just below 3% of global reserves, while the dollar accounts for around 59%.

Some deem the status quo untenable. “I think the level of renminbi reserves as a percentage of global reserves is outdated, because pretty much for every country outside of Mexico and Canada, China is going to be the biggest trading partner,” says Jon Turek, founder and CEO of JST Advisors, a US hedge fund advisory service.

However, the dollar retains unmatched strengths. In contrast to China, US financial markets are fully liberalised, open to international investors. The US has deep and liquid markets governed by a rules-based system, and a transparent legal framework. Additionally, global trade in key commodities such as oil is denominated in dollars. 

One reserve manager from an emerging nation explains that if a central bank concludes it needs to reallocate its reserves away from the dollar, it needs to ponder other questions: “‘Where am I going to go?’ If the answer is the renminbi as a way of avoiding the wider western alliance, ‘am I certain that China is not going to use my RMB holdings as a weapon against me for geopolitical reasons in the future?’ I’m not entirely sure.”

A view from Israel 

The fourth chapter presents an exclusive interview with Golan Benita, the director of the market operations department at the Bank of Israel (BoI). The discussion covers the macroeconomic outlook, the BoI’s duration strategy, and the institution’s approach to asset and currency diversification.

Dr Benita thinks a soft landing for the US economy is still possible. But he warns that officials and markets must also consider less probable scenarios. “For instance, inflation in the US might be stickier than … was expected,” he says. “Secondly, the recent developments in the banking sector are also a reminder that some of the effects of higher interest rates might be unexpected.”

The official explains the BoI’s conservative approach to duration, which is set at just 24 months. “Our view is that the yield curve will continue to rise at the short end, and probably will flatten at the long end. But there is a lot of uncertainty,” he says.

As a pioneer in asset diversification, the BoI started investing in equities in 2013. This was partly due to the low-yield and low-inflation environment that followed the 2007–09 global financial crisis. Now that inflation has returned with a vengeance, and interest rates and sovereign bond yields are at levels not seen since the mid-2000s, diversification remains relevant.

In this new environment, the BoI is continuing to increase the share of reserves it invests in equities (23%) and corporate bonds (10%). This long-term commitment to diversification derives from the goals the central bank has set regarding its reserves portfolio. One of them is to cover the cost of the reserves in local terms, which have increased. “We build a portfolio that we hope will cover the financing cost of the reserves over the long term,” says Dr Benita. “Another important aspect to consider is that higher short-term interest rates allow us to take more risk, because we have a bigger cushion against losses.”

Recent experience at the BCB foreign reserves department

The fifth chapter explains the transformation of the reserves department that the Central Bank of Brazil (BCB) carried out over the last decade. This entailed changes to its investment process, asset allocation, as well as the adoption of sustainable investment criteria.

Alan da Silva Andrade Mendes, head of the international reserves department, describes the process. This includes currency diversification, including Chinese government bonds managed in-house, as well as new asset classes, such as US agency mortgages and investment-grade corporate bonds, and new tools, like TBAs and ETFs.

Additionally, sustainability has become part of the central bank’s official agenda. The reserves department has been trading green bonds for almost 10 years, and managed to include ESG criteria on the evaluation process of its counterparts. On the local FX market, the department implemented important improvements such as new types of auctions. “Most of these changes were backed up by new modules of an in-house suite of systems for foreign reserves management and operation or by completely new systems that were developed from scratch by the team,” writes Mr Mendes.

As a direct result of diversification, the department’s back office had to provide custody solutions to the whole array of new investments. Although challenging, this responsibility offered the institution the option to expand existing relationships among custodians, allowed the selection of new ones, and liaising with partner national central banks. As a result of this, the number of custody accounts with national central banks grew from one to seven. 

Initially, asset diversification was driven by external managers. Although the external management programme ended in 2018, it was considered a success, as it served as a vehicle to gain exposure to non-traditional asset classes, and allowed the BCB to evaluate which asset classes could be added to the reserves portfolio.

External managers also offered comprehensive training opportunities to BCB’s portfolio managers, operations and compliance officers, among others. “The know-how gathered during the external management programme has been instrumental over the last few years, especially during the pandemic shock, when the BCB incorporated the internal management of these new asset classes,” says Mr Mendes.

Asset classes that were already part of the portfolio started to be managed internally via futures contracts, in the case of equity indexes. ETFs are used in the management of corporate bonds, US agency MBS and equity indexes.

NDF interventions in Latin America

The sixth chapter analyses to what extent central banks in Latin America have successfully implemented FX interventions through non-deliverable forwards (NDFs). Elisa Vilorio Painter, adviser to the governor’s office at the Central Bank of the Dominican Republic, explains that central banks in the region have been recently reducing their FX spot interventions in favour of FX derivatives. For instance, in a selected sample of central banks comprising Argentina, Brazil, Colombia, Chile, Ecuador, Mexico, Paraguay and Peru, the total weighted average use of derivatives has increased from 1.86% of GDP in 2017 to 8.96% in 2022.

“Within the FX derivatives instruments, the role of NDFs has increased significantly during the past decade,” points out Vilorio Painter. In Brazil, the continent’s largest economy, trading of this type of derivative rose by 150% from 2013 to 2022 to reach around $40 billion in daily trading volumes.

These interventions are interesting for reserve managers because, in contrast to spot FX interventions, they do not require transfers of reserves. Additionally, the NDF market provides valuable insights for policy-makers. Among other factors, this is because NDFs can be used to hedge exposures or speculate on a move in a currency where local market authorities limit such activity. “Furthermore, NDF prices provide useful information for market monitoring as their prices reflect market expectations, as well as supply and demand dynamics that cannot be fully observed in onshore currency product prices in countries with capital controls,” adds Vilorio Painter.

After studying the interventions carried out by major central banks in the region, the author argues that NDFs have been effective. They have served to lower exchange rate volatility in periods of elevated stress, such as the Covid-19 pandemic. Nonetheless, Vilorio Painter warns that the success of these interventions depends on country-specific circumstances, including central bank credibility, the structure and depth of the foreign exchange market, and the macroeconomic and political environment. All in all, the author concludes that, “given the empirical evidence, which suggests that interventions in derivatives markets can be no less effective than interventions in spot markets, it highlights the usefulness of NDFs to the broader central bank toolkit.”

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On behalf of Central Banking Publications, I would like to thank all who contributed to this year’s book, both as authors and survey respondents. As ever, the editors welcome comments on this year’s book and suggestions for future editions. 

We would like to express our thanks to Bernard Altschuler and his colleagues at HSBC for their continued support of this title.