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Central Bank Reserves Management in an era of uncertainty -Gary Smith and John Nugée.

Updated: Nov 23, 2023

Our readers will not need us to tell them that we live in a time of heightened uncertainty and tension. With wars in the Middle East and Ukraine, economic hardships in much of the West due to inflation and high interest rates, and volatile and unsettled weather patterns across the globe – flooding in the UK and much of Europe, heatwaves in the southern hemisphere – there is much to cause concern. Even the world’s volcanoes are agitated (and climate change may be playing a role) with eruptions ongoing in Japan and Italy and a major eruption brewing in Iceland.

And all this is before one contemplates key elections in the coming year, most notably in the US and for the EU parliament, but also in several other European countries including the UK, and Ukraine, where President Zelensky faces re-election in March. For central banks, trying to steer economies between the Scylla of inflation and the Charybdis of recession, there are few easy answers. And if anything the questions are getting more urgent and challenging.

An unsettled world

This year the weather has repeatedly set new regional records, and it looks as though at a global level 2023 will be the warmest year ever recorded. Although climate change might be a gradual process, tipping points are being triggered with regularity, and extreme weather events are becoming more frequent. Despite this widely recognised truth, the appetites of governments around the world to pursue net zero agendas has weakened.

In this context the consequences of the 2022 Russian invasion of Ukraine have been multiple, interrelated and highly damaging to the net zero agenda. Firstly, higher energy prices have pushed the general price inflation level higher and central banks have hiked interest rates in response. As nations have sought to improve energy security they have scrambled to prolong the life of their own fossil fuel industries, and to increase their stockpiles of imported fossil fuels, helping to underpin their prices. At the same time those higher interest rates have dealt a blow to profit breakeven calculations for capital intensive projects such as offshore wind farms.

The result is that nations face a complex trade-off between energy security, energy affordability and environmentalism. For politicians who have an eye on the electoral cycle, the short-term fix will outweigh the long term strategic target. Although climate change has been recognised by governments and government agencies as an important issue, it has not been viewed as urgent. Action on climate change has been framed around setting longer term aspirational targets. Yes, we must do something, but perhaps we can delay?

As a result Russia’s war in Ukraine has shunted the starting line for the race to net zero in a backwards direction. The current crisis in Gaza, and resulting heightened political tensions both in the Middle East generally and at national level, will compound that concern. With US aircraft carriers in the Mediterranean, and an Iranian government on high alert, a misstep by a key player could lead to another spike in oil prices.

Setbacks mean that in order to reach the finish line on schedule we will have to run faster than previously planned. But the outlook is not good. It is worth reminding ourselves that ahead of COP26 in November 2021 there were hopes of an agreement to deploy the words “phase out” when referring to fossil fuel subsidies. That was diluted to “phase down” after last minute lobbying - a change which implies a large loss of collective urgency by the delegates.

The failure to agree “phase out” language for fossil fuel subsidies continued at COP27 in 2022, and hopes for progress on this issue at COP28 later this month in Abu Dhabi are not high, with commentators pointing to the fact that the event president, Sultan Al Jaber, is also CEO of the Abu Dhabi National Oil Company. UAE ministers have been championing the argument for lowering emissions from future fossil fuel production through the use of exciting but unproven carbon capture technology, not by reducing fossil fuel production itself.

Unfortunately carbon capture technology is unproven at scale. The more we depend on it being a miracle cure of the future, the longer will be the delay in cutting the fossil fuel production and usage which is pushing net zero ambitions backwards. To put this into context, Carbon Capture Utilisation and Storage capacity is estimated at 60 million tonnes this year, and based on existing plans capacity has been forecast to increase to 1,700 million tonnes by 2050. However, in order to be consistent with a 1.5 C target in 2050 this capacity will need to reach 7,750 million tonnes. Shades for our British readers of the magical (and mythical) technological solutions promised by Prime Minister Johnson to the conundrum of the Northern Ireland border with the EU.

The role of central banks

So far, so gloomy. But the question for central banks is, what if anything can they do about all this? Are not questions of war and peace, climate change and energy security more the purview of elected governments?

Central banks have more influence over decision-makers than might initially appear to be the case. They have played a critical role in raising national awareness of climate issues, and have consequently been pushing governments to take action. In September 2015, then Bank of England Governor Mark Carney gave a landmark speech on the “Tragedy of the Horizon”. The concept was simple: climate change creates tremendous risk for financial markets, but these mounting long term risks are not correctly priced by investors who have a short term bias.

As central banks regulate the domestic financial system they will be concerned that in an energy transition where banks could be adversely impacted by a collapse in the value of fossil fuel assets. Equally in their capacity as regulator of insurance markets they will be concerned about vulnerable regions becoming uninsurable against flood or storm damage.

The Network for Greening the Financial System was established in December 2017, and is a collaboration of 127 central banks and financial supervisors. NGFS has produced scenario analysis to help financial players to assess the implications of climate related risks. In early November the fourth version of their scenario analysis was released, and importantly they were the first of their scenarios to recognise the consequence of the Russian invasion of Ukraine on “energy system trajectories”.

This most recent batch of scenarios has included one described as a “too little too late” scenario, where the implementation of policies are fragmented and disorderly, and the end of century warming result is estimated at 2.3 C. A believable scenario? Many fear so. And it is one that central banks, working with the NGFS, might be able to utilise in order to place pressure on their respective governments.

Utilising FX reserves management as a tool for change

There is one other tool that central banks have and can use to pressurise governments, and that is the management of their FX reserves. Here, judicious use of their reserves, and the decision of what to invest in, may be another route by which central banks can collectively put pressure on governments.

The fracturing of the geopolitical status quo has heightened the desire in many countries for national self-sufficiency in products such as energy and food – and this will likely have two consequences for central banks.

Firstly, it will stoke the appetite for ever larger FX reserves for self-insurance reasons against difficult-to-measure national threats. Secondly, it argues for a higher price for goods such as food, energy, steel, or during the pandemic, PPE. Where domestic production is replacing imported goods, this is likely to cost more than the imported production being replaced.

Sticky inflation data will support the argument that monetary policies in the nations issuing reserve currencies are unlikely to be eased in the near future, and also support the view that future monetary easing cycles may result in a higher trough in both policy rates and bond yields.

All of this changes the attractiveness of bonds as the core part of any central bank’s reserves portfolios. Government bonds have been disparaged for over a decade – yielding little, and offering reduced liquidity as QE has reduced the number of free bonds available to trade. But with increased issuance by indebted governments enhancing market liquidity, and at current elevated yields, government bonds can reassert their traditional role as the cornerstone of foreign exchange reserves portfolios.

The sharp increase in bond yields and the consequent revitalised role for bond investing in central bank portfolios might also provide an opportunity to think afresh about the active management of FX reserves. The traditional benchmark for central bank reserves managers have been cap weighted government bond indexes. Alternatives are available, and one innovation has come from the team at Saltmarsh. (

They have calculated scores for sovereign issuers that are based on perceived national resilience to possible future climate related events, as well as on an assessment of their current emissions profile.

The scores give the investor an opportunity to structure a portfolio that gives enhanced exposure to sovereign issuers that have better scores on key climate related metrics. The expectation is that the bonds of these sovereign issuers will outperform those of sovereigns that are assessed as being less resilient, who have a worse emitter score, or both.

Central bank reserves management already encompasses the inclusion of green and sustainability labelled bonds, but with these and other innovations it might evolve into a much wider active management space.

The “holy trinity” of central bank reserves management is Security, Liquidity and Return. It is not an exaggeration to say that for most of the period following the Global Financial Crisis in 2008, government bonds struggled to provide even one of the three. The seismic move higher in yields since 2021 means that all three are once again provided to investors in government bonds.

Our expectation is that central bank reserves managers will take advantage of this. And with the trend for ever larger FX reserves intact, government bonds back in fashion, and with a possible shortage of experienced players in central bank reserves management departments, it could also prove exciting times for asset management houses who have maintained a commitment to the product and have a strong track records in high grade bond product.


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