C. Banks Search for Ways to Invest Reserves Without Risk

Global financial turmoil has   had a "major" impact on the reserve management policies of two  thirds of central banks and almost all are rethinking  diversification tactics, a survey showed on
Wednesday. 

The survey of 39 central banks who control reserve assets  worth $3.2 trillion, just under 42 percent of the world's total,  showed reserve managers were much more conservative and cautious  last year than a year earlier.

Reserve managers expressed "great concern" about credit and  liquidity risks, with over two thirds of respondents saying they  experienced bouts of illiquidity in even the major bond markets. 

Over 90 percent of respondents to the survey conducted by  Central Banking Publications said they have been forced to  reassess counterparty risk and most said the hunt for diversity  and yield in recent years has been severely curtailed. 

The majority of respondents also said they expect reserves  to fall as the crisis unfolds before recovering to only  "marginally" above current levels over the next four years. 

"The unprecedented changes to the financial landscape  witnessed over the last (few) months have dramatically altered  previous paradigms and beliefs," said a respondent from a  central bank in the Americas. 

"These events have increased risk aversion and central banks  have not been an exception." 

This was in stark contrast to the findings in last year's  survey, which showed reserve managers still inclined to seek  yield and almost 60 percent of them saying derivatives were an  attractive asset class in which to invest foreign exchange  reserves. 

This year's survey showed that as the financial turmoil  ebbed and flowed reserve managers, like most other investors,  opted for safety.  

"Less credit and more 'plain vanilla' instruments are  preferred," said on European reserve manager. 

Diversification Grinds to a Halt

Over two thirds said they had experienced illiquidity in important government bond markets, and the survey said reserve managers had expressed surprise that even these markets had  frozen up as spreads widened and trades failed to settle. 

Almost 80 percent of respondents said government bonds rated AA or higher were a more attractive investment than a year earlier, 61 percent said the same for agency paper and 57  percent said gold was a better investment. 

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Between roughly two thirds and all the respondents said virtually every other asset class was a less attractive investment than a year ago: equities, mortgage-backed  securities, derivatives, lower-rated government bonds, commodities and hedge funds, amongst others.

"In view of the coming recession in the world economy, almost all the listed instruments are considered too risky for  central bank investments," said an Asian reserve manager. 

The survey's findings also suggested there had been a loss  of faith in credit rating agencies. 

Just over half the respondents said they had altered the way  they judge credit quality, with some of their comments noting a  downgrading of agencies' assessments and an increasing recourse  to other external indicators such as credit default swaps, share  prices, and/or a strengthening of internal models. 

In terms of reserves' currency composition, 74 percent of respondents said there was no change over the year in the number  of currencies they invested in, and 94 percent of them said they  didn't even consider investing in other currencies. 

"Central banks have refrained from diversifying their  reserves in terms of currencies," the survey noted. 

"Whereas previous surveys had revealed interest or active  allocation in non-traditional reserve currencies, that was not  the case in 2008." 

Reserve managers believe overall reserve levels will fall  this year as countries draw down the cash needed to fund the  huge financial and economic rescue packages needed to fight  recession. 

Most believe reserves will slowly accumulate again over the next four years but a significant minority — almost a quarter — believe the crisis will bring the build up in reserves over  recent years to a shuddering halt.

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