Emerging Central Banks Provide Counterweight During Risk-On and Risk-Off Markets

(July 25, 2012) — Emerging market central banks perform a critical function during both risk-on and risk-off markets, a paper published by the Bank for International Settlements argues.

Central banks in emerging markets encourage capital inflows in calm markets and provide safe havens for global investors during volatile periods, contends author Robert N. McCauley in the paper. In both environments, emerging central banks reinforce global capital flows by moving in the opposite direction.

During risk-on markets, or when optimistic global investors take on higher risks to pursue better returns, international capital pours into emerging markets. As the paper explains, the response by central banks in those regions is to purchase safe assets in reserve currencies so as to resist exchange rate appreciation. “Thus,” writes McCauley, “calm periods, marked by leveraged investing in emerging markets, lead to an asymmetric asset swap (risky emerging market assets against safe reserve currency assets) and leveraging up by emerging market central banks.”

In risk-off markets, when investor sentiment is pessimistic, international capital pulls out of emerging markets. In reaction, central banks draw down their reserves, flooding the market with safe assets precisely when global investors are seeking them most. “In effect, global investors purchase a call option on emerging market growth, holding equities for the upside and selling them for the downside,” says McCauley. “And emerging market central banks provide safe assets – reserve currency government bonds – to global investors when risk is off.”

Importantly, the asset swap is asymmetric in its risk character. In other words, instead of global investors and emerging market central banks exchanging equally risky assets during both risk-on and –off environments, only one side is taking on risk in either scenario.

“The international flow of funds produces not an exchange of risky assets but an acquisition of risky assets on one side and an acquisition of safe assets on the other,” he writes. “The alternation of risk-on and risk off markets is… a kind of international asset swap, in which gross flows allow investors in different countries to alter their risk profile.”

Central banks in emerging markets act in the opposite direction as global capital, he concludes, and thereby serve as essential players in international investing.

To read the paper in full, click here.