Chea Serey
Looking at the large financing gap which exists if we are to achieve the sustainable development and net zero emission goals, it’s hard to overlook central banks’ foreign exchange reserves as another primary source of financing due to its size, which is currently more than $12tn. These reserves can provide an important catalyst to add much-needed momentum to our sustainable development ambitions if a larger portion is diverted to financing them.
At present, less than 3 per cent of these reserves are invested in sustainability. This has to change if we are to realistically achieve the UN Sustainable Development Goals by 2030 and net zero emissions by 2050. There is an increasing awareness that foreign reserve investment can be scaled for these goals, such as the decision by the European Central Bank to invest its non-monetary policy portfolios in a sustainable and responsible manner. This has prompted many national central banks to divert reserve portfolio investment to sustainable and green bonds. This is a very positive development, but the inclination by other central banks to follow suit has been limited.
The National Bank of Cambodia, despite being a central bank in a low-carbon-emitting developing economy, heeded the moral call to contribute to the global efforts, incorporating environmental and social considerations in our reserve investment guidelines and allocating more than 5 per cent of our reserve to sustainability bonds.
Investing With Higher Purpose
Conservatism and prudence are still important virtues for managing the portion of the reserve intended to provide a liquidity buffer to safeguard monetary and financial stability. Whereas central banks in more favourable conditions, with a level of reserve in excess of what is needed to achieve these objectives, can afford to, and should, pursue other meaningful investment objectives. In particular, those which also ultimately contribute to the citizens’ welfare beyond those brought about through monetary and financial stability.
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In this situation, rather than being passive investors that are simply funding and lowering the interest rate cost of developed countries’ fiscal deficit by mechanically optimising its allocation using financial metrics alone, central banks can afford to have a soul and invest with their hearts to improve the environment and social wellbeing, while remaining mindful of the financial characteristics of the reserve.
Central banks can enjoy higher standing and respect from society in pursuing these noble causes by investing to achieve sustainable development goals. If public opinion supports this, why shouldn’t the central banks, as public institutions that serve the citizens, follow through on this aspiration if doing so does not impede on their core mandates?
To scale up investment, central banks need to address the impediments that are currently discouraging reserve managers from investing in more meaningful amounts.
Recognising Return Trade-Off
One of the reasons for the lack of investment by reserve managers into sustainability bonds is that these bonds quite often yield lower than a regular bond by the same issuer, with this lower yield being known as the “greenium” for green bonds. The reasons can be attributed to low supply of high-credit quality sustainability bonds relative to demand by large institutional investors. Additionally, sustainability bond issuers, which are often subjected to a more stringent issuance process to demonstrate their sustainability credentials, also require some financial incentive to issue. This is provided by a lower cost of borrowing. The resulting lower yield makes investing in these bonds inconsistent with optimal reserve portfolio objectives, from a pure financial standpoint.
This also means that when a central bank in a developing economy like Cambodia purchases lower-yielding sustainability bonds issued by development or policy banks intended for projects in developed countries, which are already enjoying low cost of funding, is it in fact a poorer, low-carbon-emitting country subsidising green projects in rich ones. Ordinary Cambodians might not be too receptive to that idea and expect the scarce resources of their country be put to use to maximise the benefit of its own citizens. Commercial returns of many sustainable projects still need to improve before free market forces can work in their favour but, until then, investors need to acknowledge that there could be some return trade-off of investing in sustainability bonds.
Decision Makers Must Decide
With recognition of the return trade-off, for central banks that want to contribute there is a need to rethink reserve management principles, that traditionally only include safety, liquidity and return, to also include environmental and social impact to allow reserve managers to consider non-financial factors in decision making. For this to happen on a larger scale, a central bank will need clearer direction and approval from top-level decision makers, parliaments or boards, on how reserves should be used for financing the SDGs and for achieving the country’s nationally determined contributions set out in the Paris Agreement.
A discussion and decision which are still largely absent among decision makers at the top level needs to take place to decide how central banks’ foreign reserves should be used for the sustainability agenda. If the leaders are convinced that achieving the SDGs and tackling climate change are imperative and urgent, they need to warm up to the idea that the conventional institutional set-up and functions need to change, and that an optimal reserve portfolio should also include positive environmental and social impact. Only with parliamentary and board endorsement will the technocrats at central bank level have more legitimacy to act.
Funding Local Projects
One way to attract investments from reserve managers into sustainability bonds on a larger scale is for the invested reserves to be diverted back to local sustainable projects in their own country. Based on current investment practice, central banks cannot directly invest in local projects as reserves are meant to be an emergency fund that should be readily available when a country faces a crisis. Therefore, they need to be invested away from the local market to ensure they are not exposed to the same risk.
However, with the right financial arrangement, reserve managers can divert funds to local sustainable projects, while keeping risk exposure outside the country with high-credit, quality issuers. To do so, supranational and development bank issuers, which are traditionally part of the central bank eligible investment universe, should exercise some flexibility and innovation with their social and green financing programmes.
These issuers should have country-specific bond issuance programmes, under which all proceeds are earmarked for social and green projects in the selected countries. This will provide strong justification for reserve managers of the selected country to invest in larger amounts if proceeds are all intended for their own country, even if the bond yield is lower, with assurances that the country retains the full benefits of the positive externalities related to these projects.
Sustainability Investment Swap
A lot more can be done to promote regional investment to resource scarce countries with high-impact social and green projects with the portion of excess reserves that have a longer time horizon and higher risk tolerance. While there are regional initiatives to pool reserves and invest in regional sustainable projects, the amount contributed and amount received in investment is often disproportionate. This can discourage countries with larger reserves from contributing more. However, if there is an arrangement in place to ensure the contributions and investments received are equivalent, then that could change.
In order to enable this, sovereign issuers and reserve managers can establish bilateral co-operation to carry out sustainability bond investment swaps using the respective countries’ central bank reserves. This arrangement is also meant to overcome the same above-mentioned constraint that reserves should not have direct risk exposure locally, but still allow reserve managers to direct funds to sustainable projects in their own country.
The swap arrangement is a simple idea, whereby country A’s treasury issues sustainability bonds that will be bought by country B’s reserve manager. Meanwhile country B’s treasury will likewise issue sustainability bonds and country A’s reserve manager reciprocates the action by buying the same amount of those bonds. The proposed bilateral arrangement could work more easily among countries of a similar investment grade credit rating that issue in hard currencies. A few bilateral arrangements of such kind will allow the reserve managers to diversify risk across different sovereign issuers and raise more funds for projects in their respective countries.
New Approaches For A Generational Challenge
All these proposals might be unconventional, but they are rather simple practical ideas. Larger established institutions, such as the central banks, as investors, and supranationals and development banks as issuers — being rightly conservative — often stick to conventional business models. Unfortunately, with temperatures rise already exceeding the Paris Agreement’s 1.5 degree threshold, we really need to keep an open mind to new ways of doing things because the planet’s temperature rising to record levels is an unprecedented generational challenge. Our habitat is under existential threat and we need to come together to act now.
Serey Chea is governor of the National Bank of Cambodia. This article was originally published in The Banker.
