Ricardo Adrogué: Balancing Security with Returns

2017-12-06 IMI

This article first appeared in OMFIF Commentary on October 11, 2017. Ricardo Adrogué is Head of Emerging Market Debt at Barings. Emerging market economies have resumed modestly accumulating international reserves after the three-year hiatus which followed the ‘taper tantrum’ of May 2013, when the US Federal Reserve implied it would slow its rate of bond purchases. Overall international reserves – roughly 80% of which are held by emerging market economies - reached a two-year high of $11.2tn at end-June, up from $10.9tn at end-2015. This resumption underlines emerging markets’resilience, as well as the success of self-insurance policies based on floating currencies and high stocks of international reserves. In fact, a small fraction of international reserves has been used to protect these economies from the global shocks of the last 10 years. So emerging markets as a whole are over-insured. Existing stocks of international reserves far exceed the levels necessary to meet their main practical benefit - the ability to smooth domestic economic adjustment in response to sudden stops of financing. In the light of the renewed rise in international reserves, currency diversification has become an important allocation decision for policy-makers. While security is paramount, more central banks are including return objectives in their reserve management procedures. Managing the trade-off between security and returns is a difficult task. Moving international reserve holdings away from the dollar could lead to large declines in returns that prove difficult to recover. An optimal portfolio for a central bank should provide maximum returns in times of crisis. Currency diversification is key to achieving an optimal allocation. However, in times of stress or sudden stops, the cumulative return of an optimal portfolio of currencies tends to underperform significantly one that is predominantly dollar-based. The result of these different factors is that, over time, central banks which hold an optimal currency-diversified portfolio tend to outperform purely dollar-based portfolios, but at the expense of experiencing greater volatility during periods of market stress. Moreover, it could take more than a decade for an optimally currency-diversified portfolio to recover from the negative effects of a sudden stop. This is a clear disadvantage which, in some cases, could prove to be politically untenable. In the long term, however, the positive attributes of a diversified portfolio should prevail. Adding emerging market inflation-linked currencies to central bank reserve allocations may improve the return potential of portfolios without causing a sizeable deterioration in their safety characteristics. These securities can provide insurance against nominal currency depreciations, thus reducing the large decline in returns which are typical of global currency markets. Emerging market inflation-linked bonds can, too, represent a superior investment to a set of liquid emerging markets currencies. The varied impact of global shocks on different countries makes it necessary for central banks to implement differentiated optimal allocations for international reserves. One policy target which they should perhaps all share is to include more inflation-linked securities to enhance optimal portfolio returns without meaningfully increasing underlying investment risks.

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Ricardo Adrogué: Balancing Security with Returns

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