The Covid pandemic has fuelled a need for more quantitative easing, but with central banks around the world already holding trillions of dollars in government debt, is it time for central banks to intervene directly in the stock market?
The influence of central banks is growing. Once known for being the lender of last resort, over the past 12 years national banks in the US and Europe have also become something of an investor of last resort.
In a bid to get their economies moving again in the aftermath of the credit crunch, central banks announced multi-billion-dollar bond buying programmes. Now that the pandemic has seen market volatility and economic uncertainty return, these strategies are back.
Following a multitude of purchasing programmes from covered bonds to asset backed securities and corporates, Christine Lagarde has now added the €750bn (£681.1bn) Pandemic Emergency Purchase Programme to her repertoire.
Meanwhile, Bank of England governor Andrew Bailey has committed an additional £200bn in bond purchases, adding to the £645bn it has invested in government debt since 2008, and effectively paved the way for negative interest rates. Could this mean that central banks may have reached their limits?
Zurich and Tokyo offer inspiration for further purchasing programmes. Both the Swiss and the Japanese central bank have had equities on their shopping list for quite some time. And smaller central banks have also started purchasing shares.
But the first quarter of 2020 was a painful one for Swiss taxpayers, as the Swiss National Bank (SNB) booked a loss of CHF31.9bn (£26.5bn) on its equity portfolio. The central bank has CHF32bn (£26bn), or 20% of its portfolio, invested in shares spread across 6,800 individual stocks, of which 1,000 are situated in emerging markets.
By moving into stock markets, the SNB hopes to improve the risk-return profile of its exchange reserves, which by the end of the first quarter amounted to CHF160bn (£132.6bn). By mid-2016, the central bank had an equity portfolio of CHF120bn (£99.5bn).
In addition to investing in equities, the SNB also aims to spread its exchange reserves over the broadest possible spectrum of currencies, issuers and instruments in order to book higher returns over the long term whilst reducing earnings volatility.
Since introducing equities to its portfolio in 2005, it has booked an average annual CHF-denominated return of 4.5%, compared to 0.9% on bonds over the same period.Since 2015, the central bank has also exercised its voting rights, focussing on European large-and mid-caps. It has delegated part of its shareholder engagement to external providers, with good governance being an important focus point of its ESG policies.
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The equity purchases by the Bank of Japan are even more bold. Having already launched new credit facilities in March, the bank’s governor Haruhiko Kuroda also announced a doubling of share purchases to ¥12trn (£88.3bn). By upping its share purchases, the bank hopes to boost corporate financing conditions and stabilise financial markets.
But critics quoted in the Financial Times point out that these measures reflect a distinct lack of alternatives by a bank which has pursued monetary easing for more than a decade. Interest rates have been around zero and even negative during the past 10 years. This decision suggested that the bank had reached the limits of its monetary policies, opponents argue.
The Japanese central bank started its first “temporary” share purchases in 2010. As a result of this decade long shopping spree, the BOJ’s equity ETF portfolio now amounts to $372bn (£294bn), overtaking GPIF, the Japanese public sector pension fund, as the largest investor in domestic equities.
By the end of last year, the Bank of Japan was among the top 10 shareholders for almost half of all Tokyo-listed businesses. The decision to double the share purchasing programme appears rather desperate, but we do not know what would happen to financial markets without these share purchases.
Smaller central banks are also invested in equities. This includes the Bank of Israel, which has held stocks since 2012 to control its exchange reserves and as an alternative easing measure to already low interest rates.
Just last year, the Israeli central bank raised its annual Conditional Value at Risk Index to 475 basis points from 400, which increased the maximum equity allocation to 17.5%, up from 15%. In 2018, some 13% of the portfolio was invested in equities.
But in the first quarter of 2020, this asset allocation has been challenging. Andrew Abir, deputy governor of the Bank of Israel, braved the press explaining: “I emphasise that the investments by the Bank of Israel in the reserves portfolio are for the long term and that all investment decisions are made with at least a twoyear outlook.” By the end of 2019, the bank held $126m (£102.5m) in currency reserves, aided by an investment performance of 6%.
One particularity of the Israeli investment strategy is that it involves an actively managed component, which has been lucrative. For the past five years, the central bank has beaten the benchmark by 1.65% and last year it exceeded it by 4.5%, largely due to its equity investments.
Meanwhile, in Europe
The Czech national bank is also invested in equities. In 2018, Ceská Národní Banka handed over the management of no less than 10% of its reserves to BlackRock and State Street Global Advisors. Two thirds are invested with European firms, the remainder in US, British, Japanese, Canadian and Australian stocks, in line with global investment performance standards.
Its Slovakian counterpart, Národná banka Slovenska, also ventured into stock market investing for the first time in 2018. It is invested in a global equity portfolio managed on a passive basis.
The Czech central bank invests its exchange reserves to support independent monetary policy decision making and as a source of foreign currency liquidity for its clients. In contrast, the Danish central bank describes interventions in currency markets to stabilise the fixed exchange rate of the Danish Krona as the main reason for its foreign exchange reserve management.
It also aims to book the highest possible return at the lowest possible risk, which it is why it has opted for a combination of equities and corporate bonds. Just last year, the Danes increased their equity exposure to €1.3bn (£1.1bn), up from €900m (£822.9m).
Could the BoE and ECB follow suit?
Why are the European Central Bank and the Bank of England not considering similar measures? Having already purchased corporate bonds, why not venture into the stock market, given that supply of government bonds is limited?
Jürgen Michel, chief economist at Bayerische Landesbank, predicted last year, in an interview with German business paper Börsen-Zeitung, that the ECB would launch the first round of share purchases by the end of 2020 at the latest.
Commerzbank’s chief economist Jörg Krämer argues that in the event of a deep recession, central bank share purchases could facilitate corporate investments. A second advantage could be that these transactions would signal unlimited central bank ammunition.
Nevertheless, he does not consider central bank share purchases to be a desirable trend. Even if the European Central Bank would only buy stocks indirectly, Krämer points out it would nevertheless send shivers down the spine of any observer with a degree of regulatory awareness. But since the outbreak of the global financial crisis the ECB has done a lot of things which were previously deemed unthinkable.
Conflicting interests
Among those who have researched the potential impact of central bank share purchases is the late Martin Hüfner, who spent many years as chief economist at German asset manager Assenagon and sadly passed away at the end of last year.
Hüfner wrote in 2018 that central banks should not occupy themselves with maximising investment returns or broader societal goals, such as the viability of pension provision, but should focus purely on maintaining monetary stability. “It is very sensible to keep these things separate, otherwise there could easily be conflicting interests.”
Central banks could, for example, keep interest rates lower for longer than necessary to avoid losses in its securities portfolio. Central banks should also establish “Chinese walls” between monetary politics and asset management firms to avoid insider trading.
The Swiss National Bank has kept an eye on these potential conflicts between monetary policies and investment targets. In the event of conflicting interests, monetary policies should always have the priority, according to the SNB.
The central bank should after all be able to adjust its balance sheets at any time to fulfil its monetary policy mandate, without first having to consider impact on its investment portfolio.
“State capitalism”
Hüfner also cautioned that by owning shares, the state could exercise further control over the economy, considering that many central banks already play a dominant role in their respective bond markets. He warns that by venturing into equity markets, central banks would take a dangerous step towards state capitalism and in turn towards the destruction of a democratic, free-market system. Switzerland could be steeled against such a threat by nature of its well-established democracy and market economy as well as the level of independence of the SNB.
The relative openness of some central banks towards share certificates is perhaps based on many of these lenders being listed companies. This includes the Bank of Japan, the Banque Nationale de Belgique, the Bank of Greece and the Swiss National Bank.
The investment that would have been worthwhile in this group would have been taking a stake in the SNB. Its share price rose by 300% during the past five years. Central banks are back under the spotlight having to lead the fightback against contracting economies. They have options, but they must also be careful not to comprise their independence and influence. This is a delicate balancing act, and something tells me that these latest QE packages will not be the last.
