By R.M.B Senanayake
Mr. W.A Wijewardene, a former Deputy Governor of the Central Bank, has raised the issue of the Central Bank running at a loss. The Bank’s accounts show that for the year ended 2014 it ran at a Net (Loss) for the Year of Rs (32,309,390 mn.) which is an increase in the loss for the previous year of Rs (24,264,529 mn.). The loss has arisen mostly in the Foreign Exchange transactions which amounted to Net Foreign Exchange Revaluation Gain/(Loss) of Rs (32,266,690 mn.). The Central Bank has defended the position stating as follows:
The "profitability related approach, if adopted by the Central Bank, could result in the bank pursuing profits while compromising its core objectives, since it has the unique ability to create its own profits through its monetary policy activities, which could influence interest rates and exchange rates." It therefore glosses over the losses incurred in the Central Bank of Sri Lanka Management Statement for the period ended 31 December 2014. Accountability and the financial performance of the Central Bank in relation to its objectives follows that the "Central Bank’s objectives of economic and price stability and financial system stability need to be distinguished and detached from the pure profitability objective which should essentially be incidental or academic only."
It goes on to explain that "the Bank’s financial statements record gains and/or deficits in the implementation of its monetary policy operations, exchange rate management, issuing of currency, etc. at the values as realized and hence, the financial performance as reported in these statements need to be interpreted and understood in that context".
Capital structure of a Central Bank
Strictly a Central Bank with a company type capital structure is not necessary to carry out monetary policy which is its main function. Nor is such a capital structure required to carry out its other functions like the issue of currency or the supervision of the commercial banks. These functions could be carried out by a board or statutory authority such as the Monetary Authority of Singapore. But even such Authority must have a legal identity and hence it uses the corporate form with a paid up capital.
In 1950 when the Central Bank of Ceylon was set up, it was established as a corporate body with a paid up capital. The bank’s capital was subscribed entirely by the government. It has taken the structure of the commercial banks that hold deposits with the Central Bank. Some central banks pay interest on these deposits but some don’t. Recently some Central Banks have imposed a charge on the banks for holding their deposits.
Will the fact that the Central Bank has negative net worth influence the commercial banks holdings of deposits with them? Perhaps not since there is an implicit State guarantee of such deposits. There is of course no such formal guarantee for the Central Bank of Sri Lanka.
Mr. W.A Wijewardene, a former Deputy Governor of the Central Bank, has raised the issue of the Central Bank running at a loss. The Bank’s accounts show that for the year ended 2014 it ran at a Net (Loss) for the Year of Rs (32,309,390 mn.) which is an increase in the loss for the previous year of Rs (24,264,529 mn.). The loss has arisen mostly in the Foreign Exchange transactions which amounted to Net Foreign Exchange Revaluation Gain/(Loss) of Rs (32,266,690 mn.). The Central Bank has defended the position stating as follows:
The "profitability related approach, if adopted by the Central Bank, could result in the bank pursuing profits while compromising its core objectives, since it has the unique ability to create its own profits through its monetary policy activities, which could influence interest rates and exchange rates." It therefore glosses over the losses incurred in the Central Bank of Sri Lanka Management Statement for the period ended 31 December 2014. Accountability and the financial performance of the Central Bank in relation to its objectives follows that the "Central Bank’s objectives of economic and price stability and financial system stability need to be distinguished and detached from the pure profitability objective which should essentially be incidental or academic only."
It goes on to explain that "the Bank’s financial statements record gains and/or deficits in the implementation of its monetary policy operations, exchange rate management, issuing of currency, etc. at the values as realized and hence, the financial performance as reported in these statements need to be interpreted and understood in that context".
Capital structure of a Central Bank
Strictly a Central Bank with a company type capital structure is not necessary to carry out monetary policy which is its main function. Nor is such a capital structure required to carry out its other functions like the issue of currency or the supervision of the commercial banks. These functions could be carried out by a board or statutory authority such as the Monetary Authority of Singapore. But even such Authority must have a legal identity and hence it uses the corporate form with a paid up capital.
In 1950 when the Central Bank of Ceylon was set up, it was established as a corporate body with a paid up capital. The bank’s capital was subscribed entirely by the government. It has taken the structure of the commercial banks that hold deposits with the Central Bank. Some central banks pay interest on these deposits but some don’t. Recently some Central Banks have imposed a charge on the banks for holding their deposits.
Will the fact that the Central Bank has negative net worth influence the commercial banks holdings of deposits with them? Perhaps not since there is an implicit State guarantee of such deposits. There is of course no such formal guarantee for the Central Bank of Sri Lanka.
In ordinary and calm times central banking is simple and profitable. The Central Bank has a monopoly over the issue of the currency - a profitable business since the face value of the notes exceeds the cost of printing them. The Central Bank of Sri Lanka has made substantial profits in the past and has paid out its profits to the government- its sole shareholder. Similarly foreign central banks have paid out dividends to their government shareholders. Switzerland’s National Bank pays out dividends to its federal and regional governments. So does the European Central Bank which is owned by several national banks in the Euro area.
The national central banks in the developed countries have become bigger over the years. Between 2006 and 2014 central banks balance sheets in the G7 countries jumped from $3.4 trillion to 10.5 trillion. But some of the Central Banks assets are liabilities issued by foreign governments. In their attempts to hold their domestic currency exchange rates steady they have acquired and hold foreign currencies and foreign securities. In addition the Central Bank has purchased government securities issued by the government or even foreign governments. They use printed money to do so for domestic securities.
The new feature since 2007 financial crisis is the issue of new printed money under the program called Quantitative Easing. This is an attempt to provide a stimulus to the economy which may have faltered in its growth path. This is done entirely by the creation of new money. The central banks expect the issue of such new money to stimulate economic growth. There is no risk of default since the securities are government bonds. But there is the question of leverage which refers to the creation of new liabilities in relation to the paid up capital of the bank. With regard to borrowing by private sector institutions, economists sound a word of caution regarding the extent of leverage.
From a narrow security perspective it is necessary to be cautious about excessive leverage. The Net Foreign Exchange Revaluation Gain / (Loss) of our Central bank was Rs (32,266,690) mn.in 2014, which is higher than the loss the previous year of Rs (26,758,639 mn.).The Central Bank’s Capital Funds was Rs 50 billion. The total equity was 81,711,851 mn. But this is less than the Equity of Rs 114,907,213 mn. of the previous year. The Total Liability of the Bank was Rs. 1,389,688,541 and the Total Equity was Rs 81,711,851 mn. which is less than the figure for the previous year. The total foreign currency liabilities was Rs 468,273,901 ; the total foreign currency assets however were Rs 1,045,257,758. So the position is quite healthy. So there is no necessity to worry.
It is only the theoretical question of whether the Central Bank should pay attention to its capital structure and equity that must be the issue. The risk arises where a central bank borrows heavily in foreign currency and incurs liabilities to be settled in foreign currency; if it becomes unable to settle them, that would constitute a risk of default. Such foreign liabilities cannot be settled by using the domestic currency. So the central bank’s power to create domestic money will not avail if the liabilities are in foreign currency. For example the central bank could buy foreign exchange to maintain its domestic exchange rate vis-a-vis the foreign currency. In order to prevent higher domestic inflation as a result of such purchases the Central Bank may sell its domestic securities to sterilize such risk of higher inflation and thereby reduce the money supply. If it doesn’t have sufficient government securities in its portfolio it may even issue is own securities for such sterilizing at the prevailing rate on government bonds. They are low yielding assets in dollars. The Central Bank would then have to face losses if it were to cash them.
Weak Central Banks have survived
The survival of weak central banks in several countries shows that central banks are not in the same position as weak companies whose capital base has eroded. They all faced the problem because of buying low yielding assets like dollars by incurring high cost liabilities. By the late 1980s the central banks of Jamaica and Nicaragua were regularly losing 5% of GDP or more per year. (The Economist Jan. 24, 2015) The assets of several central banks like Indonesia, Russia, Switzerland, China Japan, and the Euro Area were below 10% of their total assets. Chile had negative capital to assets ratio of 10%. But two central banks have suffered devastating crunches which undermined their monetary policy stance. These weak central banks don’t like to raise interest rates in such circumstances. Or they may do so by less than what is required.
When returns on government bonds decline, it will mean central banks income will decline. After 20 years of similar losses Chile’s central bank is in negative equity. Several other central banks have faced losses. None of these toppled however. Some economists think losing central banks might be tempted to create or print more and more money, rather than focus on inflation control which is their main task. Another worry is that the losses and low capital could lead to the loss of independence of those central banks for they have to look up to the government to pump more capital. The bank could then be captured by the government and the government ministers. In either case the central bank which is losing capital might be induced to overlook inflation for politicians do not like austerity.
The Economist (Jan, 24, 2015) refers to some evidence found by IMF researchers who tested the relationship between bank capital and interest rate policy. Collecting data for 41 advanced and emerging countries between 2002 and 2011, they work out what a hypothetical central bank behaving rationally would do and contrast it with the central banks actual choices and explain why the two might diverge. They explain the divergence by referring to the weak capital position of their central banks. The central banks with weak capital positions would most likely resort to more money printing which will push interest rates down when what is required is to raise them owing to inflationary conditions. In weak capital positions may undermine their monetary policy for inflation control.
So t is best for the Central Bank not to make losses which could water down their capital too much.
www.island.lk
The national central banks in the developed countries have become bigger over the years. Between 2006 and 2014 central banks balance sheets in the G7 countries jumped from $3.4 trillion to 10.5 trillion. But some of the Central Banks assets are liabilities issued by foreign governments. In their attempts to hold their domestic currency exchange rates steady they have acquired and hold foreign currencies and foreign securities. In addition the Central Bank has purchased government securities issued by the government or even foreign governments. They use printed money to do so for domestic securities.
The new feature since 2007 financial crisis is the issue of new printed money under the program called Quantitative Easing. This is an attempt to provide a stimulus to the economy which may have faltered in its growth path. This is done entirely by the creation of new money. The central banks expect the issue of such new money to stimulate economic growth. There is no risk of default since the securities are government bonds. But there is the question of leverage which refers to the creation of new liabilities in relation to the paid up capital of the bank. With regard to borrowing by private sector institutions, economists sound a word of caution regarding the extent of leverage.
From a narrow security perspective it is necessary to be cautious about excessive leverage. The Net Foreign Exchange Revaluation Gain / (Loss) of our Central bank was Rs (32,266,690) mn.in 2014, which is higher than the loss the previous year of Rs (26,758,639 mn.).The Central Bank’s Capital Funds was Rs 50 billion. The total equity was 81,711,851 mn. But this is less than the Equity of Rs 114,907,213 mn. of the previous year. The Total Liability of the Bank was Rs. 1,389,688,541 and the Total Equity was Rs 81,711,851 mn. which is less than the figure for the previous year. The total foreign currency liabilities was Rs 468,273,901 ; the total foreign currency assets however were Rs 1,045,257,758. So the position is quite healthy. So there is no necessity to worry.
It is only the theoretical question of whether the Central Bank should pay attention to its capital structure and equity that must be the issue. The risk arises where a central bank borrows heavily in foreign currency and incurs liabilities to be settled in foreign currency; if it becomes unable to settle them, that would constitute a risk of default. Such foreign liabilities cannot be settled by using the domestic currency. So the central bank’s power to create domestic money will not avail if the liabilities are in foreign currency. For example the central bank could buy foreign exchange to maintain its domestic exchange rate vis-a-vis the foreign currency. In order to prevent higher domestic inflation as a result of such purchases the Central Bank may sell its domestic securities to sterilize such risk of higher inflation and thereby reduce the money supply. If it doesn’t have sufficient government securities in its portfolio it may even issue is own securities for such sterilizing at the prevailing rate on government bonds. They are low yielding assets in dollars. The Central Bank would then have to face losses if it were to cash them.
Weak Central Banks have survived
The survival of weak central banks in several countries shows that central banks are not in the same position as weak companies whose capital base has eroded. They all faced the problem because of buying low yielding assets like dollars by incurring high cost liabilities. By the late 1980s the central banks of Jamaica and Nicaragua were regularly losing 5% of GDP or more per year. (The Economist Jan. 24, 2015) The assets of several central banks like Indonesia, Russia, Switzerland, China Japan, and the Euro Area were below 10% of their total assets. Chile had negative capital to assets ratio of 10%. But two central banks have suffered devastating crunches which undermined their monetary policy stance. These weak central banks don’t like to raise interest rates in such circumstances. Or they may do so by less than what is required.
When returns on government bonds decline, it will mean central banks income will decline. After 20 years of similar losses Chile’s central bank is in negative equity. Several other central banks have faced losses. None of these toppled however. Some economists think losing central banks might be tempted to create or print more and more money, rather than focus on inflation control which is their main task. Another worry is that the losses and low capital could lead to the loss of independence of those central banks for they have to look up to the government to pump more capital. The bank could then be captured by the government and the government ministers. In either case the central bank which is losing capital might be induced to overlook inflation for politicians do not like austerity.
The Economist (Jan, 24, 2015) refers to some evidence found by IMF researchers who tested the relationship between bank capital and interest rate policy. Collecting data for 41 advanced and emerging countries between 2002 and 2011, they work out what a hypothetical central bank behaving rationally would do and contrast it with the central banks actual choices and explain why the two might diverge. They explain the divergence by referring to the weak capital position of their central banks. The central banks with weak capital positions would most likely resort to more money printing which will push interest rates down when what is required is to raise them owing to inflationary conditions. In weak capital positions may undermine their monetary policy for inflation control.
So t is best for the Central Bank not to make losses which could water down their capital too much.
www.island.lk
