Yesterday I had a conversation with someone who was criticizing Central Banks’ recent move to invest in equities. Specifically, he was wondering why Central Banks invest in equities. A recent survey's results by the Central Banking Publications and Royal Bank of Scotland Group Plc, (see here) showed that eight of the 60 reserve managers were investing in equities and/or currencies. Also, approximately 25% of them are planning to do so in the next five years. As a reminder, not all the Central Banks are allowed to invest in equities (FED and BOE for example). The total amount of foreign-denominated reserves held by the Central Banks is right now at $11 trillion.
But why do Central Banks invest in equities? And does it make sense to do so? I argue that yes, it does makes for them to invest in such asset classes. The first (and most important reason) that justify it is that Central Banks have seen their reserves increasing dramatically over the last 5 years. And this is explained by the monetary policies they have been pursuing. Precisely, the several quantitative easing programs in the US (QEs) and Japan have had as target, direct purchases, on large scale, of government bonds, corporate bonds and MBSs. As for the European case (LTRO), only indirect purchases of government bonds. As a logical consequence, the yield on these securities went down with the 10-year U.S. treasury reaching a record low of 1.38% in July 2012 with the current dividend yield on stocks being 2.2% (on the S&P500) which is indeed higher than the 10-year Treasury yields (1.69%, from Bloomberg). However, the US economy has not been able to absorb the liquidity provided by the Fed (because of the liquidity trap, with monetary policies almost useless, see Noah Smith’s post here) as well as the several European economies (because of austerity policies and huge fall in aggregate demand). As a consequence, banks have put the money back into the CBs' reserve accounts in the form of excess reserves (see Mark Dow's post here) and this has created big opportunity costs (with short term interest rate at the lowest) and risk of negative returns. Not to mention the intrinsic risk of owning foreign denominated reserves when they get too large. Therefore, as taught in any Corporate Finance course, central banks are now looking for diversification in non-traditional currencies, emerging debt, gold and equities and they are rightly doing so in order for reserves not to lose values (with bad consequences for the entire economic system). In some cases, this may also help central banks to stimulate risk-appetite for investors (QE's main goal). We must also remember that almost every central bank in the world has a very, very small stake of reserves invested in equities and the ‘unusual’ purchases of stocks are only temporary and dictated by the current economic environment, as the several centrals banks involved in equity purchases have pointed out (Japan, Switzerland, Israel, etc.). Finally, an obvious and necessary condition for central banks is not to reveal the composition of their portfolios as this may raise huge conflict of interests.
Having said all of this, YES, it makes sense for Central Banks to invest in equities!
FOLLOW @DvegaDtime ON TWITTER