from Follow the Money

Just paper losses?

April 20, 2005

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CPI up; expected path for US short-term interest rates up; stocks down; long-term bonds up (yields down). Bond market conundrum back.

I suspect most people have many more things to worry about than how central banks account for capital losses on their reserve portfolio.

But it is not entirely an irrelevant topic, given that the US is pressing China to take some potentially significant capital losses. In any case, I hope to address some broader themes later -- but I certainly have no intent of trying to top Billmon’s magnus opus.If the government of say China issued lots of renminbi debt, used that debt to buy dollars, and then saw the value of those assets fall (in renminbi terms) after a revaluation, it would -- rightly -- come under a fair amount of scrutiny.

Try the math. Sell renminbi 828 billion in bonds, paying a coupon of say 3%, use that to buy $100 billion in treasuries, paying say 4%. See what happens if the renminbi rises from 8.28 to the dollar (12 cents per renminbi) to 6 per dollar (17 cents per renminbi). The $100 billion in dollar bonds is worth 600 billion in renminbi after the revaluation, far less than the renminbi debt issued to buy the Treasuries.

Central banks are wrapped in a fair amount of mystery, and are surrounded by their share of jargon.

The core business of a central bank -- buying government bonds, whether domestic government bonds or foreign bonds like US treasuries, for local currency cash -- is intrinsically profitable. That does make them different. It changes things, but only just a bit.

The People’s Bank of China has, to a large degree, substituted low-yielding foreign currency bonds for low-yielding domestic currency bonds as the key asset it holds backing the domestic currency cash it issues. Relative to its reserves ($610 billion at the end of 2004, roughly $660 billion now), the stock of its sterilization bonds is still low ($134 billion at the end of 04). And it pays a very low rate on its sterilization bonds. It is still profitable, on a cash flow basis.

But the health of the central bank’s balance sheet still matters.

Lots of governments count on revenue from the central bank to cover some of their expenses. Central banks usually turn over their profits to the national Treasury. As central banks earn less, they can contribute less -- this is putting pressure on even European central banks to seek out higher returns on their reserves.

That pressure is even greater for countries like South Korea. Remember, South Korea alone holds more reserves than the Euro area ($205 billion v roughly $188 billion). It also lost money last year, and was not able to contribute to the Korean Treasury.

That is the first way the health of the central bank’s balance sheet matters. If it is losing money, it can no longer contribute positively to the national treasury.

But it can get worse. If the central bank takes large losses, including large losses from valuation changes on its portfolio of foreign currency reserves, it can go from being a net contributor to the budget to a net drain on the budget.

The IMF is pretty clear:

"When central bank losses give rise to negative net worth, IMF recommended practice is for the government to recapitalize the bank by an injection of either cash or government securities through a transparent budgetary appropriation."

Plain English for "transparent budgetary operation" is tax paper money. That sounds like more than just a paper loss to me.

The PBoC may still have a positive cash flow, but it is sitting on a large expected valuation loss on both its dollar and its euro reserves. Diversifying out of dollars does not help much; the best way for the PBoC to reduce its prospective loss is to stop adding to their reserves. And in any case, it might want to start provisioning against that future loss now ...

The real debate here is not whether the losses are "just paper" losses or not -- the losses from a revaluation would be very real, though they could be partially offset by the PBoC’s ongoing profits from issuing renminbi cash. The real question is whether these mounting losses are a worthwhile price to pay to sustain China’s rapid export growth for a while longer.

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