Storms ahead if monetary losses turn political

Far-right rise exacerbates central banks communications problems

The rise in Europe’s populist parties, underlined by this week’s far-right election win in the Netherlands, further exacerbates central banks’ political and public relations problems over their weakened balance sheets.

The far right’s surge, with anti-Islam, anti-euro Party for Freedom leader Geert Wilders favourite to become the next Dutch prime minister, makes life more difficult for central banks for several key reasons. It concentrates the spotlight on policy mistakes by largely independent central banks contributing to an unpopular mix of high (though now diminishing) inflation and high interest rates.

The rise of a new breed of politicians unstinting in their criticism of public sector technocrats will focus attention on central bank operating losses and measures taken to stem them. A landmark report from the International Monetary Fund in July found that losses throughout the euro system were ‘temporary and recoupable’. However, following the European Central Bank’s further interest rate rise in September, prospects for a medium-term easing of the central banks’ balance sheet plight have deteriorated further.

As the IMF wrote, quantitative easing – large-scale, across-the-board purchases of government bonds introduced in 2015 – removed duration risk from the private sector’s balance sheet, in an effort to support credit provision to the real economy. ‘In effect, the ECB executed a fixed-for-floating rate swap for public debt. This leaves the ECB and its shareholder national central banks with a large interest rate exposure in the current tightening cycle.’

Campaign to raise minimum reserve levels could hit bank lending

Deposit rates paid by central banks to commercial banks have increased sizeably in the past 18 months. These outlays hugely exceed the paltry interest rate return on the asset side of central banks’ balance sheets, heavily swollen by huge purchases of low- (sometimes negative-) yielding bonds during the past decade.

This imbalance – as well as some more mainstream monetary policy reasons – represents one reason why some euro area central banks have been campaigning to raise much further the volume of commercial banks’ non-remunerated minimum reserves held at Eurosystem central banks.

This aim is unlikely to be met, at least in the short term. Increasing minimum reserves might lower banks’ profitability and capacity to overpay staff, potentially garnering political applause. But bank executives argue it would impede lending at a sensitive time for European economies.

As the IMF wrote, major euro area central banks seem unlikely to turn to governments for recapitalisation or other forms of overt state support. But an end to a long cycle of paying profits to aid public finances is politically problematic. De Nederlandsche Bank is likely to pay no dividends to the government for the next 10 years. The Bundesbank is braced for a wider public debate over its finances in 2024-25. This will coincide with a probably stormy run-up to the next scheduled general election for Germany in autumn 2025.

QE criticism and appeal of populist parties

The Bundesbank will have used up nearly €20bn of provisions on its balance sheet in covering 2023 losses, to be announced in early 2024. These balance sheet problems, although soluble through accounting adjustments, will sharpen the debate about the drawbacks of large-scale QE. Many now believe this continued too long in the European Union and the UK. QE has been blamed for exacerbating wealth imbalances and undermining the solidity of public finances – both factors enhancing the appeal of populist parties.

The UK has a different mechanism to the euro area for dealing with central banks’ QE-induced losses. The prospective levy on UK taxpayers to stem losses through the Bank of England’s asset purchase facility is estimated to be as high as a cumulative £150bn by 2033.

The Bundesbank may see its sizeable gold reserves as an important buffer for its balance sheet strains. For political, legal and accounting reasons, it probably will not resort to direct use of its gold valuation reserves to plug its deficit. But it pointed out in its 2022 annual report that its balance sheet is underpinned by a gold revaluation reserve of €176bn, eight times larger than when the euro started in 1999.

A similar approach seems likely to be followed by De Nederlandsche Bank. Drawing on gold directly might have adverse side effects if politicians opined that the Bundesbank’s gold should be diverted to other channels. In view of the political and constitutional imbroglio over German public finances, such speculation would be anathema to the Bundesbank and to Chancellor Olaf Scholz’s embattled government.

David Marsh is Chairman, OMFIF.

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