The irrelevance of central bank equity

  • In Sweden, there is currently concern about the Riksbank’s losses from its quantitative easing.
  • But capital losses on assets purchased through QE are the inevitable result of success.
  • More importantly, a central bank’s equity is (almost) completely irrelevant.

A Swedish friend has recently been sending me articles about the losses suffered by the Riksbank on its quantitative easing. He has also expressed personal concern regarding this issue; including noting that the Riksbank’s losses – potentially as much as 100 billion kronor (about 9.5 billion dollars) in 2022 – is money which could have been deployed elsewhere by the government. As it happens, I think this is an almost completely irrelevant issue from beginning to end. But my friend has had a long career in Swedish and international financial markets; and similar comments have been raised elsewhere (see, for instance, an article on John Cochrane’s always extremely readable blog The Grumpy Economist, https://johnhcochrane.blogspot.com). It might therefore be worthwhile to explain exactly why the Riksbank’s (or any central bank’s) losses from QE are (almost) wholly meaningless.

First, the losses are not a sign of failure. They are the inevitable consequence of the Riksbank’s success. Why? Because if the Riksbank felt that inflation was too low and that one way to boost inflation back towards target is by lowering long-term interest rates further to stimulate activity, this means that if and when their policy is successful, interest rates will rise. This will of course mean lower prices on the bonds they have bought. Unless they can expect interest rates to fall back again in the future, then when they dispose of their assets, they will make a capital loss. The only way to avoid this would be if they actually bought bonds at par, and then hold them to maturity. However, this is unlikely in the interest rate environment of the last ten years (and longer), when ultra-low interest rates also meant very high bond prices. The Riksbank’s capital loss is therefore because its policy has been successful and inflation and thus interest rates have risen.

Is current high Swedish inflation (11.5% in the year to November) due to the Riksbank’s success? No, almost certainly not. As in most other advanced economies, it is due to a surge in broad money growth during the pandemic, the post-pandemic surge in demand following the clampdown during the pandemic itself (although Sweden of course didn’t lock down the way other countries did); and the impact of the Russian war on Ukraine. It is of course also well above the Riksbank’s 2% target. But that is beside the point. The point is that the Riksbank attempted to boost inflation and if inflation, for whatever reason, accelerated, this would inevitably lead to a loss on its asset portfolio.

Second, could the money have been put to better use? Leaving aside the issue of what ‘better use’ means (that is a political decision), the key point here is that this was not money diverted from other spending. The asset purchases of the Riksbank (of any central bank) were undertaken by creating new money out of thin air. That was, in fact, the whole point, at least if you ascribe any importance to money.

Third, could the losses wipe out the Riksbank’s equity? They certainly could. According to its most recent Annual Report, at the end of 2021, the Riksbank’s equity amounted to 66.5 billion kronor. So a loss exceeding that amount would indeed wipe out the central bank’s equity. But, importantly, so what?

A central bank with an independent currency, cannot go bust. Nor is there any particular reason why it can’t operate with negative equity. In fact, there are plenty of examples of central banks that have operated for years in this way. True, it might look a little embarrassing, but from a strictly economic perspective, the central bank’s equity is meaningless. What really matters for a central bank’s reputation and credibility is whether its policy is successful or not. If it generally meets its target (whatever that is), it will have credibility and a good reputation, regardless of its equity. And if it regularly fails to meet its target, the opposite will hold true – again, regardless of the equity.

The only reason this might be a problem is if the central bank by law is banned from operating with negative equity. If that were the case, it would be necessary to apply to the Riksdag for a capital injection. (Note: In Sweden, the central bank is owned by the Riksdag, the Swedish Parliament, not by the government as in most other countries.) Such a request could conceivably be met with demands for changes in Riksbank policy or its operations and infringe on the central bank’s independence – either in fact or at least be perceived to do so. This would indeed be worrying.

However, in the absence of a ban on negative equity, there is no need for the Riksbank to ask for a capital injection. Like most other central banks, the Riksbank is under normal circumstances a profitable institution. (Actually, of course, central banks are not in the business of making money; they are supposed to benefit society and the national economy. The make money mainly through seigniorage.) If the central bank has negative equity, all it needs to do is to accumulate annual profits until such time that it has rebuilt its equity to the desired level again.

However, this is the one instance in which this topic is perhaps not wholly meaningless. Central bank profits are normally remitted to the national government. In the case of Sweden, this is according to a formula where 80% of average profits over the most recent five-year period are passed to the Swedish government. Since 2017, this sum has fluctuated between 2.5 and 7 billion kronor.

Obviously, if a central bank loses money, there can be no remittance of profits to the government. Absent the remittances from the Riksbank, the Swedish government will have around 5 billion kronor less per annum to spend. In 2022, Swedish government expenditures were about 1.231 trillion kronor. In other words, the remittance from the Riksbank amounted to less than ½% of government expenditure. True, 5 billion kronor is still a lot of money (about 470 million dollars); and I am sure that Swedish politicians would, all things considered, prefer to have this extra money to spend. But in the great scheme of things, it really isn’t very much. 

Seemingly, one more point has been made in the Swedish debate. This is that the Riksbank’s negative equity impairs Sweden’s national balance sheet. But this is a ridiculous argument. National balance sheets are pure fiction. The valuation of state assets such as roads or the defence, justice or educational establishments (to name but a few) are anyone’s guess and can be set at any number desired. And in any case, the erosion of central bank equity would at most amount to a rounding error.

Hence, this is a meaningless discussion.

Gabriel Stein