Continuing on the FX theme and the recent RCI, something’s puzzled me for quite a few years. Why did BNM and/or the government decide to “amortise” the FX losses, rather than take them on BNM’s balance sheet at once?
For the uninitiated, BNM’s losses of approximately RM31.4b in the early 1990s were progressively “written-off” on a gradual basis over a period of 10 years beginning in 1993. My memory on this is a bit hazy, but my understanding was that the losses were carried as memo items, and periodically written off against the Bank’s annual profits (and euphemistically carried as “deferred expenditure” on the asset side of the Bank’s balance sheet).
The main effect of this clever piece of accounting, or boondoggle depending on your perspective, is that it preserved the illusion that BNM’s equity base remained in the black. Writing off the lossses at one go would have wiped out BNM’s equity and accumulated reserves (not to be confused with FX reserves) of about RM13.6b (at the end of 1991), resulting in the central bank being technically insolvent, or more vulgarly, bankrupt.
For most any company this would be a death blow, as with liabilities exceeding assets, there would be justifiable reason to believe that creditors would not receive the full value of what’s owed to them. For banks especially, such a situation is unbelievably dangerous, as even a hint of it would cause a bank run which would make insolvency not just possible but probable.
But central banks are very different animals. Some parts of central bank “liabilities” are not liabilities in the common sense of the word. Each and every one of us carries some of those liabilities in our pockets and wallets – specifically notes and coins. These are carried on a central bank’s balance sheet as liabilities, but they’re not “redeemable” except in other forms of money/currency.
Second, because a central bank can “print money” on demand, there’s no question of it ever defaulting on the other liabilities it has, specifically deposits of the banking system at the central bank. A call on such deposits can simply be met by the central bank crediting the relevant accounts ex nihilo. An independent, sovereign central bank can never be illiquid (Eurozone institutions excepted).
So from an operational perspective, whether a central bank has a positive or negative balance in its capital account is hardly relevant, as it can perform its functions regardless. This isn’t even just an academic, theoretical viewpoint – central banks have operated, quite sucessfully, with negative equity in the past. For an example of a currrent one (click here for the full document):
So negative capital (i.e. being bankrupt) isn’t really an issue for central banks. If there is a problem, the academic literature points to the potential for a conflict of policy objectives (a run on central bank deposits might lead to higher inflation from excessive money creation), or political (loss of independence, due to “needing” a government guarantee).
But this leads me back to my original question. Why weren’t the losses taken on in full and immediately? I still can’t figure it out.
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I could point out to only one reason. It would be a political suicide for the government to allow BNM doing that.
ReplyDeleteBut Malaysians back then were more pliable back then. Clearly the administration at the time can just divert any questions about the loss easily.
DeleteUnder the understanding that CB can never go under, why would they need any equity in the first place? From that perspective, equity feels meaningless, being a mere accounting formality.
ReplyDeleteOn a different point, I think BNM preference for amortization instead of money printing may have to do with human preference/culture/bias, that losses are looked at very unfavourably. BNM had a public reputation to protect. Such reputation would be important in running monetary policy. If you were not credible, your inflation targeting wouldn't work. BNM is/was independent, but not that independence from societal norms.
Furthermore money printing requires debt monetization. I haven't checked but I'd assume the government then wouldn't be happy to bump up its debt ratio for this, which money raised would be used to bail BNM out. BNM could forgive the debt theoretically but well, imagine the political fallout from that.
Alternatively, BNM could raise its own debt and print money to buy those papers. But was there any institutional arrangement that allowed such maneuvering?
At the end, I think there is no legal way to achieve the money printing, regardless of its economic possibility. The legal (and accounting?) institutions were a real constraint.
I wish I had proofread this. But well...
Delete@Hafiz
DeleteOn the equity question: first, startup costs, and second, for credibility especially at the initial stages. Afterwards, its pretty much not necessary, especially since most central banks remit most of their profits to finance ministries anyway.
On your other points:
1. I'd point out that quite a few central banks have and continue to operate with negative equity, with no apparent loss of credibility;
2. I think you're getting confused about money printing. It does not require monetisation of government debt, and by definition, does not require BNM to raise its own debt.
ALL FX reserve accumulation is achieved through money printing. ALL. You don't need (real) government resources for that, nor do you need to issue your own bonds.
That's why sterilisation is almost always conducted in tandem. Or in other words, they print the money first then raise the debt, not the other way around.
This is in fact normal FX reserve management, and well within the powers of BNM to conduct. So I don't see any legal constraint here.
And anyway, this is really beside the point. How the losses are paid for are quite distinct from how the impact is accounted for on the bank's balance sheet. The losses would have had to be paid for in 1992-93 regardless.
On #2, I feel money printing re: FX reserves is different from debt monetization money printing in the sense that the former would go to buying other assets, i.e. foreign currencies. At the end of the day, the liability (the money printed) is backed/linked by foreign currency assets.
DeleteBecause of that, I'd separate such money printing from debt monetization-style printing. Debt monetization coupled with forgiveness is truer to printing money out of thin air vs FX reserves style.
Furthermore, FX reserves money printing wouldn't have addressed the losses, unless the ringgit fell enough WRT foreign currencies bought, hence creating FX profits. Come to think of it, money printing FX reserves-style would sound like a doubling down of whatever Nor Yakcop was doing then. It'd open BNM to greater FX risk.
So, I feel only debt monetization style money printing coupled with debt forgiveness (BNM buys government bond, government bails BNM and BNM forgives the debt) would be the alternative solution to support the idea that CB could never go under, without FX risk.
And finally, going to another point, there's something repugnant about CB printing money for its own use rather than arising from demand from the economy. I haven't figured out what yet, but this may go back to your point that "Second, because a central bank can “print money” on demand, there’s no question of it ever defaulting on the other liabilities it has, specifically deposits of the banking system at the central bank. A call on such deposits can simply be met by the central bank crediting the relevant accounts ex nihilo. An independent, sovereign central bank can never be illiquid (Eurozone institutions excepted)."
The money is printed in response to demand outside of the CB, not from within CB itself. Again, I haven’t fully explored this issue yet, but it sounds like something relevant is hiding in here that can explain why BNM chose amortization instead of money printing of whatever method.
Hafiz, I don't think you're thinking clearly on this. HOW they pay is almost irrelevant to my post.
DeleteFor example, assuming the losses were due to a shift in some of the reserve holdings from USD to GBP, all the losses would be purely on paper, and no payment would be required. It would appear as a drop in FX reserve valuation, with the paper loss booked to the P&L. If it was a hedge (which appears to be the case and is supported by the data), the realised loss would be offset by paper gains on USD holdings. But you'd still have to take the loss on the balance sheet.
Second, there's a bit of cognitive dissonance in objecting to fiat money creation for FX losses, but being ok with fiat money creation for FX purchases. Using fiat money to buy other types of fiat money does not "back" it with anything. Hence my comment above on money printing and FX accumulation.
Third, my statement both in the post and in the comment on money printing, has nothing to do with "paying" for the losses. It's purely an observation on the solvency and liquidity of a central bank regardless of the circumstances. They don't need to print money to cover the loss, regardless of what happens to their capital base.
As far as something "hiding", I have a bigger concern which I won't write down in public. Otherwise the neighbours across the street might take my head. I'll DM you later.