Bond market fragility and foreign exchange reserve management

Because of their nature and intended purpose, foreign exchange reserves must be invested in high quality liquid assets. Until recently, there was a consensus that this meant government bonds of a handful of reserve currency issuers. But in the post pandemic era, a number of developments have called this consensus into question, and it is instructive to examine this from first principles.

Reserves are meant to meet sudden unanticipated balance of payment deficits, and to intervene in the currency markets to ward off unexpected speculative attacks. Both of these mean that the reserves must be invested in assets that are unconditionally liquid, and be denominated in currencies that are always easily convertible into the intervention currency. Reserves are likely to be needed during periods of stress and turmoil in global markets, and it is not enough that the assets be liquid in normal times. What matters is liquidity in bad times. Historically, only four asset classes met this requirement:

1. Among the near-cash assets, only short term government bonds or repos fully collateralized by government bonds satisfy this need for unconditionally liquidity. Bank deposits are not acceptable because in times of stress, the solvency of even the largest banks is suspect as we found out during the Global Financial Crisis of 2008. To be unconditionally liquid, the bonds must be:

   • Denominated in the major reserve currencies like the dollar, euro and yen, and
   • Issued by AAA rated governments

2. AAA rated, reserve currency denominated, long term government bonds have traditionally been unconditionally liquid in the sense that large volumes could be traded at the prevailing market price. Unlike in the case of short term bonds, there is however no guarantee that long term bonds can be sold at or close to par. Prices of long term bonds fluctuate considerably depending on the prevailing interest rate. However, historically, the prices of these bonds tended to rise during periods of global stress and turmoil. This happened partly because of a flight to quality in such periods, and also because central banks tended to lower interest rates during such episodes. An asset that tends to trade at high prices in periods when there is a need to sell them is clearly a very attractive asset, and therefore such bonds traditionally dominated the investment portfolio of foreign exchange reserve managers. Long term bonds also typically offer a higher interest yield than short term bonds, because of the usual upward sloping yield curve.

3. Large capitalization stocks listed in countries which are reserve currency issuers are also unconditionally liquid in the sense that large volumes can be traded at the prevailing market price even during periods of market stress. However, historically, the prices of these stocks tended to fall during periods of global stress because of recessionary fears and elevated risk aversion. This made them unattractive to foreign exchange reserve managers.

4. Gold has always been unconditionally liquid; it is in fact regarded as a reserve currency in its own right. Gold prices can be quite volatile, and they have sometimes (but not always) risen during periods of market stress. But there are many drivers of the gold prices (including real interest rates and expectations about inflation and financial repression), and there is no guarantee that the price would be favourable when there is a need to sell gold. Gold does not produce any cash flows like dividends or interest, and there have been extended periods of declining gold prices. Until recently, many reserve managers found gold an unattractive asset for these reasons.

Taking all these factors into account most countries tried to ensure that the quantum of foreign exchange reserves that could plausibly be needed for intervention purposes were invested in government bonds issued by a handful of reserve currency countries. Foreign exchange assets beyond this precautionary need were moved to a sovereign wealth fund that could be deployed in riskier, less liquid assets in the pursuit of a higher return.

Recent developments have upended all these assumptions.

• After the pandemic, government debt in all the reserve currency issuing countries has risen to very high levels. On top of that, the reserve currency issuers also face unfavourable demographics that increase the explicit and implicit pension and social security liabilities of the government, and worsen the fiscal position of the state. Centuries of historical data indicate that reserve currency issuers now face heightened risks of fiscal distress (Reinhart, C.M. and Rogoff, K.S., 2009. This time is different: Eight centuries of financial folly. Princeton University Press. and Dalio, R., 2025. How Countries Go Broke: Principles for Navigating the Big Debt Cycle, Where We Are Headed, and What We Should Do. Simon and Schuster). In short, reserve currency government bonds are now a risky asset.

• As the manager of Norway's wealth fund pointed out in a recent letter to the government, the degree to which government bonds will do well in future crises will depend on the nature of the crisis, and the next crisis could well be a government bond crisis.

• Questions are being raised about the liquidity of reserve currency government bond markets. The crisis in the UK government bond market in 2022 (see Thirteen days in October − speech by Andrew Hauser at the ECB’s 2022 Conference on Money Markets 04 November 2022) could be brushed aside as being restricted to a minor reserve currency. But the chaos in the Japanese government bond market on January 20, 2026 when the yield of the 30-year bond spiked by a quarter percent in a single session is not so easy to brush off.

The turbulence in Japan also exacerbated worries about the fragility in the largest government bond market, US Treasury, where hedge funds carrying out Cash-Futures Basis Trades have become major holders of these bonds. As highly leveraged hedge funds (rather than unlevered real money investors) become the marginal buyer of US Treasury bonds, the market becomes more fragile as was observed during the pandemic. Some analysts have expressed concern that if Japan for example were to liquidate a large amount of its vast holdings of US Treasury to intervene in the currency markets, the bond market might find it difficult to absorb this selling.

The US Federal Reserve has introduced the Foreign and International Monetary Authorities (FIMA) Repo Facility which allows approved foreign central banks to borrow against Treasury bonds (The purpose of this facility was to avoid disorderly sales of the bonds in the open market that could adversely affect the Treasury market). The facility is priced in such a way that it will primarily be used only in times of unusual market stress. Since the usage of the facility is at the discretion of the US Federal Reserve, this creates a situation where a country's usage of its own reserves begins to resemble a loan from the IMF with its explicit and implicit conditionality.

• There are now significant legal and political risks attached to investment in financial assets concentrated in a few jurisdictions. The freezing of Russia's foreign exchange reserves after the Ukraine war demonstrated that reserves could be lost precisely when they are needed most.

In my view, reserve managers need to borrow some ideas from sovereign wealth funds to diversify their risk across a much wider range of asset classes in order to make it more likely that adequate resources would be available to fight a currency crisis.

• Reserve managers have already responded to some of these developments by increasing their holdings of gold, but given the limited depth and size of this asset class, many reserve managers may be approaching the limits of the potential allocation to this asset. There are also concerns about buying lot of gold within a single price cycle.

• It is a good idea to make a modest allocation to nonfinancial (unprintable) real assets that can be relocated to the home country. Physical holding of critical commodities like crude oil and industrial metals is immune to fiscal stress and financial repression in reserve currency jurisdictions. These inventories also provides much needed protection against supply disruptions of the kind witnessed during the Ukraine and Iran wars.

• A modest holding of large capitalization public equities also makes sense. If the next crisis is in government debt rather than private balance sheets, equities might benefit from a flight to quality in times of stress.

• A modest amount of high quality corporate bonds backed by cash flows in multiple currencies and multiple jurisdictions might prove more resilient than undiversified government bonds. Until a couple of centuries ago, private borrowers were regarded as safer than sovereign borrowers (see my blog post of a few months ago), and we may be returning to such an environment now.

• Diversification beyond the narrow number of reserve currency jurisdictions might be useful to hedge against demographic headwinds facing the major reserve currencies. In a period of demography induced crisis, emerging market bonds might prove to be excellent diversifiers because of the favourable demography of these countries.

Above all, in a de-globalizing world, some countries might also decide to wean themselves off their dependence on foreign capital flows, and reduce the need for foreign exchange reserves. Given the right incentives, precautionary holdings of foreign assets could be decentralized so that large importers and borrowers hold these reserves directly on their own balance sheets instead of relying on the state to protect them from balance of payment shocks. Such a decentralized portfolio would hopefully be better diversified than current reserve manager portfolios.

Posted at 9:46 am IST on Thu, 17 Sep 2026         permanent link

Categories: bond markets, international finance, investment, sovereign risk

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