On Friday, in “Is Mario Draghi About To Go Full-Kuroda? RBS Says ECB Could Buy Stocks,” we took a closer look at what the ECB’s options are when it comes to implementing further easing measures come December.
As a reminder, Mario Draghi telegraphed either another depo rate cut, an expansion of PSPP, or both at Thursday’s ECB presser and now the market is keen to analyze the situation and determine not only what Goldman’s man in Europe is most likely to announce, but what the implications of his announcement are likely to be.
To be sure, further cuts to the depo rate will simply trigger a chain reaction whereby the Riksbank and the SNB will be forced to respond in kind, lest they should lose ground in the global currency war on the way to seeing their inflation targets threatened. This raises the spectre that NIRP may soon come to household deposits, something which, despite the proliferation of negative rates, hasn’t yet occurred.
As for the expansion of PSPP, we looked at a variety of options courtesy of RBS’ Alberto Gallo who notes that Draghi could end up buying corporate bonds, munis, equities, and even individual bank loans before it’s over. Here’s how we summed it up yesterday:
In the end, all that will happen is the EMU's neighbors will be forced further into NIRP and the ECB will end up with a nightmarish balance sheet full of stocks, corporate credit, munis, and God only knows what kind of loans purchased from banks, and all of which will have been bought at or near the top. That sets up the possibility that central banks could end up being forced to operate from a negative equity position. In other words: it sets up the possibility that they'll technically go broke.
There’s been no shortage of coverage over the past several years regarding the idea that central banks can effectively go bankrupt.
There are plenty of commentators who say that’s nonsense because after all, they control the printing press. Of course that argument suffers from the same defect as the argument that providing fiscal stimulus to an economy that isn’t acting the way you want it to is as simple as printing one liability (a government bond) and buying it from yourself with another liability you also print (fiat money). The common thread is this: if it were that simple, then we wouldn’t be having the conversation in the first place.
If a central bank ends up in a negative equity position because the “assets” it purchased at nosebleed valuations decline in value, there are very real consequences both in terms of the ability to effectively conduct policy and in terms of optics. For more, we go back to RBS’ Alberto Gallo.
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What is the endgame of QE? Central bank balance sheets larger than GDP, potential losses or even negative equity capital. Large balance sheets can expose central banks to heavy losses. The SNB, for example, lost CHF52bn or 60% of equity in the first six months of the year, given unfavourable FX movements and price drops in its bond/equity holdings. As we discuss below, there are also other central banks that have accumulated losses and gone into negative equity in the past, including Chile, Czech Republic, Costa Rica and Jamaica. In theory, central banks can take losses and live with negative equity, as suggested by the SNB’s Vice Chairman Thomas Jordan in 2011. The example of the Czech Republic below also shows that central banks can sometimes grow out from negative equity through investment returns, over long periods of time. However, as suggested by the ECB, negative capital can limit central banks’ independence. A BIS paper also argues that significant losses could undermine their credibility, which has already been declining.
A history of central bank losses: towards the limits of balance sheet powers Central Banks could operate with negative net worth, but at the risk of affecting “the credibility of […] monetary policy” according to the ECB. The Chilean and Czech Central Bank are examples of central banks which have operated with negative net worth for a prolonged period (almost continuously since 1982, for Chile). However, while the Czech Central Bank has reduced their negative net worth due to good equity investments, Chile’s central bank has received two recapitalisations from the government since 1982. This dependence on the government brings into question the independence of central banks. The ECB have also previously said that negative net worth would “affect the credibility of the Eurosystem’s monetary policy”.
Negative capital could hinder central banks’ ability to meet their monetary targets. The central bank of Costa Rica suffered from losses for almost 20 consecutive years, leading it to a negative capital balance at the end of 2000. In fear of its balance sheet sustainability, the central bank chose not to lower their target rate of inflation. Jamaica is another example. Estimates show that in 1991 it had a negative net equity of USD 1.5bn. Large losses limited the policy instruments at the bank’s disposal. As a result, the country entered a stage of hyperinflation where CPI exceeded 80%.
Concerns about potential losses could also limit central banks’ policy flexibility. According to an IMF working paper, the market questioned whether Japan’s central bank could continue their purchases of government debt due to the risk of incurring substantial capital losses. According to the paper, because of these concerns, the monetary policy did not have the desired effect and failed to bring interest rates down to the desired levels. In January 2015, the SNB surprised markets by ending its Euro-buying programme because of concerns with Euro devaluation. But this change in monetary policy, which caused the Swiss Franc to strengthen, has also hurt Swiss exports (-3.8% YoY in September).
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So, far from being some trivial problem that can be fixed by pressing "print", central banks operating from a negative equity position face the possibility of i) losing their independence as they have to be recapitalized at the behest of the government, ii) being forced into policy decisions (or, perhaps more appropriately "in"decisions) that they might not otherwise make, and iii) losing the ability to control the narrative, thus heightening market concerns about the loss of omnipotence (or, in Haruhiko Kuroda's words, a failure to believe in Peter Pan).
Also bear in mind that the more focus there is on central banks, the more scrutinized their balance sheets will be. Of course one cannot mark an equity portfolio "held to maturity", which begs the question of what happens when central banks that have bought stocks begin to incur losses. Will they simply print more money to buy more stocks in order to prop up their portfolios in a never-ending loop?
In any event, what the above underscores is that in short order we may move beyond the merely theoretical idea that central banks have "lost credibility" with market participants into a world where there is demonstrable, quantitative evidence that the emperors have no clothes.