The rapid growth of assets managed by central banks and sovereign wealth funds (SWFs), which began a decade ago, is set to resume after a hiatus during the global recession.
Over the next few years we forecast a growth rate in sovereign financial wealth of some 17 per cent per year, reflecting large and persisting current account surpluses in commodity exporting countries and Asian exporters.
An additional driver is continuing capital inflows to emerging markets, particularly Asia and Latin America, and to some advanced economies such as Switzerland, as investors reduce their exposure to fiscal crises in the US and the euro zone.
This results in growing foreign exchange reserves as central banks sterilise their impact on domestic monetary supply.
The continuing rise in foreign exchange reserves translates into a growing volume of assets managed by state-controlled investment vehicles as countries optimise the management of their sovereign wealth by shifting a growing share to SWFs.
We forecast that assets managed by SWFs will amount to over $US9 trillion by 2015, more than double the current amount.
SWFs are a heterogeneous group with different policy mandates, investment styles and risk appetite. Despite their diversity, however, SWFs share one important feature. They diversify foreign exchange reserves across countries, asset classes and currencies as their mandate is to boost the return on the accumulated sovereign wealth.
Foreign exchange reserves are mostly used by central banks for transaction and precautionary motives, so they are largely invested in safe asset classes such as highly rated government bonds and the most liquid currencies such as the US dollar, the euro, the Japanese yen and the British pound. Thus, when foreign exchange reserves are shifted from the books of central banks to those of SWFs, their allocation across regions, asset classes and currencies changes dramatically.
The diversification of sovereign wealth via SWFs is reducing the role of the US dollar, the euro, the Japanese yen and the British pound - historically the dominant currencies in reserve management. The diversification from traditional reserve currencies started four years ago with the financial crisis. We expect growing concerns about rising debt levels in most advanced economies to accelerate this process in 2012.
The "new reserve currencies" are currently those of commodity-exporting countries such as the Canadian dollar and Australian dollar, those of Nordic countries such as the Swedish krona and Danish krone, and Asian exporters such as the Singapore dollar.
In the future, the Chinese yuan is also set to play a growing role as China accelerates the process of internalising its currency, which is already evident in the rapid growth of the offshore yuan market.
Massimiliano Castelli is responsible for sovereign strategy at UBS Global Asset Management.