Chapter 5
Evolution of Central Bank Balance Sheets and Their Heterogeneous Dimensions
An increased size of central bank balance sheets arose from the financial crisis of 2007–2009. This chapter discusses what makes central bank balance sheets different across regions and countries, and how they have evolved over time. Furthermore, factors that will bring more evolution to central bank balance sheets in the future are examined.
5.1What Makes Central Bank Balance Sheets Special?
Central bank balance sheets consist of assets and liabilities, like any other balance sheet. But, the composition of central bank balance sheets is somewhat different. Figure 5.1 shows typical assets and liabilities common to central banks. The mix of these assets and liabilities varies quite a bit from country to country. In addition, there are differences in assets and liabilities that some countries utilize in their balance sheet that others do not and the naming of the assets also varies from country to country, making comparisons slightly more difficult. However, by comparing the balance sheets, a lot can be learned about the situation of these countries, their policies, and their motives. History plays an important role in the condition of the balance sheet of any country and so it is important to compare different points of history, which is the intention of this chapter and the next. In doing so, you can gain a good understanding of how events, policy, and time shape the balance sheets and therefore the range of economies of the countries we have selected. Data availability as well as the means of reporting the data in terms of language influence the number of countries utilized in this chapter and the subsequent one. The Organization for Economic Cooperation and Development (OECD) countries were selected based on access to data and how easy it is to transform the data for comparative analysis. In light of this, eight central banks’ balance sheets are utilized for this purpose. Five of these belong to advanced economies while the remaining three are linked to emerging countries. Currencies of these selected central banks are mostly traded in the international currency market except for Mexico and Chile, which might influence their balance sheets.
Central bank balance sheets entail the following unusual features:
–Owing to the central bank’s role as an issuer of banknotes, notes in circulation are a significant component of a central bank’s liabilities.
–Their operation can work with negative equity. For instance, central banks of countries like Chile, the Czech Republic, Israel, and Mexico were able to attain their policy aims effectively even with technical insolvency in recent years.
–An appropriate yardstick of central bank performance is not only profit but includes much wider objectives such as financial and monetary stability.
Apart from the above-mentioned features, there are peculiarities associated with the accounts of any one central bank. For example, the Bank of England separates its issue department from the rest of the bank, that is, the “banking department.” This separation is mainly based on an accounting deceit, which, according to the Bank Charter Act of 1844, was to ensure that the bank’s note issue was supported by gold. However, the bank no longer abides by the rule of gold standard. In terms of the profit formula, 50 percent of the banking department’s profits are allocated to the government while the remaining percent are used to cover operational expenses. The entire profit of all issue departments goes to the Treasury on the basis that seigniorage income belongs to the sovereign.
5.2Historic Uses of Central Bank Balance Sheets
All central banks in the world responded to the global financial crisis of 2007–2009 through expansion of their balance sheets as depicted in Figure 5.2. New liabilities were formed to purchase assets from other economic agents in a channel called quantitative easing (QE). The increasing size in central bank balance sheets was implemented to prevent the recession from becoming even more severe.
QE is commonly considered as unconventional monetary policy from a longer-term perspective. The Bank of England has used its balance sheets to implement policy for a very long time. Therefore, it is necessary to show how the bank has previously utilized its balance sheets in response to crises of 1847, 1857, and 1866.
In Figure 5.3, the horizontal lines capture two standard deviations from the mean holdings while normal values lie between the two lines. In the period of crises (circled), safe assets like banknotes witnessed a rise in their demand, thus the banking department sought to meet this demand out of its note reserve (see Figure 5.3).
In order to satisfy the demand for the notes, assets were purchased from the private sector (known as discounting of bills) or loans were secured on those assets (known as advances). Figure 5.4 depicts discounts and advances spiking in the period of crises of balancing the decline in notes and coins in reserve.
On the other hand, the failure of the Bank of England’s note reserve in satisfying public demand for money during the crisis, resulted in a problem. In reference to the 1844 Bank Charter Act, the issue department was only permitted to print extra notes providing they were supported by gold.
In the time of crisis, successive governments permitted the bank to temporarily avoid this rule in order to meet the additional demand for notes. This indemnity was usually sufficient in itself to bring back stability in the markets and end the crises. The breaking of the rule only occurred in 1857, indicating the potential use of central bank balance sheets as powerful policy instruments.
5.3Composition of Central Bank Balance Sheet Liabilities
Central banks’ usefulness has expanded beyond the basic operations and collateral generally thought of as the mandate of the central bank. In studying their balance sheets in recent years, we have witnessed a significant number of uncommon uses. The activity beyond the fundamental ones is regarded as “unconventional” or “non-standard” or “non-traditional.”
Therefore, along with the reasons already discussed, there is a need to understand a normal central bank balance sheet, how central bank asset and liability compositions differ across countries, and how the crisis affected this composition—all require extensive explanation. This will be the main focus of both chapters 5 and 6 of this book. In order to achieve this, the main features of central bank balance sheets before the crisis, and how this composition has changed in response to the crisis, are analyzed. The remainder of Chapter 5 will look at the liability side of the ledger and Chapter 6 will look at the assets.
5.3.1Central Bank Liabilities in Normal Times
The major liabilities of central banks are mainly currency (banknotes) and reserves (deposits from banks and government kept at the central bank). Reserves are used to make payments among banks and to the central bank. Furthermore, some central banks issue deposits to the government, which are regarded as the government’s checking account at the central bank. The general central bank liabilities are depicted in Table 5.1.
Table 5.1: Typical central bank liabilities
| Assets | Liabilities |
| Currency Bank’s reserves Government deposits Capital |
Source: Eisner et al. (2018.)
In the analysis that follows, you will see large tables that include balance sheets of the United States, Europe, Switzerland, Australia, Norway, Mexico, South Africa, and Chile beginning with Table 5.2 for 2005 and 2006 (pre-recession), then moving on to Table 5.3, which covers recession years 2008 and 2009, and ending with looking at most recent data for 2016 and 2017 in Table 5.4. You should look carefully at these tables and see how each country differs and the impact that the recession had on the balance sheets. We will comment on the highlights in the text that follows. In Chapter 6, we will go through the same exercise for assets in the balance sheet. You will note that data may not be included for some countries in years where inclusion would not have significantly added to the discussion. We hope that in the process of reviewing these balance sheets you will learn a great deal about country-by-country variations, the impact of history and policy by looking at the balance sheets of this diverse group of countries.
5.3.2Snapshot of Selected Economies’ Performance before the 2007–2008 Crisis
As indicated in Figure 5.5, the economic performance of the concerned regions and countries improved from 2005 to 2006, with the exception of Australia, Norway and the USA. A substantial rise in economic growth was noticeable for Mexico and the Euro zone. For instance, the economic growth rate in Mexico increased to about 5 percent in 2006 from 3 percent in 2005. Similarly, the Euro area witnessed a rise in its growth rate from about 1.8 percent in 2005 to nearly 3.5 percent in 2006. However, the United States experienced a significant drop in its economic growth rate from about 3.5 percent to 2.5 percent in 2006. Other countries like Norway and Australia witnessed a slight fall of about 0.5 percentage point in their growth rate.
During these periods, the Fed’s liabilities were mainly made of currency in circulation, which constituted of 90 percent, whereas liability-side composition of other central banks like the European Central Bank (ECB), the Reserve Bank of Australia (RBA), and the Swiss National Bank (SNB) was diversified in the sense that banknotes in circulation did not exceed 50 percent of their total liabilities in these periods. However, their banknotes still accounted for the largest share.
For the case of emerging economies, their liability composition pattern replicated the structure observed in the advanced countries. South Africa’s economy was improved in 2006 despite a shift in the leading role from banknotes to deposit accounts. In addition, the composition of the Mexico’s central bank liabilities remained the same between 2005 and 2006.
5.3.3Country-by-Country Snapshots of Economic Structure Since 2005
We will start with an analysis of the economic structures of each selected central bank so that we have a general sense of the economies and variables pertinent to the central banks.
United States
The Federal Reserve ended adding to its balance sheet through bond buying programs and commenced the process of normalizing interest rates in 2015. Any rise in interest rates needs to be in line with inflation to reach the Fed’s inflation target in order to not trade-off the economic recovery.
The ending of unconventional monetary policy implies more tasks for its fiscal policy in stimulating domestic demand through well-targeted public investment. In addition, structural policies would support the normalization of monetary policy through boosting potential output growth and a neutral interest rate. These policies would provide resilience for monetary policy in addressing negative shocks, as well as mitigating the risk related to the lower bound of the target.
The fragmented nature of the financial regulatory system still exists in the United States and this might make necessary macroprudential policy measures complicated. In addition, the Federal Reserve is constrained in acting as a lender of last resort outside the banking sector.
The country was able to reduce the general government deficit in terms of gross domestic product (GDP) from 10.5 percent in 2009 to 4.4 percent in 2015, reflecting both the improving economy and a period of sustained and substantial consolidation since 2011. Similarly, the federal deficit declined from a peak of 9.5 percent of GDP to only 2.5 percent in 2015. The suspension of the federal debt ceiling until March 2017, and the approval of the Bipartisan Budget Act of 2015 that fully funded the government during 2016, would improve financial stability and support a path toward long-term fiscal sustainability.
Switzerland
During the recession time, the SNB adopted an ultra-low interest rate policy, and in 2011 put a cap on the domestic currency, franc against the euro. The quick economic recovery after the 2009 recession was substantially led by exports. Many immigrants are attracted to the country because of its dynamic and open economy. This also contributed to a significant part of the country’s robust economic growth. However, the policy of mass immigration initiated in February 2014 put quotas on immigration by 2017. This initiative poses a big challenge to a key source of Switzerland’s growth model, and reflects weak confidence.
The economy witnessed an internal shock when the SNB removed the franc ceiling in January 2015. This led to a sharp appreciation of the franc especially against the euro. Indirectly, it has affected its exports and growth as nearly as 70 percent of Swiss exports go to Europe, and the appreciation has been reducing consumer prices in the country.
The Swiss economy was adversely affected by the sharp 15 percent appreciation of the franc against the euro in early 2015, following the removal of the currency ceiling. The appreciation put an end to the trade-led drive in 2014. However, robust domestic demand led to 0.2 percent growth in mid-2015. There was a shift from consumption-related components to manufacturing, and Swiss households utilized the opportunity of strong domestic currency through involving cross-border shopping of about 30 percent (Bloomberg, 2015).
The declining global oil prices as well as currency appreciation contributed to a fall in consumer prices of 1 percent year-on-year in mid-2015. In order to be competitive with imports, Swiss companies were forced to reduce their prices.
Expansionary monetary policy with near-zero policy rates have been implemented since 2009; and the placing of ceilings on its domestic currency against the euro were observed between mid-2011 and the early 2015. Recently, the presence of negative interest rates was noted. However, with persistent negative inflation, real policy rates were relatively tight compared to nominal rates.
In late 2014, the SNB intervened in foreign exchange markets in order to protect the currency ceiling through accumulation of more reserves and expansion of its balance sheets. In December 2014, foreign currency reserves increased to about 7 percent of GDP because of interventions.
Owing to the presence of divergence in monetary policy between the United States and the euro area, this posed a challenge to the sustainability of the exchange rate ceiling. This resulted in the abandonment of the franc ceiling in January 2015. At the same time, the SNB reduced its policy rate further by imposing 0.75 percent on all deposits above a specific exemption threshold. The threshold was twenty times the minimum reserve requirement for domestic banks and was adjusted in relation to the amount of cash held. A threshold of Chf 10 million was placed on other account holders.
This expansionary policy is suitable for long-term very low or negative inflation, but it poses a challenge to pension funds in meeting their legal target returns on portfolios. In addition, this might lead to low-quality investment in other assets. This would lead to a situation where individuals and institutions hold cash instead of bank deposits (a “rush to cash”).
As the Swiss removed the exchange rate ceiling in January 2015, its domestic currency appreciated intensively against the euro but then reached about 1.05, which recorded a 12.5 percent appreciation. The value of the franc against the euro has fallen since September 2015 because of a decline in the volatility of the exchange rate market. This lowered safe haven effects, and the interest rate differential effect became more pronounced.
Norway
With the strong recovery in Europe, if continued, Norway’s exports would be further enhanced. Furthermore, Norway is not immune from the risks emerging in China and geopolitical risks. The movements in the global financial market influence the value of the sovereign wealth fund. A little change in the fund’s value poses short-term effects on the economy by influencing fiscal policy because its fiscal rule is connected to the value of the fund.
The country is in a very strong position to mitigate risks and shocks because of flexible monetary policy with a floating exchange rate that mixes with the wealth fund and fiscal framework. These measures reduce exposure to oil-price-related (and other) risks.
Its flexible inflation-targeting regime provides a good track record in achieving low and stable inflation. Its policy rate has been reduced recently, as of September 2015, the policy rate was 0.75 percent. Inflation had temporarily increased due to currency depreciation but is declining due to remaining economic slack.
Australia
The country’s current account deficit is huge but poses insignificant economic risks because a large share of foreign-held debt is either denominated in Australian dollars or is hedged against exchange rate volatility. In addition, the Australian government only issues in Australian dollars.
However, changes in U.S. monetary policy, uncertainties about Brexit, rising protectionism and revisions to China’s exchange rate may increase the global exchange-rate volatility that could influence the country’s trade.
The main measure for boosting aggregate demand in recent years has been monetary policy. Fiscal policy is used to address the issue of deficits following the huge fiscal expansion during the global financial crisis and thus a rise in public debt. The inflation rate in Australia has been low and its interest rate is higher than in the United States or the euro area. This makes the monetary stimulus consistent with the RBA’s medium-term inflation target band of 2 to 3 percent.
The present supportive stance of monetary policy remains effective especially in the absence of inflationary pressures. Nevertheless, accommodative policy might pose a risk of increasingly distorting financial markets, and particularly house prices, which have risen to very high levels. The normalization of rates is required but the timing and pace will be subject to developments in growth, employment, inflation, and the housing market.
The global financial crisis did not result in systemic bank failures in Australia but encouraged tighter regulation and alteration in banking practices. This led to adjustment of banks’ funding composition from short-term debt toward deposits.
Chile
The large depreciation of the exchange rate puts a lot of pressure on prices despite well-anchored inflation expectations. Inflation increased to 4.7 percent in 2014, beyond the central bank’s target range of 2 to 4 percent. High inflation has remained for a number of quarters in recent years. The exchange rate depreciation significantly influences net exports mainly through its impact on imports. However, the stimulus to export could not yield the expected result because of the following: the appreciation of the dollar influenced all currencies including the peso in Latin America, relatively high currency depreciation was notable in Brazil and Colombia; weakening external demand in China and Latin America exceeded the expansionary effect of the peso depreciation; and the continuous decline in the exchange rate elasticity of industrial exports arising from the further integration of trade linkages.
The Chile’s central bank increased its interest rates from 3 to 3.25 percent in mid-October 2015 due to the headline inflation above the policy target. However, further increases in interest rates might not be effective because the recent inflation has been substantially attached to exchange rate depreciation. Slow domestic and external activity as well as a recent fall in commodity prices indicate the likely chance of a reduction in price pressures. Nevertheless, if expectations are continuously above the target, this might require some further monetary tightening.
The country had a current account surplus because of a fiscal rule, which allowed fiscal surplus to be saved in the sovereign wealth fund during much of the commodity boom. Its fiscal surplus increased from 2 percent in 2004 to over 7 percent of GDP in 2007, encouraging the country to keep more than 10 percent of GDP in its sovereign wealth fund. Then the surplus turned to deficits due to the counter-cyclical response to the 2009 global financial crisis, reconstruction spending related to the 2010 earthquake and tsunami, and the rise in production costs in mining. However, the government was able to respond counter-cyclically to the 2014 slowdown in activity, as well as sustain aggregate demand because of the near absence of net debt.
Mexico
Its economic performance is good in the midst of these shocks. The good performance is driven by domestic demand as well as structural reforms that support a low inflation environment and strong expansion of credit, resulting in gains in real wages and employment. The great depreciation of the peso further boosts the competitiveness of Mexican non-oil exports and does not lead to high inflation. In addition, it generates a positive effect on the fiscal balances, indicating the dollar denominated oil receipts and the low exposure to foreign currency debt. Concomitantly, the sufficient resources that have been saved in the oil stabilization fund put the country on the appropriate track with its fiscal consolidation trajectory without additional measures.
The huge depreciation of the peso during 2016 will continue to boost international trade, with insignificant pass-through to domestic prices, pushing inflation to converge toward Mexico’s central bank target band (3% + or –1%).
Oil-related activities constituted about 13 percent of GDP in Mexico until the mid-2000s. However, falling oil extraction from the national oil company (PEMEX) for the past decade has significantly affected the oil-GDP contribution, which declined to nearly 8 percent in 2016. The main source of Mexican government revenue is oil-related receipts and exports. The oil sector also serves as the key source of foreign exchange receipts. The country’s revenue dramatically reduced in recent years because of the collapse of oil prices. The tax reforms boosted the government revenue from taxation.
The Bank of Mexico has been able to control inflation within its target band despite the large depreciation of the peso. The policy rate was increased to 5.75 percent in December 2016. The purpose of this rise was to manage inflationary pressure arising from the significant depreciation of the peso. These actions were done based on the related monetary decision of the U.S. Federal Reserve and the output gap. The country halted foreign exchange intervention in February 2016, which was aimed at providing liquidity to the peso market and preserving its orderly functioning. Mexico reestablished and raised its access under the IMF flexible credit line (FCL) in May 2016. These measures allowed the central bank to control inflation expectations.
A wide range of macroprudent measures were enacted following the Tequila crisis in the mid-1990s. In addition, the country implements some appropriate regulation in relation to foreign exchange (FX) exposure such as limits to FX net open position of banks. Nevertheless, the country needs to closely monitor currency mismatches and balance sheet risk, given the recent significant depreciation of the peso.
South Africa
Its current account deficit has shrunk due to a slowdown in growth that reduced imports, but low saving rates made it huge. The country’s terms of trade (price of exports/price of imports) figures were favorable because of currency (rand) appreciation in 2016 and the pick-up of global commodity prices. Portfolio investment flows are used to finance the current account, which leads to high exposure to a reversal in capital flows. In 2016, South Africa witnessed huge equity outflows partially covered by bond inflows, indicating investors’ portfolio arbitrage and political uncertainty.
Foreign-owned debt at 41 percent of GDP in 2016 is higher than the percentage of the other emerging countries. Most of the external debt of the government is denominated in rand while external debt related to state-owned enterprises (SOEs), banks, and corporates are in foreign currency. SOEs are demanded to hedge their foreign currency risk, but the cost of doing that might rise because of the downgrade of the SOE’s credit ratings.
The country’s inflation rose from 4.6 percent in 2015 to 6.4 percent in 2016 due to currency depreciation and the drought-related rise in domestic food prices. From the domestic view, the confidence level in the economy is shaken given changes in the political environment. Private investment could further be constrained by a rise in political tension. From the global perspective, the local currency is highly sensitive to U.S. interest rates, thus increasing its exposure. Furthermore, with the United Kingdom, being its largest European trading partner, mean that the country’s imports and financial flows may be affected by uncertainty about the Brexit.
The monetary policy operation takes place in a difficult environment of high inflation and low growth. Inflation exceeded the Reserve Bank’s target band (3–6 percent) throughout 2016. This was as a result of delayed exchange rate passthrough following the substantial depreciation of the rand throughout 2015. A long-lasting drought further created pressure on agricultural prices in 2016 but there was a huge fall in prices, which pushed the headline inflation down into the target band. Stable core inflation was witnessed throughout 2016 but at the upper limit of the target band.
The reserve bank maintained the purchase rate at 7 percent from March 2016 until reducing it by 25 base points in 2017. With a long-term fall in inflation, monetary policy would have room for adopting accommodative measures. On the other hand, if the rand value falls as U.S. monetary policy continues to tighten, this would impose pressure on inflation.
The country’s stock market exhibits more volatility than many other emerging countries due to the fact that its currency is mainly driven by external factors such as U.S. monetary policy, and national policy uncertainty.
ECB
The ECB was established on June 1, 1998. A year after the creation of ECB, the common currency euro was launched in January 1999. The ECB was tasked with the responsibility of maintaining price stability in the region. The extent of attaining the mandate influences its credibility and the public confidence in it. The procedures on the law related to the European System of Central Banks (ESCB) and the ECB supplied the financial resources in terms of capital, foreign reserve assets, and monetary incomes, that was required for the functioning of the ECB.
The ECB executes its tasks through conducting monetary policy, with the main aim of not generating profit. The successful implementation of its tasks is strongly attached to solid financial means. New activities emerged as new EU member states adopted the euro. This led to the transfer of the foreign reserves from the Eurosystem national central banks (NCBs) that created a remunerated EUR-denominated claim of the NCBs on the ECB. In addition, the ECB was exposed to the interest rate gap between the interest earned on investments (mainly in U.S. dollars) and the interest paid on the foreign reserves to the NCBs (in EUR) because of this transfer approach. Seigniorage (interest income from the allocation of euro banknotes within the Eurosystem) mainly boosted the ECB interest income since 2002.
The ECB is involved in different activities connected to these special operations, which influenced its balance sheet. The two important factors that influence the changes in the composition and values of the foreign reserves and own-fund portfolios, are financial market development and portfolio management. The ECB provided liquidity operations by acting as an intermediate in the provision of foreign currency to Eurosystem counterparties, and the supply of euro to other central banks. This operation led to a rise in the level of the balance sheet that occurred at the end of 2008.
The key driver of the ECB operation is the ECB banknotes issuance, which has significantly risen over time and gradually increased the balance sheet. The ECB’s foreign reserve holdings are made up of gold and net assets in foreign currency, which account for their considerable size on the balance sheet. These foreign reserve holdings allow the ECB to execute foreign exchange operations, which are among its fundamental mandates. Intervention on the foreign exchange market as well as decisions relating to the ECB foreign reserve management influence the amount of these holdings. The value is attached to asset price movements while the euro equivalent of the external reserve holdings relies on exchange rate developments for the underlying assets.
The ECB manages its own funds in terms of its paid-up capital and reserves. These funds are invested in euro-denominated assets whose value depends on asset price movements. The foreign reserves accounted for 66 percent of the ECB total assets in 1999 but its share reduced to 35 percent by 2006 as other items especially banknotes, which were added to the total in 2002, witnessed strong growth thereafter. The significant share of the ECB foreign reserve is kept in foreign currency mainly in U.S. dollars and Japanese yen while the remainder of its holding are in gold.
At the commencement of 1999, the ECB foreign reserves were made up of nearly US$35 billion, JPY 445 billion and 24 million ounces of gold. The amount changed as its capital, which determines the contribution of each ESCB member altered or an EU member state adopted the euro. This led to small structural breaks. However, the key reason the central bank keeps foreign exchange reserves is to serve as potential interventions on the currency markets, in order to protect their own currency. In the autumn of 2000, the ECB executed this purpose in the foreign exchange market because of the continuous depreciation of the euro since the onset of 1999. The effort was exerted by the ECB in September 2000, together with the monetary authorities of the United States and Japan, but the ECB executed its own measure in November 2000. These actions were responsible for the fall in the dollar and yen reserve volumes at the end of 2000. Shortly thereafter, the yen reserves were restored at the expense of U.S. dollars.
The revenue generated from the sales of the ECB gold was mainly invested in Japanese yen. This contributed to a sharp rise in the Japanese yen reserves in the ECB foreign reserve holdings. Foreign currency portfolios were composed of 90 percent in U.S. dollars and 10 percent in Japanese yen in 1999. The composition pattern remained the same until 2003, with the exception of 2000 when the ECB intervention led to the sale of the Japanese yen but later readjusted against the U.S. dollar.
The decision of the Governing Council created a rebalancing of the foreign currency reserves, which was executed from the first half of 2004. The gradual adjustment of foreign currency shares resulted in 80 percent in the U.S. dollar and 20 percent in the Japanese yen by early 2008, and then to respectively 78 percent and 22 percent at the end of 2009 because of the depreciation of the dollar against the Japanese yen.
In addition to ongoing investment gains and losses in the volume and composition of foreign reserves, liquidity and security are the key drivers for the investment of the ECB reserves. The foreign reserve management is based on ensuring liquid resources for any foreign intervention at any point in time. In 2000, the interest income gained was utilized to stabilize the currency split but this policy ended afterward mainly due to the intervention later in 2000, thus leading to huge U.S. dollar outflows.
The first weakening of the euro against the dollar occurred up to 2001. The euro began to appreciate following the foreign exchange intervention in late 2000. Strong appreciation of the euro was observed between 2002 and 2004 mainly connected to a deterioration of the growth outlook for the United States, the widening U.S. current account deficit, and geopolitical tensions. The euro depreciated in 2005 but gained its strong currency value at the onset of 2008. The continued appreciation of the euro was linked to a dynamic market evaluation of the relative cyclical outlook for the economic areas in favor of the euro area, as well as developments in interest rate differentials. On the other hand, the weakness of the U.S. currency is driven by the persistently huge current account deficits. In the period of the financial crisis of 2008, the euro value substantially dropped against the United States up to the first quarter of 2009, but rose by the end of 2009.
The price of gold continued to witness an upward trend since 2004, because its price gained from the rise in inflation and commodity prices as well as from the U.S. dollar depreciation. This served as a safe haven during the global financial distress that commenced in mid-2007. The persistent rise in the price of gold accounted for an increase in the euro equivalent of the gold holding by 78 percent at end 2009 despite the gold sale strategy adopted by the ECB. The shares of different assets in the composition of foreign reserve holdings changed in favor of gold and the yen.
From mid-2007 onward, the challenge of much higher liquidity needs from the banking sector manifested in the Eurosystem and other central banks because of disruption of the euro and other money markets. The Eurosystem responded to the challenge by providing the necessary liquidity to direct the short-term interest rate to its target, performing the role of a lender of last resort, and extending its operations in order to maintain financial stability.
The ECB plays the role of coordinating monetary policy of the ECB while NCBs are saddled with the execution. In addition, the ECB performs other roles in order to provide foreign currency to Eurosystem counterparties. These additional operations commenced at the end of 2007, and made a significant impact on the size of the ECB balance sheet.
The ECB initiated U.S. dollar-liquidity providing operations in connection with the U.S. dollar term auction facility (TAF) during the period of December 2007–January 2010. This measure was used to provide a temporary reciprocal currency arrangement. The magnitude of the arrangement was sometimes adjusted in order to accommodate rises in needs. The initial arrangement ended in February 2008, but relaunched after a month due to rising tensions in the run-up to the rescue of U.S. investment bank Bear Stearns. The tensions increased further because of the uncertainty created by the collapse of Lehman Brothers.
Foreign exchange swap tenders were established by the Eurosystem with its counterparties against euro cash at a fixed price agreed in swap points. Foreign exchange swaps with the United States were ended in January 2009 because of limited demand.
The ECB experienced difficulty in accessing Swiss currency funding. This led to the establishment of a swap arrangement with the SNB in order to provide Chf to counterparties against EUR. After January 2009, one-week EUR/Chf foreign exchange swaps continued to supply Swiss francs with the aim of improving liquidity in the short-term Swiss franc money market. The SNB kept an account with the ECB for the placement of EUR funds obtained by the SNB from the same type of operations with other central banks and from its counterparties.
5.3.4A Look at the Balance Sheets: 2005 and 2006
Let’s start with the United States. Currency accounted for the largest share of U.S Federal Reserve balance sheet liability before the crisis. In December 2006, currency constituted 90.2 percent of the Fed’s liabilities, while reserves and government deposits accounted for the remaining percent. Currency is a significant liability on most central bank balance sheets in normal periods, but the U.S. dollar’s use as a standard (of sorts) around the world, accounts for this significantly high percentage (see Table 5.2).
In the same vein, about 50 percent of the ECB liabilities were linked to banknotes in circulation in 2005 and 2006. The banknotes in circulation accounted for the largest share for the European union, followed by the intra-Eurosystem liabilities, while the liabilities to noneuro area residents had the lowest share (see the second section of Table 5.2).
More than 40 percent of the SNB (Swiss) liabilities were banknotes in 2005 and 2006. In addition, as total liabilities of the SNB increased by CHF 2825.3 million between 2005 and 2006, its banknotes in circulation rose to CHF 43,182.2 million in 2006 with an increase of CHF 1,815.7 million. However, the largest share of a rise in the two periods was attributed to the distribution reserve component (see the third section of Table 5.2).
Australian notes on issue (banknotes available and put in circulation) accounted for the largest share of RBA liabilities in 2005, but in 2006, deposits took the leading role, followed by the banknote component. Other components constituted less than 15 percent of the RBA aggregate liabilities (see the fourth part of Table 5.2). The reason behind this is that the RBA are in charge of issuing and distributing banknotes to commercial banks. Commercial banks directly buy banknotes from the RBA. In addition, the RBA holds a certain amount of banknotes in order to meet seasonal and other fluctuations in demand. The country’s current account deficit is huge, but poses insignificant economic risks because a large share of foreign-held debt is either denominated in Australian dollars or is hedged against exchange rate volatility. Furthermore, the Australian government only issues in Australian dollars.
Deposits including the government pension fund, recorded the largest share of the Norges Bank balance sheet liabilities with about 80 percent in 2005 and 2006. Treasury deposits accounted for the largest of the Norges Bank domestic liabilities in 2005 and 2006, while borrowing took the leading role in the total foreign liabilities (see Table 5.2). The Norges Bank was the only advanced central bank that witnessed a fall in its deposits in 2006. This decline is as a result of changing its financial system which was initially dominated by domestic banks. At the end of 2005, there was a considerable increase in the activities of foreign-owned banks in Norway to the extent that they had a market share of over 30 percent of the total assets. In addition, their lending growth was relatively high for several years. However, it poses a big challenge to the Norges bank in terms of supervision and crisis management. The inclusion of the borrowing item on the Norges Bank liabilities can be traced to the growth rate of foreign bank activities in the country.
Table 5.2: Central bank liabilities (2006 and 2005)
In other central banks, reserves accounted for a much larger share of their liabilities before the crisis. The reason for the large amount of reserves in normal times is to encourage a smooth running of interbank payments. If reserve supply is small, the focus of banks would be on running out of reserves at the end of the day. Thus, this might lead to a delay in payments to other banks, which can create “gridlock” and affect the confidence in the banking system.
For example, the Norges Bank balance sheet had liabilities in which about 50 percent was attributed to treasury deposits at the end of 2006. Only 16 percent of them were represented by currency. Currency and reserves are considered as immediate maturity liabilities because of instant transfer to other parties for payment. It is worth noting the extreme difference between the currency numbers in the United States and that of Norway.
In addition, some central banks issue term maturity liabilities, in the form of either term deposits (available to counterparties that have a central bank account) or term repos (which are collateral and available to counterparties beyond depositing institutions who do not have a central bank account).
Some central banks can issue bills to non-account holders in the secondary market while others limit primary issue to account holders. Term liabilities are issued to decrease the quantity of reserves in the system and also to control the central bank’s target interest rate. For example, the ECB, the Fed, and the RBA have been adjusting term deposit facilities and repo instruments to have longer maturities than overnight.
5.3.4.1Central Banks’ Balance Sheet Liabilities of Emerging Economies
Thus far we have examined the balance sheets of influential established economies albeit with different histories. We now look at countries that are considered in some ways as emerging, having diverse histories. We will start with Mexico. In Mexico, currency in circulation constituted about 40 percent of the Bank of Mexico’s balance sheet liabilities as of the end of 2006. Monetary regulation deposits, for historical reasons, recorded a very significant share in the composition as indicated in Table 5.2. The historical reasons emanated from the two significant financial crises occurring in Mexico in 1982 and 1994. Prior to the early 1980s, the Mexican economy adopted strong protectionist economic policies that included high trade barriers in several key industries like the automotive industry. After the 1982 debt crisis, the country’s trade policy shifted toward unilateral trade liberalization to attract foreign investment. This made Mexico more competitive in non-oil exports. However, the country suffered another financial crisis in 1994–95 that was caused by a number of complex financial, economic, and political factors. Its monetary stimulus to the crisis was to replace the fixed exchange rate policy with a floating exchange rate regime. This led to strong depreciation of the peso by nearly 50 percent with six months, thus putting the country into a deep recession. Its currency steadily weakened through the end of the 1990s, which resulted in greater exports, and boosted its exporting industries. Nevertheless, there was a sharp increase in import prices along with low terms of trade. The United States and International Monetary Fund provided a supporting mechanism to the Mexican government through an emergency financial support package made up of US$50 billion loans, in which the U.S. Treasury provided the largest share. In addition, Mexico adopted tight monetary and fiscal policies to stem inflation and mop up some of the costs of the banking crisis. In order to prevent the occurrence of the financial crises, monetary regulation deposits took the huge share of its liabilities.
The largest share of the South Africa Reserve Bank (SARB) liabilities was attached to notes and coin in circulation in 2005 but shifted to deposit accounts in 2006. In addition, the contingency reserve account increased from 0 in 2005 to 1,824,430 rand in 2006 (see Table 5.2). The shift toward deposit accounts in 2006 can be traced to the modification of SARB’s repo-based refinancing system adopted in March 1998. The system was adjusted in September 2001 and later in May 2005 in order to provide liquidity to the private sector. This allowed private sector banks to meet their daily liquidity requirements.
Table 5.2 shows that the significant portion of the Bank of Chile’s liabilities was attached to its banknotes and coins in circulation in 2006. This could be linked to the implementation of monetary easing in Chile with the purpose of ensuring consistency with the inflationary outlook rather than to reestablish the operation of credit as done in other countries. Reductions in the Bank of Chile’s interest rate have been consistent with the prevailing economic circumstances. This also reflects its negative capital and reserves on bank liabilities.
5.3.5Snapshot of Selected Economies’ Performance during the 2007–2008 Crisis
With the inception of the global financial crisis in 2007, all concerned countries and regions excluding Australia, witnessed a huge fall in their economic growth rate. The sharpest decline was observed in the United States, Euro area, and Norway between 2007 and 2008 (see Figure 5.6). The economic performance was even worse in 2009 when all countries with the exception of Australia experienced a negative growth rate, as indicated in Figure 5.6. The worst economic performance was observed in Mexico and the Euro area with a negative growth rate of more than 4 percent in 2009.
5.3.5.1Central Bank Liabilities during the 2007–2008 Crisis
In the period of the global financial crisis, about 90 percent of the Fed liabilities were banknotes, while other components accounted for the remaining share. This implies that there was no change in the composition of the Fed liabilities before and during the crisis. In addition, the Fed initiated its bond buying program in 2008, in order to inject capital into the market with the aim of boosting the economy. This set the pace for the use of unconventional monetary policies especially QE in stimulating economic activities.
The banknotes accounted for almost 40 percent of the ECB liabilities in 2007 and 2008, indicating a decline in the banknotes share compared to 2005 and 2006. The total liabilities of the ECB recorded an increase from about £102billion in 2005 to £2,075 billion in 2008. The components of the ECB liabilities witnessed an increase with exception of deposits and fixed term deposits (see Table 5.3). The ECB’s balance sheet expanded gradually because of the strong demand for euro banknotes. According to the EU Treaty, the ECB is given the exclusive right to authorize the issuance of euro banknotes. In reality, the NCBs circulate the euro banknotes while a share of 8 percent of the total banknotes in circulation is assigned to the ECB. Since 2002, euro banknotes were in circulation, and the ECB’s share is indicated on its balance sheet, thus implying a claim by the ECB on the NCBs, as the ECB itself does not put banknotes in circulation. The decline in the ECB banknotes was a result of low demand for banknotes in the region. The demand for banknotes influence the ECB notes, which are based on fixed percentage shares of the region’s banknotes.
As at the end of 2008, the banknotes in circulation accounted for the largest proportion of the SNB with about 20 percent as in Table 5.3. Cash in Switzerland has restored its value since 2008 due to a persistently low level of interest rates, which increased the demand for banknotes. Furthermore, cash holdings became more attractive because of the financial market and sovereign debt crises.
The banknotes and deposits components had a share of more than 80 percent in the RBA liabilities in 2007 and 2008. At the end of 2008, Australian notes on issue constituted the largest share of the total liabilities, seconded by the deposit component (see Table 5.3). As other advanced central banks experienced a rise in their deposit accounts, RBA recorded a drop in its deposits because the global financial crisis did not result in systemic bank failures in Australia but encouraged tighter regulation and alteration in banking practices. This led to the adjustment of the banks’ funding composition.
Unlike other central banks in selected developed economies, the Norges Bank reduced its banknotes in circulation between 2007 and 2008. This may be attributed to the pattern of conducting monetary policy in Norway. The Norges Bank implements its monetary policy by weighing the inflation outlook against developments in output and employment. Therefore, it is less worried about inflation than if real economic prospects are also weak. The flexible inflation targeting adopted by the Norges Bank makes monetary policy significant in stabilizing the economy. This encouraged rapid adjustment in the policy rate in response to the crisis in 2008.
Table 5.3: Central banks’ liabilities (2008 and 2007)
In the era of the 2007–2008 Global financial crisis, the composition of the Norges Bank balance sheet liabilities remained similar to the pre-crisis composition. This implies no significant changes in the liability-side composition from 2005 to 2008 (see Table 5.3).
5.3.5.2Central Banks’ Balance Sheet Liabilities of Emerging Economies
With reference to Table 5.3, currency in circulation still had the largest share of the Bank of Mexico aggregate liabilities, followed by government securities deposits. The pattern of South Africa’s SARB liability composition remained unchanged in 2007 and 2008, as deposit accounts still made up the largest percent. As at the end of 2007, banknotes and coins in circulation maintained its leading role in the composition of the Bank of Chile’s balance sheet liabilities. However in 2008, central bank bonds accounted for the largest share (see Table 5.3). The Chilean economy was able to wipe out its negative capital to zero value in 2008. There was a remarkable deterioration on Chile’s external demand and financial conditions between August 2007 and August 2008. A rise in global inflation from high global food and energy prices caused the country’s inflation to rise to 9 percent by mid-2008. The tight monetary policy from the Bank of Chile in response to the crisis led to substantial appreciating pressure on the peso during 2008. This contributed to turning the negative value of capital into positive value at the end of 2008.
5.3.6Snapshot of Selected Economies’ Performance Today
As illustrated in Figure 5.7, all economies witnessed a positive economic growth rate by the end of 2015. In Figure 5.7 the locations are listed in the order they are presented in the chart (front to back). The United States economy (in the back of Figure 5.7) experienced the highest growth rate of about 3 percent, followed by Mexico with about 2.5 percent, while South Africa and Switzerland recorded the lowest rate with less than 1.5 percent. By the end of 2016, all the countries witnessed a decline in their economic growth rate with the exception of Australia whose economy grew from 2 percent in 2015 to about 2.5 percent in 2016. A substantial fall was recorded for the economy of South Africa from 1.5 percent in 2015 to less than 0.5 percent in 2016. During these periods, the liability-side of the central banks’ balance sheets were structurally changed except for the case of Australia whose banknotes still accounted for the largest share. For instance, in the ECB liability components, half of its total liabilities were shared by banknotes and liabilities to euro area credit institutions, while SNB’s liabilities were mainly made up of domestic banks’ deposits.
United States
The U.S. economy has been able to restore its economic growth rate seven years after the global crisis. This made its economic growth outweigh its pre-crisis peak by 10 percent. The country recorded robust private-sector employment gains that significantly reduced its unemployment level, and the restoration of fiscal sustainability. The improvement in its economic performance is attributed to robust monetary policy support and an early fiscal expansion. The creation of many private-sector jobs reduced unemployment to its pre-crisis level, thus providing consumers with higher incomes and enhancing their confidence. However, the country has not addressed its long-term puzzles especially the continuous slowdown of productivity growth since the mid-2000s. The slow speed of its economic recovery is a result of the severity and depth of the financial crisis, world trade stagnation driven by the slowdown of China and lower demand from oil-exporting countries. The effective exchange rate has significantly appreciated since mid-2014 in real effective terms. Its fiscal policy has had no significant effects after several years of budget consolidation. Monetary policy is highly accommodative even after the Federal Reserve halted the expansion of its balance sheets and commenced with a gradual increase in its interest rates from very low levels.
Switzerland
The Swiss economy recorded robust economic growth after the 2009 recession. This growth was mainly driven by low interest rates, high immigration, and an exchange rate ceiling until early 2015, which enhanced robust export growth. The Swiss economy has been witnessing low or negative inflation over the past four years, as a result of its strong currency. Its short-term economic performance was hurt by the sharp appreciation following the end of the currency ceiling.
Norway
The discovery of commercially viable offshore oil and gas fields in the late 1960s contributed to the economic transformation in Norway. This led to the achievement of its high per capita GDP. The improvement in its living standard was attributed to good macroeconomic management of the oil wealth through the sovereign wealth fund and the associated fiscal rule. Its economic activity has been enhanced by inflows of labor from other European Economic Areas (EEA).
A sharp fall in the global oil prices in mid-2014 provided a timely reminder of the relevance of a flexible, competitive, and productive mainland economy as well as floating exchange rate in addressing external shocks and developing balanced growth, once the income from petroleum commences to fade. The aggregate output growth in Norway continued to fall in 2015 as the sharp drop in oil prices in 2014 hampered oil-related activity. Oil sector investment began falling prior to the decline in oil price as a result of cost-reduction campaigns by the oil industry.
Australia
Over the recent decades, Australia witnessed robust economic growth driven by strong macroeconomic policy, structural reforms, and the long commodity boom. Low interest rates boosted its aggregate demand, triggered risk-taking by investors, and drove house prices as well as mortgage lending to historical highs. The country recorded an impressive twenty-five consecutive years of output growth. The rebalancing of the economic activity from commodity investment to other activities is well-implemented through monetary and fiscal policies, currency depreciation, and flexible labor and product markets. Despite this, its economy shares the global risk of a low-growth trap; the country’s productivity is in line with its longer-term average.
At present, the country faces the risk of low growth and lackluster private-sector investment arising from pessimistic expectations and weakening global trade.
Chile
Chile’s economy recorded a long period of strong growth as well as improved living standards, which significantly reducing its poverty level. Its growth was safeguarded from the large commodity price volatility including the recent decline in copper prices through a sound macroeconomic framework and flexible exchange rate. However, the country still requires further economic expansion beyond extracting natural resources, and enhanced knowledge-based contribution to global value chains by implementing productivity-enhancing structural reforms.
Chile’s economic reforms, such as trade and investment liberalization and the sound macroeconomic policies, have managed its inflation and smoothed economic cycles, thus mitigating uncertainty and boosting investments. Added progress can be made through economic transformation toward a more knowledge-based and innovative economy, complemented with more firms that can participate and improve their activities in global value chains.
The country being the largest producer of copper in the world, gained substantially from the upsurge in commodity prices and the environment of low global interest rates in the recent commodity supercycle.
The investment growth rose from about 2 percent of GDP in 2002 to almost 7 percent in 2012 due to the capital intensive nature of mining activities. This led to multiplier effects of other sectors especially construction. On the other hand, the opposite side of increasing commodity prices has appeared because of weakening copper prices. The falling copper price is anticipated to remain in the future. The mix of lower copper prices and higher costs has adversely affected mining profitability, thus sharply reducing investment. Household incomes declined as a result of lower terms of trade, and this led to low private consumption. The country’s output growth reduced sharply in 2014.
South Africa
For the past few years, South Africa’s economy grew weak as a result of low consumer demand, persistently declining business environment, policy uncertainty, and the prolonged drought. However, the country is considered as a regional hub for financial services because of a sophisticated banking system and deep financial markets. Supply-side constraints in the form of electricity shortages, falling commodity prices, and policy uncertainty significantly trended down its growth since 2011.
Furthermore, the country confrontations with many structural hindrances, such as high inflation, limit room for monetary policy support; high public debt constrains public spending; high costs of doing business weaken competition; and political uncertainty affects investment and confidence. Therefore, the country is in need of structural reforms that would enhance its economic potential.
Mexico
Its economy is globally ranked as the world’s fifteenth largest economy in terms of GDP, just behind Australia. Over the past thirty years, the country witnessed tremendous structural changes that shifted its economy from an oil-dependent economy up to early 1990s to a manufacturing center in the aftermath of NAFTA in the mid-1990s. Presently, the country is increasingly becoming an international trade hub. Mexico’s peso and the competitive advantage rising from its proximity to the U.S. export market, now make it a top global exporter of cars and flat screen TVs, among other products. In 2016, the Mexico’s GDP was close to US$1.08 trillion.
However, the country is undergoing a difficult external environment due to weak global trade, investment, productivity and wages, and uncertainty about the future evolution of economic and trade policies in the United States. Mexican related headwinds entail collapsing oil prices, which led to a fall in government revenue as well as energy sector investment, the sharp depreciation of the Mexican peso as a result of tight market expectations of the U.S. Federal Reserve, and increasing global policy uncertainty. The country is anticipated to witness a drop in its economic performance by the end of 2018 because of the above-mentioned difficulties facing its economic activities.
5.3.7Central Bank Liabilities Today
As shown in Table 5.4, the liabilities to euro area credit institutions took the leading role from the banknotes component in 2016 and 2017, with a slight difference of about £200billion in 2016, growing to a huge margin of about £700billion in 2017. Both banknotes and liabilities to euro area credit institution components accounted for more than 50 percent of the ECB total liabilities in 2016 and 2017.
As at the end of 2016 and 2017, the size of deposits of domestic banks constituted more than half of the SNB total liabilities, followed by equity and banknotes in circulation. This indicates how the composition pattern of the SNB liabilities changed over the past decade (see Table 5.4).
Deposits and banknotes still accounted for the largest share of the RBA liabilities in 2016 and 2017. However, the Australian notes on issue had the highest share in 2016, followed by deposit component. At end of 2017, the deposit component constituted the largest with about 50 percent (see Table 5.4).
More than 90 percent of the Norges Bank liabilities were deposits including government pension fund in 2016 and 2017. Total financial liabilities recorded the second largest share of the aggregate liabilities.
The ECB’s banknotes in circulation fell as the Norges Bank’s deposit also reduced between 2016 and 2017. The decrease in the ECB’s banknotes is influenced by the demand for banknotes among the NCBs in the region. The Norges Bank’s policy rate remained at 0.5 percent in 2017, after being slashed by 100 basis points between December 2014 and March 2016 in response to the oil-induced economic slowdown. Expansionary monetary policy was widely considered in 2017 as the country experienced a continued negative output gap, low international interest rate, and 9 percent inflation (below the target). However, rapid house price growth and a high and increasing debt burden for Norwegian households are recognized as the building up of financial imbalances in the country. This was the reason for the reduction in demand for banknotes, which resulted in the fall in banknotes in circulation.
Table 5.4: Liabilities (2017 and 2016)
5.3.7.1Central Bank Liabilities Today : A Case Study of Emerging Economies
The composition pattern of the Bank of Mexico in terms of liabilities remains unchanged before, during, and after the financial crisis, except for the amount of bank deposits in current accounts, which witnessed a significant increase from $1 million in 2008 to $515 million in 2016 (see Table 5.4).
As indicated in Table 5.4, the total liabilities of SARB recorded a decline between 2016 and 2017. This decline was attributed to a significant drop in the SARB’s debentures. However, both notes and coins in circulation, and deposit accounts still constituted the largest percent of the total liabilities. A huge decline in the SARB’s debentures was driven by its political chaos. South Africa’s credit was downgraded to junk by the S&P Global Rating and Fitch Rating in April 2017 after President Jacob Zuma sacked Pravin Gordhan as finance minister. The continued political uncertainty in South Africa showcases the bad image of its securities in the global financial market and makes investors lose their confidence in the country.
In Chile, banknotes and coins in circulation recorded the highest share of the total liabilities reported in Table 5.4 at the end of 2015 and 2016. However, there was a slight decrease in its total liabilities between 2015 and 2016, which was significantly attributed to a fall in Bank of Chile bonds. The privatization of the pension system in 1981 transformed the Chilean economy from being one of Latin America’s poorest countries to the richest country in the region. This remarkable achievement was notable when pension funds were utilized in stimulating its nascent capital market. Recently, the country is facing the problem of insufficient savings from the pension scheme because of inconsistent payments and large informal economic settings. This might be linked to the decline in the Bank of Chile’s bonds.
Conclusion
In summary, this chapter provides robust insights on the heterogeneous evolution of liability-side components of central bank balance sheets in different economies at different periods (pre-, during, and post-2007–2008 global financial crisis). The next chapter will focus on the asset-side components of central bank balance sheets and how these differ with respect to countries in economic periods.
Questions
- What is the evolution pattern of liability-side components of central bank balance sheets in advanced countries before, during, and after the 2007–2008 global financial crisis?
- What is the heterogeneous nature of liability-side components of central bank balance sheets in developing countries pre-, during, and post-2007–2008 era?
- What are the similarities and differences between the pattern of liability-side composition in advanced economies, and emerging and developing countries?
- What is the link between the structure of central bank’s liabilities and economic growth before, during, and after the 2007–2008 crisis?
- For each country, what changes took place in their balance sheets from 2007–2008 to 2016? Why?