CENTRAL banks and sovereign wealth funds are among the most significant investor groups in global financial markets today — rivalling institutional investors like pension funds as to their size.

Central banks alone (excluding sovereign wealth funds) manage around US$12 trillion (RM45.3 trillion) assets — a decent amount of money by anyone’s standards. The amount of reserves under management has grown dramatically over the course of the last quarter century, and of course much of the increase in sovereign reserve accumulation has taken place in Asian economies.

Sovereign reserves are the “elephant in the room” for financial markets — a large, powerful bloc of funds that has the potential to influence various financial markets.

Traditionally central bank reserves were held to manage currency values and global trade. Today, however, foreign exchange reserves are 10 times the level that they were in 1990; meanwhile, global trade is three times the level it was in 1990.

The fact that reserve accumulation has outstripped the growth of trade by so large a margin suggests that the traditional motives for holding reserves have altered. Partly, this is due to the Asian financial crisis in the late 1990s.

The lack of foreign exchange reserves forced Asian governments to apply for assistance from the International Monetary Fund (IMF), and of course the IMF dictated strict fiscal conditions before the aid was forthcoming. By increasing reserve holdings, policy makers could lessen the risk of a future crisis, and more importantly, lessen the risk of supranational organisations imposing domestic policy conditions that might be unpalatable.

 The 2008 global financial crisis only reinforced the desirability of holding additional foreign exchange reserves. Central banks were called upon to provide cash to the domestic economy — acting as what economists refer to as “lenders of last resort”.

The point was that in this crisis, the cash that was needed was not necessarily local currency, but increasingly international currency. Holding foreign exchange reserves to help finance the private sector, and trade finance, became part of the role of central bank reserves.

The consequence of this is that sovereign reserves have become an extremely important part of the global investment community. Now, however, things are starting to shift. The future for sovereign reserves looks somewhat different to the past.

One reason is that central banks are accumulating reserves at a slower pace. The current account surpluses of fixed and quasi-fixed exchange rate economies have fallen in recent years, and that means that there is less of a need for central banks to intervene to stabilise their currencies — China is a notable instance of this.

Bond and equity flows into fixed and quasi-fixed exchange rate economies have also slowed (at least relative to GDP), and this too reduces the need to intervene and acquire new reserves. Without the current account and capital account motive for currency intervention, the rapid pace of reserve accumulation that was a feature of global financial markets for most of this century seems to have moderated.

In theory, the slower pace of reserve accumulation should reduce the relative importance of sovereign reserves to global financial markets. However, this has happened at a time when the yields on government bonds are very low.

Government bonds are a major part of central bank portfolios and the lower return that is now earned on this asset class is causing some sovereign fund managers to look at alternative assets as a way of improving their investment performance. Diversifying into a wider range of assets means that sovereign reserve managers will become more important investors in markets where they have hitherto played a more limited role.

Two different assets in particular seem to have attracted the attention of more sovereign fund managers recently. One is the Chinese renminbi. Interest in the Chinese currency has increased because of the possibility that the IMF will make the renminbi part of the basket of currencies that form the Special Drawing Rights (the IMF’s international currency unit).

The other is inflation-protected government bonds, perhaps reflecting central bank concerns about the perceived risks of global central bank policies that remain generally accommodative.

Because of the size of existing sovereign reserve funds, even if these funds cease to grow in the way that they have done in the recent past, the possibility of portfolio diversification means that investors need to pay attention.

This is particularly the case in the Asian region, which (along with the Middle East) is home to many of the largest sovereign reserve managers. Investors cannot afford to ignore the behaviour of the sovereign elephant in the room.

Paul Donovan is senior global economist at UBS Investment Bank. His latest book, The Truth About Inflation, was published by Routledge in April 2015.

This article first appeared in Forum, The Edge Malaysia Weekly, on July 6 - 12, 2015.

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