Comparative Advantage in Reserve Management

Ashby Monk

Joshua Aizenman and Reuven Glick have a new paper out entitled, “Asset Class Diversification and Delegation of Responsibilities between Central Banks and Sovereign Wealth Funds”. The paper is a bit of a bear for the non-quants out there (and here), but if you can manage to tear yourself away from the pages of equations long enough to read the introduction and the conclusion, then I think you’ll find that they’ve done some very interesting work.

The first part of the paper offers up a model that compares the “optimal” investment diversification strategies for central banks and SWFs, focusing on the tradeoffs between safe foreign reserve assets and the higher yielding, riskier assets one might expect a SWF to hold. For me, this part of the paper falls into the “formalizing-what-we-already-intuitively-know” category. But, still, it’s a worthwhile exercise.

The second part on governance and behavior is altogether something different, and I found it quite intriguing:

“…we find that the assignment of the financial stability objective to the central bank tends to increase the gap between the optimal diversification patterns of the bank and the SWF, with the central bank specializing even more in holding safe assets so as to minimize the downside risk of sudden stop crises, while the SWF specializes more in holding foreign equity assets in its portfolio.”

In other words, the better the central bank is (or is allowed to be) at doing its job, the better the SWF can be at doing its job. Apparently, the law of comparative advantage seems to hold true even in the domain of reserve management.

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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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