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Does a Central Bank need Equity?

by ChrisCook
Sat Oct 1st, 2011 at 09:20:36 AM EST

This speech (my bold) the other day by the Vice Chairman of the Governing Board of the Swiss National Bank is very interesting, particularly in view of what the SNB has actually been doing in the market.

Essentially the SNB decided to peg its currency against the € so that the rate never fell below €1.20 to the CHF.

Speculators would normally have piled in to attack the peg through buying CHF and selling €, because Central Banks customarily ensure that the currency they create is backed by debt.

But the SNB foxed the market - and put another nail in the coffin of mainstream economic orthodoxy - by announcing that they would not be 'funding' CHF creation with debt in this way.

The speculators realised that any Central Bank has an infinite capacity to hold down its currency by creating currency and exchanging it for foreign assets, and didn't bother trying, although quite a few traders lost their arse as a result, one of them possibly being UBS.

Of course, the mainstream headbangers are now promising inflationary doom in Switzerland as a result of all of the CHF created.  But the simple fact is that while these CHF held by foreigners may - insofar as the Swiss permit - be used to buy Swiss assets, such as stocks and houses, it is not going to get out into Swiss retail demand other than through fiscal action.

What the headbangers do not realise is that this would require fiscal, rather than monetary action. In fact, hyperinflation is - everywhere and always - a fiscal phenomenon, accommodated, but not caused, by 'printing' of money.

But to return to the point, Mr Jordan's speech blows away many of the cobwebs and myths which surround Central Banks and their Alice in Wonderland accounting.


(Abstract)
The Swiss National Bank (SNB) had to report heavy losses for 2010 and the first half of 2011 due to the strength of the Swiss franc - or, more precisely, due to valuation changes on its foreign currency reserves. Consequently, it suffered a substantial reduction in its equity.

Understandably in such a situation, concerns began to be voiced in public. Questions often posed in this context include: Might the SNB lose its capacity to act as a result of a negative equity level? And, if its equity were negative, would the SNB have to be recapitalised, or might it even have to go into administration?

The short answer to these questions is 'No', because the SNB cannot be compared with commercial banks or other private enterprises. For one thing, a central bank cannot become illiquid. This means that a central bank's capacity to act is not constrained if its equity turns negative. Moreover, unlike other enterprises, it is not forced to implement recovery measures or go into administration.

For another, central banks enjoy a funding advantage over private companies, owing to their banknote-issuing privilege. Moreover, they generate surplus income over the long term. Thus, over time, a central bank like the SNB can usually rebuild its equity level all on its own after a loss. Nevertheless, even for a central bank, a long period of negative equity is not without its problems, as it can undermine the bank's credibility and its independence in the longer term.

For these reasons, it is important for the SNB to maintain a sufficient level of equity. To ensure that the SNB can carry out its monetary policy mandate without restriction, also in the long term, in the interests of the country as a whole it is essential that its capital base be adequately rebuilt. This means that the necessary profits must be earned, and retained. In the long run, the entire economy will benefit.


(Introduction)
The financial market turmoil in summer 2007 quickly gave rise to one of the most severe financial and economic crises of modern history. A major reason for this escalation was that banks had insufficient equity capital. Therefore, an important lesson from this recent crisis is that banks require more capital.

Consequently, regulatory authorities and central banks around the world have worked hard to bring about stricter capital regulations. Switzerland, too, reacted quickly to these events and adopted specific measures to strengthen financial stability.

Meanwhile, the Swiss National Bank (SNB) itself had to report heavy losses for 2010 and the first half of 2011 due to the strength of the Swiss franc - or, more precisely, due to valuation changes on its foreign currency reserves. Consequently, it suffered a substantial reduction in its equity. At times, there was even media speculation that the SNB would soon be reporting negative equity levels.

Understandably in such a situation, concerns began to be voiced in public. Might the SNB lose its capacity to act as a result of a negative equity level? And, if its equity were negative, would the SNB have to be recapitalised, or might it even have to go into administration?

These are all very legitimate questions and I intend to talk about them in detail today. However, I will start right away by saying that the short answer to all these questions is `No', because the SNB cannot be compared with commercial banks or other private enterprises.

For one thing, a central bank cannot become illiquid. This means that a central bank's capacity to act is not constrained if its equity turns temporarily negative. Moreover, unlike other enterprises, it is not forced to implement recovery measures or go into administration. For another, central banks enjoy a funding advantage over conventional companies, owing to their banknote-issuing privilege, and, in the long term, they are able to rebuild their equity after suffering losses.

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Of course, the mainstream headbangers are now promising inflationary doom in Switzerland....

What the headbangers do not realise is that this would require fiscal, rather than monetary action. In fact, hyperinflation is - everywhere and always - a fiscal phenomenon, accommodated, but not caused, by 'printing' of money. (Empahasis added)


How dare you mock the saints of the Austrian School!

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Oct 1st, 2011 at 01:52:21 PM EST
And, of course, St. Milton and the monetarists.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Oct 1st, 2011 at 01:54:38 PM EST
[ Parent ]
Not for any operational reason.

This has been another edition of "simple answers to simple questions."

- Jake

If you only spend 20 minutes of the rest of your life on economics, go spend them here.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Oct 2nd, 2011 at 11:39:00 AM EST
For us non-economic people, can you break this down a bit more: "Of course, the mainstream headbangers are now promising inflationary doom in Switzerland as a result of all of the CHF created.  But the simple fact is that while these CHF held by foreigners may - insofar as the Swiss permit - be used to buy Swiss assets, such as stocks and houses, it is not going to get out into Swiss retail demand other than through fiscal action."

How does this work? How does it lead to the purchase of assets but not stoke retail?

by Upstate NY on Mon Oct 3rd, 2011 at 09:10:26 AM EST
Because it's hot money - it's not going into CHF because its owners have any newfound appreciation for Swiss engineering, or because they want to move to Zurich and eat Swiss chocolate. It's going into CHF because people think CHF is a good sort of money to have in your mattress right now. And when they don't think it makes good mattress filling anymore, they'll give the money back to the Swiss central bank in exchange for the D-Mark and dollars the SNB bought with the CHF.

So the probability that it's ever going to go anywhere other than a mattress is negligible. And money cannot create inflation if you're using it as mattress filling - you have to spend it in order to have any influence on prices.

- Jake

If you only spend 20 minutes of the rest of your life on economics, go spend them here.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Oct 3rd, 2011 at 10:13:45 AM EST
[ Parent ]
Thank you.
by Upstate NY on Mon Oct 3rd, 2011 at 10:15:40 AM EST
[ Parent ]
But when a foreigner buys previously Swiss-held assets, it does increase the stock of Swiss money held in Swiss hands, potentially filtering into increased consumption within Switzerland. But a lot of that consumption may be of foreign goods. So a Swiss house owner might sell his house to a foreign inverstor and then use the proceeds to buy a German luxury yatch, in which case the net effect is to buy the German yatch with the Euros of the foreign investor. This might encourage the Swiss Central Bank to unload the reserves Euro reserves it accumulated when the foreign investor bought the swiss house.

Then when the hot money decides to leave Switzerland, the Swiss Central Bank might find itself in a pinch with stronger downward pressure on the Swiss Franc than it can allow, and without the Euro reserves to contain the pressure.

So it's complicated. But the simplistic view that all this new Swiss money must translate into a proportional increase of prices in Switzerland is not warranted.

In any case, it might be that the very fact of the Swiss Central Bank announcing its policy and giving a 20-sigma kick to the exchange rate to prove the point has discouraged people from attempting to buy Swiss Francs, and so the Swiss Central Bank will find it much much cheaper to enforce the exchange rate ceiling than one would otherwise expect.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Mon Oct 3rd, 2011 at 10:25:51 AM EST
[ Parent ]
Yes, if foreigners go to the trouble of actually buying Swiss real estate, you might get these sorts of effects.

But (a) it is unlikely to happen in any great volume - buying real houses involves not insubstantial transaction costs. It is much cheaper to buy bonds of various sorts, which does not do anything for the Swiss nonfinancial private sector that the SNB would not have to be willing to do in order to defend its interest rate target. And (b) as of Google's last update, the CHF/€ exchange rate is at 121, which indicates that the CHF is still under upwards pressure. Which in turn means that leakage from increasing imports of the sort you describe must be relatively minor.

- Jake

If you only spend 20 minutes of the rest of your life on economics, go spend them here.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Oct 3rd, 2011 at 10:32:50 AM EST
[ Parent ]
On that see Swiss real estate will become the new gold, which I find not entirely convincing.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Mon Oct 3rd, 2011 at 10:36:17 AM EST
[ Parent ]
What, you mean massively overpriced and lacking any convenient industrial use?

- Jake

If you only spend 20 minutes of the rest of your life on economics, go spend them here.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Oct 3rd, 2011 at 10:40:45 AM EST
[ Parent ]
Currency speculators & etc. fleeing the euro for the "safe haven" of the CHF aren't about to tie-up the money buying real estate.  Nor are they going to take their newly purchased CHF and buy Hungary -- whose real estate has all too much exposure to the CHF.

Currency speculation is a business and like any business the business stays in the business it is in.  Nobody expects MicroSoft to take it's billions o' bucks Cash Reserve and buy coal mines in the Ruhr but idiots some people think Deutsche Bank will get into the Real Estate Management business?

by ATinNM on Mon Oct 3rd, 2011 at 11:58:54 AM EST
[ Parent ]
Given that actual mortgage lenders avoid real estate management like the plague (hence the huge foreclosure backlog here in the US), no one with two brain cells to rub together would expect anyone else to jump into that game.  Which means there are a lot of people out there with just one brain cell.  At most.
by rifek on Wed Oct 19th, 2011 at 02:33:09 PM EST
[ Parent ]
There goes Switzerland. The dirty underwear of economics will haunt also swiss.
by kjr63 on Tue Oct 4th, 2011 at 05:45:53 PM EST
[ Parent ]
That's what I thought as well. But Updstate NY is asking about the reference to it being used to buy assets, not for inflating mattresses. If they do buy Swiss houses, it could drive up housing prices and eventually other costs. Presumably the "insofar as the Swiss permit" means that they will put a stop to this if it starts to be significant.

( in exchange for the D-Mark and dollars the SNB bought with the CHF.  Is the SNB really buying D-Marks already?....)

by gk (g k quattro due due sette "at" gmail.com) on Mon Oct 3rd, 2011 at 10:32:19 AM EST
[ Parent ]
Presumably they would have bought German Bunds.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Mon Oct 3rd, 2011 at 10:37:03 AM EST
[ Parent ]
That's what I thought as well. But Updstate NY is asking about the reference to it being used to buy assets, not for inflating mattresses. If they do buy Swiss houses, it could drive up housing prices and eventually other costs.

In principle, yes, but (a) as noted above it is more likely that the hot money will buy bonds, which does not change the de facto money supply as long as those bonds are eligible collateral for rediscount with the SNB. And (b) higher-order effects like the ones you describe take time to happen, and this is hot money - it's not gonna stay that long.

Is the SNB really buying D-Marks already?....)

Yes. It's buying French and German government bonds, which de facto means that it's buying Franc and D-Mark, since that's what those bonds will be denominated in if the €-zone goes tits-up.

- Jake

If you only spend 20 minutes of the rest of your life on economics, go spend them here.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Oct 3rd, 2011 at 10:39:08 AM EST
[ Parent ]
The SNB should be taking action to slow down the rate at which the 'hot money' can bail on the CHF.  These jokers need to 'share the pain' when they play their little games.
by ATinNM on Mon Oct 3rd, 2011 at 12:28:56 PM EST
[ Parent ]
Preventing people from exiting long positions is difficult. Doable, but difficult. What's easy is making sure that nobody piles on by shorting the currency as the long positions are unwound.

Which means that what they should be doing is make sure they have enough reserves to handle the long positions coming unwound, even if this may depress the exchange rate below their target.

- Jake

If you only spend 20 minutes of the rest of your life on economics, go spend them here.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Oct 3rd, 2011 at 01:26:31 PM EST
[ Parent ]
Switzerland adopts MMT.  When does the EU catch up?  I'm not even going to ask about the US, since I will be mouldering long before the Austro-Chicago death grip is pried off economic policy here.
by rifek on Wed Oct 19th, 2011 at 02:36:25 PM EST


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