In recent weeks, I have posted several articles in this blog looking at the rapid expansion of the balance sheets of three of the world's major central banks; the Federal Reserve, the Bank of England and the European Central Bank. Since the middle of 2008, all three of these banks have seen rapid increases in their balance sheets as they've made desperate attempts to stimulate their respective economies through the purchasing of their local sovereign debt instruments. What we rarely read about, are the balance sheets of the central banks of the emerging Asian economies and how the actions of these banks could impact the economy.
In a Bank of International Settlements research paper entitled "The expansion of central bank balance sheets in emerging Asia: what are the risks?" by Andrew Filardo and James Yetman outlines the growth in the balance sheets of Asia's central banks because of the huge buildup in foreign reserve assets and the risks associated with this rise.
First, let's look at how assets and liabilities are looked at from a central banker's viewpoint and exactly what a central bank's balance sheet is used for. A central bank's balance sheet assets consist of foreign and domestic assets including government bonds, foreign exchange and gold and its liabilities consist of currency in circulation, bank reserves, central bank securities, government deposits and equity capital (accumulated profits). Policies that result in an increase in the size of a central bank's assets by necessity require a corresponding increase in the bank's liabilities. This is where problems can occur.
What does a central bank use its balance sheet for? Historically, central bankers have used their balance sheets as a lender of last resort. They can alter the size of their balance sheets to achieve certain economic goals (either controlling inflation or, as we are now experiencing, stimulating economic growth) as we have all seen from the recent rather futile actions of Ben Bernanke and Mervyn King.
Let's open by looking at two graphs from the report, the first which shows the increase in the size of the balance sheets for the Fed, the Bank of England, the ECB and the People's Bank of China (PBOC) since the 2001 reference year and the second graph which shows the increase in the balance sheets since the reference year 2001 for Hong Kong (HK), Singapore (SG), Malaysia (MY), Philippines (PH), Thailand (TH), Indonesia (ID), India (IN) and Korea (KR): :
Most of the Asian central bank balance sheet growth has been in the form of foreign exchange reserve assets, some of which is related to the bolstering of reserves after the 1990s Asian crisis, however, at least some of the growth is attributed to central banks efforts to keep their local currency from appreciating. The combined size of the balance sheets of all aforementioned 9 nations (including China) has risen from $1.1 trillion in 2001 to $6.4 trillion in 2011. In some nations, the central bank balance sheets are now close to 100 percent of GDP as shown on this graph:
In general, central bank balance sheets in the Asian region are far larger as a share of the GDP in these nations than in the more developed economies of the world as shown on the right.
How have Asia's central banks behaved differently than those of the developed nations? In the world's more advanced economies, central banks generally purchase domestic assets (i.e. government bonds like Treasuries, gilts etcetera) that results in lower interest rates (i.e. QE and "The Twist") and is accompanied by an increase in central bank liabilities in the form of bank reserves. In contrast, Asia's central banks have intervened heavily in foreign exchange markets and have accumulated massive foreign reserve assets as shown on this graph:
Every action by central bankers results in an economic reaction, some of which are totally unanticipated. What are the risks to the economy associated with the increased size of Asia's central bank balance sheets?
1.) Inflation: Rapid expansion of central bank balance sheets is generally associated with higher inflation. Most experts agree that it is not the size of the balance sheet that matters, rather, it is the speed at which the balance sheet expands. A high rate of expansion can result in inflation when the financial system cannot absorb the expansion of the bank's monetary liabilities. Fortunately, in the case of Asia's central banks, the expansion of their balance sheets does not appear to pose an inflationary risk at this point in time, however, history is not on their side since there are numerous examples where strong growth of central bank liabilities is associated with higher increases in prices.
2.) Financial Instability: The accumulation of foreign reserves can lead to the crowding out of domestic lending. A study of the balance sheets of private Asian banks between 2003 and 2007 suggests that a 1 percent increase in central bank foreign exchange reserves led to a 1.3 percent decline in the rate of growth of total loans made by the private banks. On the other hand, a persistent expansion of central bank foreign exchange assets held on deposit at central banks on behalf of the private banking sector can result in a glut of very low-yielding, no risk assets on the books of the private banks. Many banks will continue to hold these low-yielding assets as long as there is risk in the economy, however, when it appears that an economy is about to enter a growth phase, the private sector banks will look to sell these assets in a search for higher yielding investment. This could lead to overly exuberant and unsustainable lending practices.
3.) Financial Market Distortions: When an emerging market central bank finances its accumulation of foreign exchange assets with thinly traded local currencies, it can quite quickly become the dominant player in a given market. This can lead to the market responding to moves made by the central bank rather than responding to economic reality. Central bank actions can, in this case, distort interest rates from what they would normally be in the open market (take note Mr. Bernanke et al).
Central banks are also running the risk of large financial losses that grow along with the size of their balance sheets. Here are three risks to central banks associated with expanding of their balance sheets:
1.) Central banks normally get a lower rate of return on their foreign assets than the cost of financing these assets; this means that the asset may well be yielding less than the cost of issuing central bank paper and the interest rate paid on excess private bank reserves.
2.) The central bank may incur losses on its foreign portfolio when the domestic currency appreciates against the foreign currency.
3.) The central bank may face a mark-to-market loss when interest rates rise, pushing the value of the asset down (since interest rates and asset (bond) prices operate in opposition). As well, the central bank may face additional losses if the asset issuer defaults.
In conclusion, the rapid growth in Asia's central bank balance sheets is concerning since the ramifications of such actions are neither fully understood nor is the response of the world's economy to such actions completely predictable. According to the authors, the ballooning of central bank balance sheets "...raises concerns about distortions in financial markets and implications of central bank losses...", an issue that is rarely discussed. The world's central banks and their bloated balance sheets are entering uncharted territory and, "...the risks associated with the size and structure of central bank balance sheets should not be overlooked."