Beyond SWFs: Getting Creative with Reserve Diversification

Ashby Monk

Don’t miss this fantastic E-Report on the future of the global reserve system that was put together by the Asian Development Bank and Columbia’s Earth Institute. It’s a remarkable collection of scholarly papers that will undoubtedly become a key reference for policymakers. All 18 papers are worth reading, but I’d like to draw your attention to one in particular: Donghyun Park and Andrew Rozanov’s work entitled, “Asia’s Sovereign Wealth Funds and Reform of the Global Reserve System.”

Park and Rozanov’s primary thesis (if I’m interpreting them correctly) is that Asia’s reserve hoarders must re-distribute their sovereign wealth away from central bankers (and their dollar-denominated government bonds) towards institutional investors better suited to portfolio diversification. Why? Because they see diversification as a crucial stepping stone to a successful reform of the current reserve system:

“This profound shift in the management of excess foreign exchange reserves in Asia would be completely in line with the widely held view on what needs to happen for global macroeconomic rebalancing to occur: Asia needs to stop the flow of uneconomically cheap financing for its main trading partners by switching to domestic and regional investment and consumption and by introducing greater exchange rate flexibility, while the United States needs to cut back on borrowing and consumption by increasing its national saving rate.”

Fair enough. But this then begs the question as to how these countries should do this. The obvious answer is to set up a SWF, which the authors acknowledge. But, then, what should countries without SWFs do? Park and Rozanov have some creative ideas. And here is one of them:

“If the principal stakeholders in a reserve-rich Asian nation do not have the political will, the risk appetite and the necessary consensus to set up a sovereign wealth fund to manage a large portion of national savings with a long-term return objective, then they might want to consider restructuring and transferring some of the excess reserves into the national pension fund, which may be a politically more palatable and viable vehicle for such long-term wealth management. In this scenario, the transfer of excess foreign exchange reserves into the pension fund would be matched by a counter-transfer of local government bonds and cash of equivalent value to the local monetary authorities, who would then be able to shrink their balance sheet by the same amount.”

I’m particularly interested in this idea of using forex reserves to bolster national pensions. In large part, this stems from the fact that I was a pension wonk long before I was a SWF wonk. So the idea manages to scratch two of my nerdy itches at once. Kidding aside, the idea at the very least has merit on the grounds that it will help countries better manage the risks of an ageing population (most countries aren’t on top of this, in my opinion). But Park and Rozanov are making their case for the pension vehicle in a slightly different way: they see an opportunity to alleviate the reserve burden on monetary authorities, all the while improving the investment performance of the pension funds:

“This would help local monetary authorities, who are reluctant holders of reserves in the first place, to shrink their balance sheets, while at the same time helping national pension reserve funds expand their allocations to foreign assets in one fell swoop, without the associated market impact.”

It’s a thought-provoking idea with some potentially important welfare implications. Moreover, given that the reserve hoarding countries ultimately discount the value of their human resources by keeping their currencies artificially low, I think it only fitting that the governments return some of this wealth back to the people through old age benefits and disability.

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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