Chapter 6
Composition of Central Bank Balance Sheet Assets
Central banks obtain assets through purchasing assets or making loans. If a central bank buys an asset, for example, a bond, it makes a payment by creating reserves or currency. This leads to an increase in its assets and liabilities by equal amounts. In the same vein, a central bank creates the new reserves that are lent if it spreads a loan. Banks are often considered as central bank’s counterparties, but some central banks accept nonbank counterparties. In a normal period, central banks’ assets mainly consist of government bonds, foreign exchange reserves, and loans to banks. Nevertheless, the relative significance of these assets differs substantially across central banks. Before the crisis, changes in the amount of a central bank’s asset were usually insignificant and possessed no influence on monetary policy.
Prior to the crisis, the Fed’s balance sheet was relatively simple, in which U.S. Treasuries accounted for about 90 percent of its assets as of December 2006. This is almost the same with the quantity of outstanding currency (see Table 6.1).
6.1Central Bank Assets in Normal Times
As depicted in Table 6.1, Intra-Euro system claims accounted for about 50 percent of the European Central Bank (ECB) assets in 2005 and 2006. The largest component of the SNB assets in 2005 and 2006 was foreign currency investments, followed by gold holdings (see Table 6.1). The Reserve Bank of Australia (RBA) assets were mainly driven by foreign exchange in 2005 and 2006. The foreign exchange component accounted for about 70 percent before the occurrence of the global financial crisis (See Table 6.1).
Prior to the global financial crisis, the asset-side of the Norges Bank balance sheet was significantly composed of investments for the government pension fund. Domestic financial assets accounted for the least share of the entire assets of the Norges Bank (see Table 6.1). As the Fed and the ECB reduced their gold holdings, the Swiss National Bank (SNB) and the RBA increased the amount of gold holdings in foreign reserves. The need for assets to meet liquidity needs in the economy could be the reason for the actions of the Fed and the ECB in terms of gold holdings. In addition, since 1999, the ECB has been a member of the Central Bank Gold Agreement (CBGA) whose purpose is to mitigate the impact of gold sales on the price of gold through imposing a cap on the sales of gold. In line with the CBGA, about 400 tons were sold yearly between 1999 and 2004, and almost 500 tons were sold annually during 2004–2009. This led to the decline of the volume of gold by 33 percent or 246 tons in December 2009, compared to its initial holdings in January 1999. A common reason for selling gold is that it is not interest-bearing. In addition, its storage is associated with significant costs and it is difficult to convert into quick liquidity in the case of liquidity needs. These demerits exceed its advantages, which include a way of diversifying away from currency holdings.
On the other hand, central banks such as the SNB and the RBA attached an important role to holdings in gold. For example, the increasing price of gold mitigated the effect of the depreciating U.S. dollar during 2005 and 2008. Furthermore, it served as a hedge against inflation, and it was considered a safe investment during the crisis era. Gold is anticipated to be broadly acceptable and tradable in quite a liquid market. Both the SNB and the RBA increased their diversifying strategies by holding more gold as a means of providing resilience in case of external shocks.
The Norges Bank felt satisfied with the amount of gold in its foreign reserve portfolio as its gold holdings were the same for both 2005 and 2006. The Norges Bank sold the gold bars in its gold reserves to England in 1940. In addition, it disbursed 33.5 tons of gold bars, which were valued at about US$450 million in the first quarter of 2004. The proceeds from the gold sales have been invested as part of Norge Bank’s foreign exchange reserves. Owing to the historically low return on gold, its central bank kept the amount of gold holdings constant in these periods.
Table 6.1: Central banks’ assets (2006 and 2005)
6.1.1Central Bank Assets of Emerging Economies
The bulk of the Bank of Mexico’s assets were held as international reserves in 2006. Credit granted to financial intermediaries and debtors from repo operations occupied the second position in its asset composition (see Table 6.1). In addition, the Bank of Mexico remained the only central bank among our selected ones that had zero shares of gold in its foreign reserve holdings. This reflects the strong measures put in place to address the issue of liquidity in its financial system. In addition, the Bank of Mexico has been globally accused of not disclosing information about the gold reserves in its balance sheets.
As reported in Table 4.1, the total assets of the South African Reserve Bank were mainly driven by gold and foreign exchange, which accounted for more than 50 percent in 2006. Foreign assets were the largest component of the Bank of Chile’s assets, which accounted for more than 70 percent in 2006. The remaining percent was shared between domestic assets and other assets (see Table 6.1).
6.2Central Bank Assets During the 2007–2008 Crisis
During the period of the crisis, the composition pattern of the ECB assets still remained as they were in 2006. In addition, the largest share of its aggregate assets was attributed to intra-Eurosystem claims with more than 50 percent (see Table 6.2). The ECB balance sheet more than tripled in size between the second quarter of 2007 and the last quarter of 2008 before it declined gradually in 2009 as the special operations matured. In addition, there was an increase in the intra-Eurosystem claims and liabilities denominated in euro. The swap arrangement led to a huge increase in liabilities to non-euro area residents, denominated in euro. The asset-side items of the ECB balance sheet increased because of other smaller operations such as the settlement of the Danish krone and the Swedish krona leg of the swap transactions.
As at the end of 2008, balances from swap transactions took the leading role while foreign currency investments accounted for the third largest component of the SNB assets, after claims from Swiss franc repo transactions (see Table 6.2). This table indicates that securities accounted for the largest share of the RBA assets as at the end of 2008. This implies that the most significant component of the aggregate assets shifted from the foreign exchange to securities in 2008. However, the SNB and the RSA were opposite each other between 2007 and 2008. The SNB’s gold holding reduced while the RSA increased the amount of gold holdings in its foreign reserves. This reflects that the SNB expanded the liquidity window in order to absorb the shocks during the global financial crisis.
During the crisis period, the composition pattern of the Norges Bank balance sheets still remained the same as in 2006. At the end of 2008, investments including government pension fund maintained its leading role in the composition (see Table 6.2).
Table 6.2: Central banks’ assets (2007 and 2008)
6.2.1Central Bank Assets of Developing and Emerging Economies during the 2007–2008 Crisis
In the period of the financial crisis, international reserves still accounted for the largest portion of the Bank of Mexico’s total assets. Government securities, with a value of zero in 2006, took the third position after credit granted to financial intermediaries and debtors from repo operations (see Table 6.2). As of March 31, 2008, almost 70 percent of the South African Reserve Bank assets were in the form of gold and foreign exchange. Gold still maintained the position up to 2008 (see Table 6.2). As of the end of 2008, almost 70 percent of the Bank of Chile’s assets were in the form of foreign assets. Foreign assets maintained the leading role up to 2009 (see Table 6.2). Both South Africa and Chile moved in the same direction by diversifying their foreign reserves through a rise in the amount of gold holdings. These strategies were implemented to serve as a hedge against negative effects arising from the global financial crisis.
6.3Central Bank Assets Today
A decade after the global financial crisis, securities of euro area residents took the lion share of the ECB total assets. More than half of the ECB assets in 2016 and 2017 were held in forms of securities of euro area residents. This implies that the structure of the ECB significantly changed from that of 2006, 2007, and 2008 (see Table 6.3). As the Fed commenced bond purchases in 2008, the ECB waited until January 22, 2015 to implement the same program. The ECB’s quantitative easing (QE) focused on mitigating financial stress through the following:
–A reduction in interest rates and a negative deposit rate.
–It set up a targeted long-term operation in order to increase incentives for banks to lend.
–It bought bonds from weaker economies like Italy, Spain, and Portugal, and backed up the stronger economies of Germany and France through the asset purchase plan (APP). Items purchased include government bonds, asset-backed securities, and corporate bonds.
Despite the low yields and stability in the present Eurozone, its balance sheet has significantly expanded from about 384 billion euro in 2008 to almost 5 trillion euro in 2017. The ECB’s balance size is likely to continue to expand in the near term because of its continuing asset purchase program. It might end this program when the ECB feels it has attained a point required to reduce its balance sheet.
The recent available data show that foreign currency investments accounted for almost 90 percent of the SNB total assets in 2016 and 2017 as balances from swap transactions were cleared out in these periods. Gold holdings were the second largest component as reported in Table 6.3. In late 2014, the SNB intervened in the foreign exchange market 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 the gross domestic product (GDP) because of interventions. Owing to the presence of divergence in monetary policy between the United States and 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 rate further 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 their 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 pronounced.
At the end of 2016 and 2017, Australian dollar investments constituted the largest components of the RBA assets, followed by foreign currency investments. These two components had about 95 percent of the total assets of the RBA (see Table 6.3). 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.
As at the end of 2017, the structure of the Norges Bank balance sheet assets did not change in terms of its composition. Investments that include government pension funds accounted for the largest percentage at about 80 percent in 2016 and 2017 (see Table 6.3). 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 in recent months, as of September 2015, the policy rate was 0.75 percent. Inflation is temporarily enhanced by currency depreciation but is driven by remaining economic slack. The Norges Bank wiped out gold holding in order to increase its level of liquidity.
Table 6.3: Central bank assets (2017 and 2016)
6.3.1Central Bank Assets of Emerging Economies Today
As at the end of 2016, international reserves as well as credit granted to banks and debtors from repo operation were the major components of the Bank of Mexico’s assets. In addition, the value of government securities returned to zero as it was prior to the financial crisis (see Table 6.3).
With reference to Table 6.3, the gold and foreign-exchange component still dominated the structure of the South Africa Reserve Bank’s (SARB’s) assets in 2016 and 2017. Despite changes in the value of assets and its components, the configuration of the asset compositions remained unchanged before, during, and after the global financial crisis.
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 was 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, the country’s imports and financial flows may be affected by uncertainty about Brexit.
The monetary policy operation in South Africa takes place in a difficult environment of high inflation and low growth. Inflation exceeded the reserve bank’s target band (3–6%) throughout 2016. This was a result of the delayed exchange rate pass-through following the substantial depreciation of the rand throughout 2015. A long-lasting drought further created pressure on agricultural prices but in 2016 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 repurchase rate at 7 percent since March 2016 and reduced 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.
As reported in Table 6.3, foreign assets still dominated the structure of the Bank of Chile’s assets in 2015 and 2016. This suggests an unchanged element in the compositions of its assets over time. 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 the 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 fiscal rules, which allowed the 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 countercyclical 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.
However, central banks in small open countries may have a large share of foreign reserves on their balance sheets as depicted in Figure 6.1. The reason can be historically traced as follows:
In the time of a fixed exchange rate regime and restricted capital flows, central banks held huge amounts of foreign reserves as a means of funding imports and making the exchange rate regime credible. However, with free capital flows and floating exchange rates, central banks sometimes intervene in foreign exchange markets and require foreign reserves to accomplish this. Additionally, in the era of financial instability, reserves can be explored to serve central bank customers such as the government, and to mitigate risk of instability in financial systems that heavily relied on foreign currency funding. The relevance of these aims will be based on each country’s thirst for interventions and the unhedged vulnerability of its financial system to exchange rate risk. Reserve holdings are valuable in the situation of financial stress, when the central banks’ exposure to exchange rate risk that could be higher than the interest rate risk attached to holding government bonds. For instance, the Norges Bank held 86 percent of its assets in the form of foreign reserves, with the exclusion of the sovereign wealth fund as at end of 2006, compared to the Fed whose foreign exchange reserve accounted for 4 percent of its assets by the end of 2006.
In addition, loans to banks can be a significant asset of central banks. This usually occurs when the central bank has few securities as assets, compared to the quantity of its liabilities, especially currency. On the other hand, central banks with huge securities against the currency can provide sizable lending to the banking sector. The loans are critical to create reserves, which can enhance interbank payments. In the case of low supply of reserves, central bank lending to banks can provide reserves to boost payments among banks. In December 2006, more than 50 percent of the Bank of England (BoE) assets were loans to banks in the form of repos, while about 40 percent of the ECB assets were loans, as illustrated in Figure 6.1. Loans and repos accounted for only 4 percent of the Fed assets at that period.
In some situations, a huge share of bank loans on the central bank’s balance sheet may be a signal of undeveloped money markets. This requires the central bank to provide direct liquidity to its banks instead of redistributing the liquidity among them through the money market.
During normal situations, the composition of central bank balance sheets can significantly differ across countries. Every central bank can issue two major forms of money, currency, and reserves as liabilities, but the relative magnitude of these items can vary considerably.
In addition, some central banks issue deposits to the government and provide term liabilities, while others do not have this privilege. Generally, assets comprise government bonds, foreign reserves, and loans to banks in different proportions, and also with wide variation across central banks.
A significant invention that is not as well known to many people, is financial contracts. Finance performs two simple roles. It serves as an economic time machine that helps savers transport current surplus income into the future or provides borrowers access to future earnings now. In addition, it can be considered as a safety net protecting against floods, fires, or illness.
In reference to these two kinds of service, an effective financial system ensures stability in a period of financial crisis, and makes an uncertain world more predictable. Additionally, finance acts as an engine of growth when investors are searching for people and companies with the best ideas.
However, finance has negative sides. For instance, the crisis of 2008 created a legacy of unemployment and debt. Therefore, it is worth investigating whether correct measures are explored to enhance the benefits of finance, and to eliminate its problems.
Historically, the commencement of America’s first crash in 1792 and the recent global financial crisis in 2007/2008 tend to provide financial innovation. The first issue then is that financial institutions such as central banks, deposit insurance, and stock exchanges were ill-designed in these periods. This contributed to the problematic nature of the second phase of finance history. The response to the crises in the second phase commenced with blame.
6.4Asset-Side Composition and Economic Growth Nexus
6.4.1Asset-Growth Nexus before the 2007–2008 Crisis
As explained in the previous sections in terms of economic growth rate in the concerned countries, there were significant variations in the structure of central banks’ assets. For instance, 50 percent of ECB’s assets were made up of intra-Euro system claims while its counterparts, SNB and RSA, were mainly driven by foreign currency before 2007. In this period, investment for government pension fund accounted for the bulk of the Norges Bank.
In emerging countries like Mexico, South Africa, and Chile, their central banks’ assets mainly consisted of foreign reserves. In the case of South Africa, its assets were driven by both gold and foreign exchange. This might be a factor that triggered the improvements in those countries between 2005 and 2006 (see Figure 6.1). For instance, Chile’s central bank assets were 70 percent driven by the foreign assets before the financial crisis. This could be the reason why the country experienced the highest growth rate.
6.4.2Asset-Growth Nexus during the 2007–2008 Crisis
During the 2007–2008 crisis, the pattern of central banks’ assets changed in countries like Switzerland and Australia. Balances from swap transactions led the SNB assets list, while securities accounted for the largest share in the RBA assets. The composition of the RBA assets in the same period was able to prevent a drastic fall in the economic growth of Australia compared to its counterparts (see Figure 6.2). All the emerging economies in Figure 6.2 witnessed a sharp fall in their economic growth rate as the overall composition of their central bank assets witnessed changes. This implies that the pattern of asset composition played a critical role in influencing the economic growth rate in the periods. Appropriate asset compositions are sufficient conditions for improving an economy as it observed for the case of the SNB and the RBA.
6.4.3Asset-Growth Nexus after the 2007–2008 Crisis
Between 2015 and 2016, all the concerned economies in Figure 6.3, excluding Australia witnessed a decline in their economic performance, but their economies still grew positively. The pattern of Australia’s central bank assets might be an important reason for the improvement in the country’s economic growth. Australian dollar investments constituted the largest components of the RBA assets, followed by foreign currency investments.
In the case of emerging economies, South Africa witnessed the most significant reduction in its economic performance. This might be as a result of maintaining the asset-side composition in which gold and foreign exchange accounted for the largest share. Other emerging economies also witnessed a sharp drop in their economic performance because of maintaining the same asset-side composition during these periods. This indicates that the amount of the central bank assets are a necessary condition for stimulating the economy while compositions of these assets provide sufficient conditions.
6.5The Evolution of Central Bank Balance Sheets in the Future
There has been a dramatic change in central bank balance sheets over a decade ago. Many factors are responsible for these changes which are expected to be continually evolving in the future. The three key drivers of these changes in the future are as follows:
a.Central Bank Digital Currency (CBDC): There is a future expectation that a central bank will be an issuer of digital currency. Since digital currency is an electronic form of money used by the public, the central bank is responsible for issuing this. However, this needs not be a cryptocurrency.
At present, the only electronic form of central bank money is reserves. The reserves exist with the physical form, which is known as banknotes. Access to these forms is restricted to only a select number of financial institutions. With the era of digital currency, the central bank would potentially have another instrument that can be used to influence its monetary policy. This will happen as the increased potential flexibility of digital currency enables both the quantity and/or the interest rate of the digital currency to be adjusted.
However in a situation where the increase in digital currency is not balanced by a decline in the issuance of banknotes, the issuance of any significant amount would result in a substantial rise in liabilities for the central bank, demanding them to purchase more assets. Part of these assets would be government bonds, even though many central banks have already acquired a very huge quantity of these bonds after the 2007–2009 global financial crisis (such as Federal Reserve). Consequently, they may decide not to have more in order to prevent distress in the bond markets. In addition, it might be due to political concerns about monetary financing or insufficient government bonds in circulation.
Quite a lot of discussions have been focused on how central bank digital currency would significantly change payment systems as well as the whole financial system. The impacts on the asset-side component of central bank balance sheets are of great concern.
b.Equity as a policy instrument: Another possible development occurs when central banks explore equity in more creative ways in order to implement policy. Currently, central bank equity is considered as a “loss-absorbing buffer” rather than a tool to implement policy. For instance with QE, central banks create new reserves in order to purchase financial assets from the private sector. Nevertheless, central banks could attain the same objective through bookkeeping channels by issuing central bank shares in return for private sector assets. These shares are not the same as the conventional ones in a listed company because they would not exercise voting rights on the activities of the central bank.
The benefit of utilizing equity to purchase private sector assets is that the central bank would boost its capital base at a period when it is exposed to more risk.
c.Helicopter money or helicopter drop;3 This measure could be implemented by a central bank to boost economic activities. The measure can take many forms in achieving the purpose, but most proposals anticipate the use of money to monetize fiscal policy basically by creating money for the government to either spend or distribute to people. In addition to the concern of central bank autonomy, helicopter money could lead to a substantial change in the balance sheet of the central bank. For example, implementation of helicopter money through the buying of a perpetual zero-coupon government bond issued particularly for this purpose would significantly change the central bank balance sheet. As these bonds can not be sold (unlike the case of QE), thus they would provide a commitment to never relax the policy, which poses a larger influence on the economy. Most economists have argued that helicopter drops create more problems than their benefits. This means that its adverse consequences in the form of high inflation rates might outweigh its benefits in the form of economic growth rate.
In summary, the relevance of the central bank balance sheet will still be identified in the future. The data-driven illustrations of responses of central bank balance sheets to the 2007–2008 global financial crisis provide in-depth insights toward computation of central bank balance sheet ratios that will be discussed in the subsequent chapters.
Questions
- What is the evolution pattern of asset-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 asset-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 asset-side composition in advanced economies and emerging and developing countries?
- What are the conditions for stimulating an economy through the asset-side of central bank balance sheets?