Central banks into equities

When I first proposed that central banks might hold a basket of diversified equities on the assets side of their balance sheets, it was an unheard-of notion. My friends advised me to take it out. “People will think you’re crazy”, they said.

Now it turns out that that is exactly what a growing number of central banks have been doing. This news has been described as the most stunning revelation about central banking and “the investment story of the year” (Financial Sense). Already some commentators are urging leading central banks that have not yet dipped their toes in the equity waters to do so. Time magazine states that:

“The U.S. Federal Reserve does not appear to have joined in the stock-buying trend. The Fed is not permitted to make direct stock purchases. But there is nothing to prevent it from funding a Special Purpose Vehicle that buys a broad basket of stocks through indexes or Exchange Traded Funds.”

The investment website Seeking Alpha, says that it is a way for the fed to boost demand by the “well-documented wealth effect”; after all, many governments boost demand through encouraging house ownership; why not do it also by enhancing stock returns?

I know something about this story. I wrote it;  I should say, as  co-author of RBS Reserve Management Trends 2013 – a survey that my colleague Nick Carver and I have been doing annually for 10 years. I am also chairman of the company that publishes it, Central Banking Publications.

It is true that 14  of 60 central banks told us that equities were either part of their assets now or would be within five years. Another 7 said they envisaged equities being part of their portfolio in the longer run. Thus more than one-third of participating central banks either were invested, planned to be so or had long-run intentions of making such investments. As we say, ‘this represents a remarkable shift in official attitude towards this class”. Central banks that gave positive answers hold just over $2.5 trillion in reserves.

We are not permitted by the rules of the survey to identify the central banks involved. But contrary to what Jim O’Neill of Goldman Sachs implies, the number is not confined to those central banks that run their country’s sovereign wealth fund (I am glad to see Jim said it “made sense” for central banks to hold equities).  We are talking about equities directly on the balance sheets of mainstream central banks.

I can confirm that the central banks with equities include those managing some of the largest national reserves in the world.

Central banks that have confirmed they have such holdings include the Swiss NationalBank, Czech National Bank, and the Bank of Israel.

Another survey of our readers – mostly central bankers, released last month confirmed that almost two-thirds believe central banks should invest some of their reserves in equities;

As somebody who has watched the development of reserve management over many years, I see the latest development as a natural evolution. Near-zero interest rates and downgrading of credit standing of core traditional assets has made it increasingly difficult to cover the cost of holding reserves. Thus central banks, like other investors, have conducted a ”search for yield”. They also want to diversify away from traditional reserve currencies. Investing in a portfolio of global equities provides a return at an acceptable risk, relative to alternatives.

I expect this trend to go much further. If central bankers were not forced to invest in government bonds, how much would they hold?

Behaviour that central bankers would have dismissed as unthinkable a few years ago suddenly becomes normal.

Pushing the boundaries

Take it further. Why shouldn’t the monetary liabilities of central banks – notes and coins, and bank reserves – be “backed” by equities? What is sacrosanct about so called risk-free government bonds? Central bankers know better than anybody that they are amongst the riskier assets around.

The traditional non-government asset of last resort has been gold. Gold still clearly has a place in a central bank portfolio. But a diversified basket of equities has the decisive advantage of offering a running yield.

I would go further and let money itself to be defined in terms of such a basket. The dollar could, for example, be one trillionth of the world’s equity market capitalisation.

That means, money would hold its value against the market portfolio of tradable claims on real assets.

It seems evident to me that stability of money in terms of claims on such a portfolio of real assets is more important today, to most people, than stability in terms of short-term retail purchasing power. In terms of long-term planning, investing, calculating future profitability of a project, or building up a nest-egg for retirement, what people and businesses need is a money that is stable in terms of real assets. Gold used to be the best available proxy for such stability. Now, thanks to the globalisation of markets, a superior option has emerged.

Those who scoff at such an ideas as “beyond the pale” are probably the same people who a few months ago would have laughed at the very notion that central banks could invest in equities.

I trust you are not one of them.

This could be one of the most hopeful developments for years.  I am, by the way, fully aware that my proposals to change the money we use will be viewed as utopian. Click on the “Ikon” tab on the website for more posts on investment currencies.