Even mighty central banks can go broke if imprudent policies are adopted

Monday, 2 December 2013 00:00 -     - {{hitsCtrl.values.hits}}

Central banks are not that mighty A central bank in theory cannot be bankrupt because it can always print money and pay out the external creditors, namely, the holders of its currency and banks and other institutions that maintain accounts with it. An institution is unable to make pay-outs to its external creditors when it does not have enough assets to do so – a situation known as having a negative net-worth. By printing money at its own discretion, a central bank, unlike any other institution in the economy, can convert a negative net-worth – the sign of the bankruptcy of a central bank – into a positive one. Yet, in practice some central banks have become bankrupt and many have got into trouble due to imprudent policies they have followed. Thus, even a mighty central bank can go broke if it has adopted imprudent policies. There are two reasons which may contribute to the bankruptcy of a central bank. Loss of credibility is the worst enemy of a central bank One is that it may have issued too much of money causing a rapid increase in the inflation rate. When inflation rises to a very high level within a short span of time, it is called ‘hyperinflation’ and when it rises without showing any sign of abatement, it is called ‘high inflation’. During either episode, people refuse to accept the currency issued by a central bank because they stand to lose if they do so. Every currency note issued by a central bank carries a promise to its holder that he could continue to acquire a desirable basket of goods and services by using it. For instance, a dollar note acquired by an exporter is a promise by the US authorities that the holder could acquire a dollar’s worth of goods and services from that country or from any other country which is willing to accept that dollar in exchange. But if prices go up as moderately as it is happening in many countries including Sri Lanka or rapidly in the case of high inflation that is taking place in Venezuela today, the basket starts shrinking making the holder of the currency note poorer day by day. Knowing this, a smart person will very quickly transfer all his currencies into other currencies or other assets that do not have that particular problem. During the hyperinflation in Bolivia in mid 1980s, the Bolivians refused to accept the Bolivian Peso and instead chose to accept the US dollar as the currency for transactions, keeping wealth and recovering debt from borrowers. Similarly, during the recent hyperinflation in Zimbabwe, it was the South African Rand that was accepted by Zimbabweans and not the dollars issued by their Reserve Bank. Thus, when people refuse to accept the currencies supplied by a central bank, it also loses the ability to issue new currency and convert a negative net-worth into a positive one. The result is the bankruptcy of the central bank raising an issue concerning its credibility. Forex mishaps of a central bank are not immediately known The second which happens even when people continue to accept the currency issued by a central bank – so no credibility issue there – is much more complex and cannot be seen immediately even by careful observers. This is because it takes place in the foreign exchange management area of a central bank about which the ordinary people do not have enough information or knowledge to make a judgment. Usually, the public and the rulers come to know about the bankruptcy of a central bank only after it has happened and at that time, it is too late to reverse the process. In this area, bankruptcy may be delivered to a central bank via two channels. Insane defence of a currency by using foreign reserves of the nation In the first channel, a central bank may in a bid to keep the exchange rate at a stable level spend the foreign reserves it is holding by supplying foreign currencies to meet the demand in the market. When the bank loses foreign reserves in this manner, it may start borrowing in foreign currencies to build the foreign reserves. It would snare a central bank in a vicious trap because it will now have to borrow more foreign currencies to repay those loans and pay interest on them. This is because a central bank cannot print those foreign currencies in the same manner as it prints local currency. Eventually, when the interest out-payments become high and a central bank’s domestic interest income becomes insufficient to meet those interest payments, it starts to make losses. The ultimate result is that its net-worth becomes negative, that is, its obligations or liabilities to outsiders are much more than the value of the net assets it is holding. Speculation on a currency should be a taboo word for a central bank The second channel is the foreign exchange losses which a central bank may make due to either misfired speculation or imprudent investment in not-so-good foreign securities or both. Central banks are required to hold the foreign reserves of a nation to enable that nation to withstand adverse shocks that may hit it from time to time. This is like a person keeping some money in his bank account to meet unexpected medical bills or disasters. Central banks should invest those reserves in suitable investments instead of keeping them idle but those investments should be made very conservatively. That is, while they should not go after huge profits, they should always see to it that the principal amounts are protected. Hence, they are not expected to speculate in the market by using those reserves since such speculations – a form of gamble – can turn out to be losses or profits depending on the situation and the associated outcome. Similarly, if the reserves are invested without taking into account the safety of the investment or if they are not followed up carefully, the result will be making losses. When these losses become substantial, again, the net-worth of a central bank may become negative leading to bankruptcy. A bankrupt central bank is a burden to taxpayers When a central bank becomes bankrupt, it is the taxpayers who, as the principal of the bank, have to bear the burden by supplying the needed capital to the bank. This is a classic example of the working of the “principal-agent’ problem where the agents – in this case those who run the central bank and the political masters who supervise them on behalf of the taxpayers – seek to satisfy their own narrow personal requirements instead of satisfying the requirements of the principals who have empowered them. Hence, if the citizens of a country do not judiciously control the activities of a central bank, those who run it and their political supervisors have no incentive to manage its affairs prudently. In a few cases, the burden of the bankruptcy of a central bank is borne by international lenders as well in addition to the burden borne by the country’s taxpayers. A good example is the Central Bank of the Philippines which became bankrupt in 1993. In this case, since Japan and the US Treasury had a stake in the Bank, they too, together with IMF had to support the liquidation of the Bank and bring out the new central bank, Bangko Sentral ng Pilipinas or BSP, into business. Let’s now examine three recent cases where the central banks had failed to satisfy the masters who had created them. Malaysia’s misfired speculation on the British Pound The first case concerns the Bank Negara Malaysia or BNM, the country’s central bank. As documented by “Malaysia Factbook” in late 2012 (available at: http://malaysiafactbook.com/Chronology:1992_Bank_Negara_Malaysia_Currency_Speculation_Scandal), in early 1990s, BNM had wildly speculated on the British Pound assuming that its value will continue to rise in the market in the years to come. During this period, Britain was a member of the European Monetary System – the precursor to the current Euro system – making it mandatory for the member countries to either rise or fall along with the currencies of other members. When Germany was unified in 1990, the high unemployment and high inflation in East Germany was imported to the West Germany making it necessary for the new Republic to increase interest rates to tame inflation. But an unintended consequence of this move was the inflow of dollars and other foreign funds to Germany in search of high interest incomes and causing a continuous appreciation of the Deutsche Mark in the market. Along with the Mark, the British Pound also started to appreciate though there were no strong economic fundamentals in the UK warranting an appreciation of its currency. BNM, taking cue from this market development, began to convert its dollar assets into Pounds – a process known as taking a ‘long position’ in a currency in the market. The strategy was that when the British Pound went up in value in the market, BNM could sell those Pounds in the market and make a huge profit. When BNM lost, Soros gained But the British economy came under severe strain as a result of the unwarranted appreciation of its currency. BNM speculated that the UK government will not leave the European Monetary System despite the severe strain which it was having at that time and therefore continued to maintain its long position. At the same time, the international fund manager George Soros was reported to have speculated the opposite and kept on borrowing British Pounds and converting them to dollars, a position known as taking a ‘short position’ in the market (available at: http://www.tindakmalaysia.com/showthread.php/5067-Finance-Bank-Negara-Forex-Loss-Mahathir-has-to-answer-Lim-Kit-Siang). His strategy was to settle such borrowings with low valued Pounds when the currency had started to depreciate in the market eventually. John Major, the British Prime Minister at that time, shocking the world, took a major decision to leave the European Monetary System and with that move, the British Pound started to depreciate in the market heavily. The total losses incurred by BNM have been estimated at $ 5.5 billion as a result of the fall in the market value in its long position and the selling losses of the Pound in an insane attempt at exiting the currency subsequently. BNM became technically bankrupt and the Malaysian government had to bail it out by recapitalising the bank. The Governor of BNM Jaafar Hussein had to resign in 1994. The Filipino Central Bank borrowed to its bankruptcy The second case relates to the liquidation of the Central Bank of the Philippines in 1993 after it was bankrupt because it could not pay its foreign liabilities amounting to some $ 11.4 billion. These liabilities had been acquired by the Filipino Central Bank to have the required foreign exchange to sell in the market so that it could prevent the country’s currency from depreciating in the market, an insane ambition that suited with the ambition of the political masters when its balance of payments was continuously in deficit. Consequently, the balance sheet of the Central Bank became corrupted with no foreign assets but only foreign borrowings on which it had to pay interest. Since it did not have foreign exchange to pay interest and repay the principal of the foreign moneys borrowed previously, it had to borrow more in order to repay the old loans. This snared the Central Bank of the Philippines in a vicious trap of foreign borrowings. When the situation became critical and the Filipino economy was on the verge of collapse, under a major but embarrassing structural plan supported by Japan, the US Treasury and IMF, the old central bank was liquidated and a new central bank under the name of Bangko Sentral ng Pilipinas was established. BOT Governor defended Thai Baht but ended being ‘mentally and emotionally shattered’ The third case pertains to the imprudent exchange rate policy adopted by the Bank of Thailand or BOT, the country’s central bank through 1990s and early 2000s. For decades, BOT, like the Philippines, had maintained a fixed exchange rate at 25 Baht per dollar. To maintain this rate, BOT had to supply dollars to the market out of its foreign exchange reserves. This came to a culmination in 2007 when BOT had lost some $ 25 billion in its insane attempt at keeping the exchange rate at that level. However, speculators, chiefly, George Soros, had speculated against the wisdom of BOT. Since Thailand had a serious balance of payments problem recurring year after year, it was quite logical for George Soros to speculate that Thailand will not be able to continue with this policy for long. Hence, Soros borrowed heavily in Baht and converted the same into dollars. After BOT had lost all its foreign reserves and could no longer support the Baht at 25 Baht per dollar, it had to allow Baht to freely fall in the foreign exchange market. Soros converted a part of the dollars he had accumulated into Baht, settled the Baht loans and pocketed out the profits he made from the transactions. After the event, a high level investigative committee was appointed by the Thai Government to identify the people who were responsible for the virtual destruction of the Thai economy. The report was out in 2000 and it had identified the key officials in BOT who could be subject to criminal prosecution. One such person identified was the BOT’s Governor, Rerngchai Marakanond. Subsequently, Rerngchai was prosecuted against the losses BOT had to incur and was fined 186 billion Baht equivalent to $ 4.6 billion in 2005 for his leading role in the country’s 1997 financial crash (available at: http://business.highbeam.com/436067/article-1G1-133571173/one-time-thai-bank-governor-46bn-fine). Later on appeal by him, this order was reversed in 2011 but not before, as he had announced, “his mental and emotional wellbeing being fully shattered” as a result of the hard criticism and charges that had been levelled against him (available at: http://pattayatoday.net/news/former-central-bank-boss-cleared-of-baht-collapse-responsibility/). Citizens should keep constant vigil on their central bank All these three cases point to a stark reality. That is, though many believe that central banks are mighty and strong, even such central banks could become the victims of the imprudent policies pursued by those who run them. A bankrupt central bank imposes a heavy burden on its citizens who are required to provide the necessary funds for building its capital and making it a going concern. If citizens are interested in avoiding such an eventuality, they should see to it that central banks’ policies are audited then and there so that they could not end up in irreparable disasters later. At the same time, those who run central banks should always follow the golden dictum that they are simply the trustees of the reserves of a nation and therefore use the same caution and prudence in managing those reserves as when they are managing their own wealth. (W.A. Wijewardena could be reached at [email protected].)

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