Bank of Israel Deputy Governor Andrew Abir delivered a speech at a conference organized by the “Euroclear” European clearinghouse, on the topic of including unconventional investment assets within the investments of the central bank’s foreign exchange reserves.  The following are the main points of his remarks:

Abir described the revolution in managing the Bank of Israel’s foreign exchange reserves during the past decade.  From a portfolio that was almost entirely invested in government bonds, with a desire to maintain very high liquidity, the Bank of Israel began putting greater emphasis on the portfolio’s yield.  Today, the foreign exchange reserves include more volatile assets such as equities and investment-grade corporate bonds.   In 2012, the Bank of Israel began investing some of the reserves in equities abroad.  The start of such investments, amounting to 3 percent of the reserves, was made possible due to the increase in the reserves, and in view of the new Bank of Israel Law, which enabled investment in a broad variety of financial assets, including equities, that were not permitted under the old law.  As the trend of increasing reserves continued, the Bank of Israel also gradually increased its investments in equities.  Today, equities account for 15 percent of the foreign exchange reserves.

The deputy governor explained that the diversification of investments to various equity markets in advanced economies was also gradual.  At first, the Bank of Israel invested only in equities in the United States, while today, there are equity investments in nine markets in advanced economies.  The increase in the reserves made it possible to invest part of the reserves for long investment horizons and in more volatile assets, such as equities.  While investment in volatile assets may lead to losses in the short term, the high level of the reserves makes it possible to absorb short-term losses without harming the Bank of Israel’s ability to provide foreign exchange to the economy at the required scale during emergencies or financial crises.  Thus, two of the aims of the investment policy for the reserves—security  and liquidity—are met. At the same time, investment in more volatile assets, such as equities, makes it possible to benefit in the long term from the risk premium inherent in such investments, and therefore improves the yield on the reserves portfolio.  Empirical findings show that investment in equities generates a higher long-term yield than investment in government bonds.  Thus, the third aim of the investment policy for the reserves—obtaining a strong return—is also attained.  In this context, Abir noted that investment in equities has another advantage.  Due to the negative correlation between government bonds and equities, investing a certain percentage of the reserves in equities is expected to moderate the risk in the portfolio (the diversification advantage).

The Deputy Governor also said that in recent years, and more so since the outbreak of the COVID crisis, a very low interest rate environment is prevalent around the world, which is causing low and even negative bond yields.  In such an environment, the more the reserves increase, the greater role the third aim of the investment policy—obtaining a strong return—plays in determining the investment policy for the foreign exchange reserves.  In addition, he noted that the increases in share prices in recent years have made a marked contribution to the return on the reserves portfolio.  Between 2012 and 2020, investment in equities contributed almost half of the return, while the rate of investment in equities during those years averaged about 10 percent of the reserves.

For the first time since the start of investment in equities, since the outbreak of the COVID crisis, there have been sharp declines in equity markets, including those in which the Bank of Israel invests, on scales not see since the 2008 crisis when the Bank of Israel was still not investing in equities.  The S&P500 index declined by about 30 percent from the end of February 2020 until the end of March 2020.  (In 2008, the index declined by about 50 percent, returning to its pre-crisis level only four years later.  In 2018 there were also declines, but on a smaller scale of about 10 percent, and the return to pre-decline levels was more rapid.)  The crisis is a stress test of the Bank of Israel’s ability to withstand the volatility of risk assets.  The Bank of Israel continued managing the reserves with a long-term view, beyond the current crisis, in accordance with the reserves holding targets and the risk profile that was set out, and did not change its strategic allocation to equities.  This was all without harming the Bank of Israel’s ability to provide foreign exchange liquidity to the market in order to maintain its stability as necessary during the crisis.

In conclusion, the Deputy Governor emphasized three points:

1. It is important that the investment strategy for the foreign exchange reserves, subject to attaining the security and liquidity targets, generate an average return over time that is at least equal to the cost of financing the reserves (the cost of liabilities on the Bank’s balance sheet).

2. The Bank of Israel is constantly examining ways to adjust the investment policy and the weight of risk assets in the portfolio to the changing environment.  The guidelines for the investment policy that are set out by the Monetary Committee are updated accordingly from time to time.

3. The Bank of Israel is currently examining whether to increase the weight of equities in the foreign exchange reserves, and whether to invest in additional assets, such as a low rate of investment in corporate bonds that are below investment grade.  (Currently, investment in corporate bonds is only at investment grade, and is restricted to 7 percent of the reserves.)