Should Central Banks Buy Stocks?

The worst financial crisis since the Great Depression has placed central banks around the world into the spotlight. The mysterious yet powerful entities have emerged from the shadows of the financial system to the foreground of a global currency war. They are well-known for lowering interest rates and purchasing government bonds, but central banks are now gaining the reputation of being stock pickers.

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Central banks such as the Federal Reserve and the Bank of Japan have been trying to create a wealth effect by injecting record amounts of liquidity into the financial system. By punishing savers through low interest rates, they hope to force more people into riskier assets such as stocks that offer a higher rate of return. As asset prices rise, the belief is that consumer spending and confidence will follow. However, loose monetary policies also appear to be affecting central banks.

Individuals are not the only participants reaching for yield. Low rates on government bonds are pushing more central banks into equities. According to a recent annual survey of 60 central bankers conducted by Central Banking Publications and Royal Bank of Scotland, nearly a quarter of reserve managers already own equities or plan to buy them within five years. In total, the 60 central banks polled are responsible for almost $7 trillion in reserves.

While questionable in the longer-term, a shift toward equities seems like the next logical step. The race to debase currencies has boosted equity markets around the world. The S&P 500 gained 10 percent in the first quarter alone, while the Nikkei has surged more than 30 percent year-to-date. When converted to U.S. dollars, the four major central banks have expanded their balance sheets to more than $13 trillion, compared to only $3 trillion ten years ago, according to Hayman Capital.

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In addition to capital gains, central banks may also enjoy higher yields with equities than they would with government bonds. Nearly half of the companies in the S&P 500 have a higher dividend yield than the yield on the 10-year U.S. Treasury. Roughly a quarter of companies in the index have a higher yield than the 30-year U.S. Treasury.

Jim O’Neill, chairman of Goldman Sachs Asset Management, recently told CNBC, “I don’t think people should worry about” central banks buying stocks. “Frankly, it makes a huge amount of sense in a world of floating exchange rates and such incredible opportunity, why should central banks keep so much money in very short term, liquid things when they’re not going to ever need it?”

Investing in stocks is not completely new for several central banks. The Bank of Japan announced another round of monetary stimulus in April. The central bank’s new governor Haruhiko Kuroda committed to nearly doubling Japan’s monetary base to 270 trillion yen by the end of 2014. As part of its ongoing asset-purchases, the central bank is buying stocks. In fact, it will more than double investments in equity exchange-traded funds to 3.5 trillion yen by the end of next year.

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In March 2012, the Bank of Israel launched a pilot program to invest a portion of its foreign currency reserves in U.S. equities. The initial investment totaled about $1.5 billion, but could reach almost $8 billion at a later stage. Bank of Israel’s spokesman Yossi Saadon explained that the investments will be made in equity index trackers, which will include stocks such as Apple (NASDAQ:AAPL).

Although central banks buying equities may seem like the next natural move, it does not come without any risk. When central banks manipulate interest rates, it distorts the true cost of money and often causes capital misallocations. This is one major reason for the current boom/bust economy. Equity purchases by central banks will add to the distortion, and the law of unintended consequences could rear its ugly head in the future.

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