The Bank for International Settlements has an interesting paper in its Quarterly Review looking at some of the issues affecting central banks’ willingness to invest their foreign currency in green bonds.
The paper attempts to calculate the “greenium” — that is, the premium one must pay to buy debt companies sell to finance new or existing green projects. It turns out the greenium is not that high — indeed the dollar-denominated debt even offers a higher return than conventional bonds. From the paper:
“Our results suggest that green bonds compare reasonably well with their conventional peers. Based on our approach, a US dollar investor tracking the green index would have enjoyed a spread 4 basis points above that of the conventional benchmark (positive “portfolio greenium”), while the euro-based investor would have earned 12 basis points less than the comparator market (negative portfolio greenium).”
However, this greenium estimate has varied considerably over time, due in part to differences in issuer composition across benchmarks, even when credit rating and sector breakdowns are set equal. It also appears that the portfolio greenium narrowed over time as the green bond market developed, with the spread between conventional and green returns closing as of 2019.
Green bonds are also increasingly securing the top investment-grade ratings — often a prerequisite for central banks, which prefer to invest their reserves conservatively. But there is a problem: a lack of liquidity in the market.
The world’s monetary guardians held about $11.5tn in foreign-currency reserves at the end of 2018. The reserves have built up in recent decades, usually as a result of foreign-exchange policies to keep the value of their currencies low against major global ones.
The reserves serve as a hedge against foreign exchange risk. The idea being that the stockpiles provide a cushion against volatility, cushioning a sharp drop in the value of the currency of the central bank in question against the likes of the dollar and the euro. That in turn protects exporters, stabilises imported inflation and boosts growth.
It also means they need easy access to liquid assets. By investing in said US Treasuries, central banks have an asset they can quickly sell. The dollars they receive can then be used to intervene in foreign exchange markets.
While more than 60 per cent of central banks polled by the BIS thought there was scope to include sustainability as part of their reserve management mandate, the market for these bonds is relatively small. While it is growing fast, issuance was only $230bn in 2018. The Institute of International Finance estimates that sustainable finance accounts for just 0.5 per cent of all global debt.
They are not, as the above chart shows, the most liquid assets.
As the BIS points out, central banks’ reserve stockpile is now so high that they have so-called “excess reserves”, which they can afford to hold in assets that are not as liquid, but yield a higher return. In an environment of trade war-induced volatility, however, the amount of reserves that can be deemed surplus to the requirement to stabilise the exchange rate is likely to be dwindling by the day.
One possible solution to the problem of there being a lack of a big secondary market would, of course, be for the central banks responsible for major currencies — many of which have committed to the Network for Greening the Financial System initiative — to put their money where their mouth is and take a more proactive stance.
The European Central Bank has committed to spending €20bn a month in bond markets from November as part of a revamp of its €2.6tn quantitative easing programme. Why not use this programme as a means of practising what they preach about sustainability?
Members of the bank’s governing council — such as Benoît Cœuré, Jens Weidmann and François Villeroy de Galhau — have so far seemed lukewarm.
Villeroy, who heads the French central bank, questioned last week whether professional standards were up to scratch, which seems to be a legitimate gripe for such a new market. He also claimed that “massive purchases on a relatively shallow pool of green bonds could seriously distort the market.”
We think that central banks are such big players in bond markets (and in the ECB’s case, are likely to remain so for some time) that a commitment to embrace sustainable finance by buying more green bonds would in and of itself encourage issuance and create a deeper pool of assets in secondary markets. This would, in turn, encourage foreign central banks with big reserves stockpiles to buy more of the paper.
Christine Lagarde has appeared more willing to green QE. One hopes she will be able to convince her more reluctant colleagues once she joins the ECB on 1 November.
Source Financial Times