Sovereign reserve funds - the elephant in the room

CENTRAL banks and sovereign wealth funds are one of the most significant investor groups in global financial markets today - rivalling institutional investors such as pension funds and insurers on size. Central banks alone (excluding sovereign wealth funds) manage around US$12 trillion of assets - a decent amount of money by anyone's standards. The amount of reserves under management has grown dramatically over the course of the last quarter century, and of course, much of the increase in sovereign reserve accumulation has taken place in Asian economies. Sovereign reserves are the "elephant in the room" for financial markets - a large, powerful bloc of funds that has the potential to influence various financial markets.

Traditionally, central bank reserves were held to manage currency values and global trade. Today, however, foreign exchange reserves are 10 times the level they were at in 1990; meanwhile, global trade is three times the level it was in 1990. The fact that reserve accumulation has outstripped the growth of trade by so large a margin suggests that the traditional motives for holding reserves have altered. Partly, this is due to the Asian crisis in the late 1990s. The lack of foreign exchange reserves forced Asian governments to apply for assistance from the International Monetary Fund (IMF), which of course laid down strict fiscal conditions before dispensing the aid. By increasing reserve holdings, policy makers can lessen the risk of a future crisis, and more importantly, lessen the risk of supranational organisations imposing domestic policy conditions that might be unpalatable.

The 2008 global financial crisis only reinforced the desirability of holding additional foreign exchange reserves. Central banks were called upon to provide cash to the domestic economy - acting as what economists refer to as "lenders of last resort". The point was that, in this crisis, the cash that was needed was not necessarily local currency, but increasingly, international currency. Holding foreign-exchange reserves to help finance the private sector and trade finance became part of the role of central bank reserves.