LONDON (MarketWatch) — Some leading central banks have become major players on world equity markets in a development that could potentially contribute to overheated asset prices.

The buildup of central-banking interest in equities is one of the unexpected consequences of the last few years’ fall in interest rates, which has depressed the returns on central banks’ foreign exchange reserves and driven them to find alternative investment targets.

In the years since the financial crisis, central banks have leapt to the forefront of public policy making. They have taken responsibility for lowering interest rates, for maintaining stability of financial institutions, and for buying up government debt to help economies recover from recession.

Now it seems that they have become important in another area, too, in starting to build up holdings of equities.

Jens Weidmann, president of the Deutsche Bundesbank. Bloomberg

Central banks as investors need to cope with demands wrought by sheer size — competition, complexity and cost. Many of these challenges are self-feeding. Whereas 20 years ago only a small number of public investors carried genuine weight in investment markets, the proliferation of such institutions is now a fact of life. Central banks’ foreign-exchange reserves have grown unprecedentedly fast, especially in the developing world.

The same authorities that are responsible for maintaining financial stability are often the owners of the large funds that add to liquidity in many markets. Large and similar-minded public-sector investors can show herd-like behavior, seeking the illusive return, for example in the “search for yield” in many markets and thus creating fresh volatility.

Evidence of an increase in equity-buying by central banks and other public-sector investors has emerged from a survey of publicly owned or managed investments compiled by the Official Monetary and Financial Institutions Forum (OMFIF), a global research and advisory group.

The OMFIF research publication, Global Public Investor (GPI) 2014, launched on June 17, is the first comprehensive survey of $29.1 trillion worth of investments held by 400 public-sector institutions in 162 countries. The report focuses on investments by 157 central banks, 156 public pension funds and 87 sovereign funds.

There are worries that central banks may be over-stretching themselves by operating in too many areas.

Jens Weidmann, president of Germany’s Bundesbank — which retains a highly important, conservative role in the euro area in spite of the establishment of the supranational European Central Bank to run the continent’s single currency — spoke yearningly last week of the need for “central banks to shed their role as decision-makers of last resort and, thus, to return to their normal business.”

He said this “would help to preserve the independence of central banks, which is a key precondition to maintaining price stability in the long run.”

It has long been recognized that sovereign wealth funds and public pension funds around the world have become large holders of company shares. The best-known example is the Norwegian sovereign fund, Norges Bank Investment Management (NBIM), with $880 billion under management, of which more than 60% is invested in equities. The fund owns on average 1.3% of every listed company globally, and 2.5% of listed companies in Europe.

Rivaling NBIM is now the State Administration of Foreign Exchange (SAFE), part of the People’s Bank of China, the biggest overall public-sector investor, with $3.9 trillion under management, well ahead of the Bank of Japan and Japan’s Government Pension Investment Fund (GPIF), each with $1.3 trillion.

SAFE’s investments include significant holdings in Europe. In a new development, it appears that the PBoC itself has been directly buying minority equity stakes in important European companies.

Another large public-sector equity owner is Swiss National Bank, ranked the world’s No. 10 GPI measured by market assets, with $480 billion under management. The Swiss central bank had 15% of its foreign exchange assets — or $72 billion — in equities at the end of 2013.

Thomas Jordan, SNB president, writes in the GPI 2014 publication: “We are now invested in large-, mid-, and small-cap stocks in developed markets worldwide…. The decision to introduce new asset classes should always be taken with the aim of improving the long-term position, and with the awareness that a change should be sustainable, even in more difficult times.”

One of the reasons for the move into equities reflects central banks’ efforts to compensate for lost revenue caused by sharp falls in interest rates driven by official institutions’ own efforts to repair the financial crisis.

According to OMFIF calculations, based partly on extrapolations from published data, central banks around the world have foregone $200 billion to $250 billion in interest income as a result of the fall in bond yields in recent years. This has been partly offset by reduced payments of interest on the liabilities side of their balance sheets.

GPIs as a whole appear to have built up their investments in publicly quoted equities by at least $1 trillion in recent years.

With regard to asset-management operations, Bank of Korea, the No. 19 GPI according to this year’s ranking, with $346 billion in assets, has become a benchmark for many central banks in different jurisdictions. It has been building up emerging-market assets, gold and equities as part of a new approach to risk management.

Heung Sik Choo, the central bank’s former reserve management chief and deputy governor, now chief investment officer at Korea Investment Corp., says in the GPI report that central banks around the world require “a new paradigm in foreign reserve management. ….We need to reconsider the investment universe for central banks. We may need to break away from rigid fixation on bonds of the highest credit ratings, and become more open-minded about expanding the investment sphere into non-traditional asset classes.”

Writing about the general tendency towards diversification, Roberto Violi, Francesco Potente and Alfonso Puorro of the Banca d’Italia (the No. 44 GPI, with assets under management of $146 billion) say in GPI 2014: “Over time, many central banks around the world have enlarged the investment range of their portfolios. Rapid reserve accumulation by emerging market countries has coincided with growing interest in the strategic and tactical portfolio allocation of external assets. Two major developments have been increased diversification and expanded use of derivatives. Banca d’Italia has gradually built over the years a significant allocation to equities, making up about 6% of its euro-denominated financial portfolio.”

Highlighting the general problem of lagging transparency on governmental assets, Edwin “Ted” Truman, a former senior Federal Reserve official who is now a senior fellow of the Peterson Institute for International Economics, writes: “One of any government’s major responsibilities is managing the country’s international assets. Reforms are urgently needed to enhance the domestic and international transparency and accountability for this activity — in the interests of a better-functioning world economy.”

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