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Central Bank Losses May Add to Sovereign Fiscal Pressures

Oct 03, 2022   •   by   •   Source: Fitch Ratings   •   eye-icon 272 views

Rising interest rates and falling securities valuations have increased the likelihood of losses for developed market central banks that have engaged in asset-purchase programmes, says Fitch Ratings. This may affect their ability to contribute to government revenues, and there is a risk that in some cases sovereigns could be called upon to restore central bank equity positions.
 
Central banks are not part of the consolidated government balance sheet, but tend to distribute profits to their governments. They are usually profitable, as the rates they pay on their liabilities tend to be lower than the rates they earn on assets – not least because of seigniorage earnings from the creation of cash. However, the build-up of assets on central bank balance sheets in recent years has complicated this picture. The process initially lifted profits, but a number of central banks now appear likely to record losses for at least the next year or two.
 
The recent rise in interest rates in most developed markets means that some central banks are now paying more on their liabilities to financial institutions than they are earning on their securities holdings, increasing the risk of losses. The Fed’s July 2022 Open Market Committee, for example, reported that staff project net income is likely to turn negative in the next few months.
 
Mark-to-market accounting approaches resulted in particularly large losses recently at the
Swiss National Bank (SNB) and the Reserve Bank of Australia (RBA) – the latter being enough to push the RBA into negative equity. Central banks that use different accounting approaches, like those in the US, Japan and the eurozone, and those like the Bank of England and Reserve Bank of New Zealand that have government indemnities covering asset-purchase programmes, are less likely to experience extreme earnings volatility. However, indemnified losses represent a contingent liability for the sovereign.
 
Central banks’ gains or losses from asset purchases in the long run should not be significantly affected by differences in accounting treatment, but total gains or losses are difficult to assess. They will be affected by the path of interest rates, characteristics of specific asset-purchase programmes, and the approach to winding them down.
 
Most central banks have buffers, which can allow them to maintain distributions to government even when recording losses. However, the scale and speed of market movements may overwhelm buffers, jeopardising government revenues from central banks. The RBA stated in September that it expects its future profits to be retained until its capital is restored; the bank paid around 0.1% of GDP to the government in the financial year ending June 2021. The Fed has also said remittances to the US Treasury could cease for a time if high interest rates cause it to accumulate net losses; such remittances in 2021 were around 0.5% of GDP.

Central banks can carry losses on their balance sheets and continue to operate with a negative capital position. Nevertheless, if governments opt to strengthen central bank capital positions, this would put additional strain on public finances. Restoring the RBA’s equity position to positive territory, for example, would require capital worth around 0.6% of GDP, and restoring capital buffers would require greater investment. The government invested additional capital into the RBA in 2013 after losses, but the bank has indicated that it is not currently seeking a capital injection.
 
If a central bank is indemnified for large losses or feels pressure to request recapitalisation from the government, this could be perceived as increasing political pressure on it to undertake quasi-fiscal activities or possibly increasing its willingness to tolerate higher inflation to rebuild capital through seignorage, potentially influencing its policy credibility.

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