Many central banks that have accumulated large balance sheets due to unconventional monetary policies are facing large losses as interest rates have increased. This may lead to negative equity and, more importantly, a drying up of pay-outs to state budgets.
A report published by the International Monetary Fund predicts the net income of the Eurosystem and its top five central banks in the next 10 years. It finds that losses, although large, will be temporary and recoupable from future profits. The losses will most likely be smaller as their projections do not encompass the European Central Bank’s decision of 27 July 2023 to remunerate minimum required reserves at 0% or other possible future changes to reserve remuneration.
The Czech National Bank is an example of a small central bank outside the euro area experiencing losses. Unlike the Eurosystem central banks, whose balance sheets are large due to the ECB’s quantitative easing policies, the CNB accumulated large foreign exchange reserves, now standing at 60% of gross domestic product, while the foreign exchange commitment policy was in place from 2013-17. In 2022, a drop in asset prices in international markets contributed to a loss of CZK412bn (€17bn) and equity was negative at CZK481bn (€20bn).
Is the loss a cause for concern?
The CNB has operated with negative equity for most of the period since 2000 without any material impact on its functioning. An article published in the International Journal of Central Banking presents projections of the CNB’s balance sheet, suggesting that losses will switch to profits at some point in the future and equity will return to positive territory eventually.
Balance sheet projections rest on a number of important assumptions. The IMF report relies mainly on future policy rates, yields on QE portfolios, the impact of targeted longer-term refinancing operations repayments and the future quantitative tightening path. Similarly, projections presented in the IJCB article assume equilibrium values of interest rates, growth in currency in circulation, exchange rates and portfolio returns. Besides the baseline scenario, the article considers policy scenarios such as a long-run decline in currency in circulation or sales of yields on foreign exchange reserves as well as feedback effects between the CNB’s equity and macroeconomic indicators.
In any case, central banks with negative equity resulting from previous losses should be able to return to profits sooner or later under reasonable assumptions.
The Bank for International Settlements argues in its Annual Economic Report that monetary and fiscal policy as core economic functions of the state are inextricably intertwined and thus need to operate within a ‘region of stability’. To shed light on how monetary and fiscal policies interact, the concept of consolidated central bank and government budget constraint is introduced. When the government, for example, issues long-term debt that is bought by the central bank, the sensitivity of government funding costs to higher interest rates decreases if one looks at the government’s balance sheet alone.
Looking at the consolidated picture, however, shows that the central bank’s expenses grow as it remunerates commercial bank reserves and that in turn reduces central bank remittances. The ‘region of stability’ is defined as the set of fiscal and monetary policy combinations that are consistent with macroeconomic and financial stability. The key challenge for policy-makers is to stay inside the ‘region of stability’, which evolves over time and can shrink rapidly.
Favouring profits over losses
Another recent study empirically tests whether central banks have a preference for profits over losses. The idea is that the observed discontinuity in the profit distribution at zero is a natural consequence of central banks being concerned with the sign of their profits and taking actions to avoid reporting losses, even though these actions are not always socially optimal. According to the results, central banks are more likely to report small profits than small losses.
The study suggests that profit concerns are related to the political environment and behavioural frictions, such as the difficulty in communicating losses to the public. An extreme interpretation would be that, especially amid large-scale asset repurchases and increased political pressure, the risks of higher-than-desirable inflation may be more pronounced than generally assumed.
Nevertheless, such results highlight the importance of open communication about the temporary and recoupable nature of losses. Projections like those of the IMF report and IJCB article help to communicate and frame the discussion. Well-managed communication is an important prerequisite for keeping monetary policy focused on delivering the key mandate of price stability.
Kamil Galuščák and Branislav Saxa are Senior Economists at the Czech National Bank.
The views expressed in this article are those of the authors and not necessarily those of the Czech National Bank.