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5 Strengthening the Central Bank

Author(s):
Alejandro Santos
Published Date:
December 2009
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Paraguay’s external vulnerability, in a region that has experienced large macroeconomic shocks, calls for a strong central bank that is capable of delivering prudent and flexible monetary policies for low inflation. However, operational deficiencies and a weak financial position have undermined the central bank’s efficiency at controlling liquidity and conducting monetary policies. Some of these deficiencies emerged as an aftermath of Paraguay’s history of financial crises (Chapter 3); others reflect a lack of instruments as well as legal and operational constraints (see Lönnberg, Åke, and Peter Stella, 2007).

The efficiency of the financial system and its ability to support high economic growth is also suffering from limitations in central bank services. Concerns about the central bank’s ability to provide timely liquidity add to the private sector’s difficulties at transforming maturities and providing longer-term financing instruments (see also Chapter 4). Addressing these issues will require a stronger and more independent central bank.

Achieving and safeguarding central bank independence requires appropriate provisions in the Central Bank Law. Besides granting protection and autonomy to the central bank administration, clear rules for distributing profits, sharing losses, and the topping up of capital shortfalls by the government are essential elements that are currently lacking in the Paraguayan Central Bank Law (Ley 489/95). However, although appropriate legislation may be necessary for de facto central bank independence, it is not sufficient, because any such rules, even if stipulated by law, need to be made consistent with the legal framework for the central government budget. Typically, capital transfers required by topping-up rules in a central bank law still require authorization by congress. Therefore, a regular and complete compensation for capital losses cannot be expected to occur automatically, even if there are well-specified rules for it. This problem can be avoided only if the central bank’s financial position is strong enough to make recurrent losses highly unlikely.2

This chapter focuses on the operational and financial (rather than legal) dimensions of central bank independence and strength. The remainder of the chapter is organized as follows: the next section takes stock of some weaknesses in the central bank’s provision of liquidity services. In particular, this section focuses on instruments for more effective liquidity management. The following section explores the case for restoring the financial integrity of the Central Bank of Paraguay’s (Banco Central de Paraguay, BCP) balance sheet. It presents the analytics and dynamics of central bank debt and capital, making use of a standard recapitalization model (see Appendix 5.1). This model is formulated in real terms, which allows for an intuitive and straightforward treatment of the inflation tax. It will be applied to generate a range of different scenarios to illustrate the impact of key variables and assumptions on debt and capital dynamics. Subsequently, the next section focuses on policy options for financial strengthening of the central bank, comparing a once-and-for-all recapitalization with more gradual approaches, which rebuild capital over time by focusing on the central bank’s cash flow problem.

Weaknesses in the Provision of Central Bank Services

Liquidity Services at the Central Bank

The high degree of free reserves in the banking system (Figure 5.1) indicates a need for strengthening the workings of the money market. Part of the large level of liquidity held by banks has structural causes in that it reflects deficiencies in the payments and clearing system. However, stimulated by the experience of banking crises in the past, banks’ large liquidity buffers also serve as self-insurance against systemic liquidity shocks, as the Central Bank has few effective instruments to inject short-term liquidity into the market. As a result, there are few interbank market transactions, making it difficult for the BCP to transmit monetary policy signals at the shorter end of the interest rate maturity spectrum. Banks have little incentive to rely on interbank markets to cover their liquidity needs given uncertainty about refinancing conditions, which is compounded by the fact that central bank interventions are not guided by systematic procedures of daily liquidity forecasting for the system. The lack of a reliable facility that would give banks short-term access to liquidity also holds back the development of domestic capital markets and limits the tradability and liquidity of domestic bonds and securities. Finally, the fragmentation of the money market is aggravated by the multitude of different maturity terms and due dates for the LRMs (letras de regulación monetaria) issued by the BCP to mop up liquidity.

Figure 5.1.Excess Liquidity in the Banking System

Source: IMF staff estimates.

The central bank has started to address these shortcomings by designing and implementing a short-term collateralized lending facility (FLIR—Facilidad de Liquidez de Corto Plazo con Reporto de Instrumentos de Regulación Monetaria) based on LRMs that resolves legal obstacles to outright repo operations. By way of the FLIR facility, banks can use LRMs as collateral for accessing short-term liquidity at a maturity of 1 to 10 days. The eligible amount is determined by the present value of the underlying LRM paper, adjusted by a discount factor. The interest rate applied to the facility is meant to provide an upper bound to interbank money market rates and is determined by the Executive Committee of Open Market Operations.

As an appropriate next step, the central bank could take measures to rationalize the issuance of LRMs. The multitude of different maturities of central bank bills and a plethora of due dates of these zero-coupon-type instruments contribute to market fragmentation and discourage banks from engaging more actively in the market. To encourage the emergence of market pricing mechanisms for securities, the BCP could usefully reduce the number of maturities for issues of central bank bills and cluster the due dates of LRMs around a limited number of focal dates. This would also facilitate assigning markets a greater role in determining interest rates and prices during LRM auctions.

In addition, the BCP should let its interventions on the money market be guided by liquidity forecasts on a daily basis with a view to achieving a greater degree of precision at matching demand and supply. These forecasts would need to be undertaken by a specialized unit at the BCP and would require the development of a model that helps project fluctuations in the public demand for money. But even in the absence of such a model, the BCP’s foreign exchange interventions, plus the banks’ legal reserve requirements on deposits and a well-coordinated information flow with the Ministry of Finance’s treasury, would provide sufficient information for an improved daily liquidity forecast. The BCP should set up a unit that collects and processes this information. A joint committee with the Ministry of Finance that would meet at least once per week could produce the necessary information for an improved daily liquidity forecast.

Financial Weaknesses at the Central Bank

There is a fundamental link between the financial solvency of a central bank and the efficiency of its monetary policy operations. This relationship may not be obvious at first glance—after all, it is hardly conceivable that a central bank could default on its own currency (see Stella, 1997). There is also the deceptive appearance that financial capital does not constrain a central bank’s capacity to restrict and expand the amount of currency issued, which is usually regarded as the main instrumental variable between monetary policy objectives and outcome. However, a financially weak central bank generates losses, and it does not have fiscally sound means to cover these losses. As a consequence, central banks with weak financial positions tend to finance their losses with money creation, which in turn tends to lead to higher inflation.3

Experience in developing countries shows that central bank financial weakness and inflation outcomes are clearly correlated. Ize (2006) compared two large samples of central bank accounting data, which were divided into financially weak and financially strong central banks. One of the findings is that inflation in sample countries with weak central banks was nearly three times as high as inflation in sample countries with strong central banks. The study concludes that weak performers tend to make up for their financial difficulties by following looser monetary policies. In a recent study, Klüh and Stella (2008) confirmed these results.

Financial weakness also impairs monetary policy efficiency by undermining central bank credibility. As long as a transparent and reliable profit/loss-sharing mechanism with the government’s treasury is not in place, a central bank can finance its losses either by printing money or by issuing short-term debt to the financial system, usually in the form of sterilization papers. While printing money may directly conflict with monetary policy objectives, issuing debt will increase interest obligations and subsequent losses, which may lead to an unsustainable path for central bank debt.

Continued losses and rising central bank debt could, at some point, destroy the credibility of monetary policies. First, if central bank debt appears to be headed for an explosive path, the ultimate resort to inflationary finance will appear increasingly likely. Second, markets perceive that central bank’s decisions on interest rates may be biased downward, because higher interest rates would hurt an already feeble balance sheet.4 In addition, the loss of credibility may worsen the policymaker’s trade-off between disinflation and undesirable real economy effects (which, in turn, feeds back into a further loss of credibility). It follows that financially weak central banks need to be capitalized in order to reestablish their policy credibility.5 Financial strengthening of the BCP would be a precondition for a successful transition toward an inflation-targeting regime.

Factors Determining Central Bank Capital: A Simple Analytical Framework

The minimum level of capital that allows a central bank to maintain a stable inflation rate depends on a number of factors (Table 5.1). These factors are related to the state of development of the financial system, a history of macroeconomic and financial system instability, general acceptance of the national currency as a means of payment, and the carrying costs for holding a desired stock of net international reserves.

Table 5.1.Baseline Scenario Assumptions for Projections of Central Bank Capital and Debt
ConceptSymbolMagnitude
(In percent)
Assumptions:
Real GDP growth rateg3.0
Domestic real interest rater5.5
Foreign real interest rater*2.0
Country risk premiumρ3.5
Domestic inflationπ3.0
Foreign inflationπ*2.0
(In percent of GDP)
Initial Conditions:
Net international reservesnir18.0
Monetary basemb8.0
Nonremunerated foreign-currency liabilitiesfc3.3
Central bank operating costsoc0.35
Central bank capital (t0 = 2006)k-3.7
Central bank debt (t0 = 2006)-nda10.4
Source: IMF staff estimates.
Source: IMF staff estimates.
  • Net international reserves (NIR). Whenever the (domestic currency) value of the optimum stock of NIR exceeds the demand for currency, the central bank needs to mop up excess liquidity by issuing central bank debt, which is a source of losses. Hence, the higher the desirable ratio of NIR to currency issue, the more interest-earning central bank capital is needed.

  • Carrying costs. In most developing countries, the domestic interest rate paid on sterilization papers is higher than the interest rate received on NIR assets. This differential creates carrying costs of holding reserves that will rise with the spread of domestic over international interest rates. Assuming an open capital account, one might consider such carrying costs as arising from a risk premium on domestic currency debt that drives a wedge between international and domestic real interest rates.

  • External vulnerability. Exposure of the balance of payments to external shocks requires a higher buffer of NIR, giving rise to higher carrying costs.

  • Dollarization. This affects both the demand for currency and the optimum level of international reserves (see Leiderman, Maino and Parrado, 2006). Demand for domestic currency issue will fall with rising dollarization (and hence reduce the base for the inflation tax), whereas the precautionary level of NIR to cover foreign currency deposit liabilities in the economy will be higher. This drives up the desirable ratio of NIR to currency (and hence carrying costs).

  • Financial system fragility. Following a history of banking crises and macroeconomic instability, confidence in the financial system is likely to be shaky for quite some time even after successful stabilization and improvements in financial sector regulation. Again, this may require a relatively higher stock of NIR.

  • Operating costs. A higher share of central bank operating costs relative to the monetary base requires a higher level of (interest-generating) capital. Given the existence of economies of scale and externalities in central banking, operating costs, if measured in terms of GDP ratios, are typically higher in smaller countries.6

  • Desired level of inflation. The more ambitious (i.e., lower) the inflation target is, the more capital may be needed, given everything else (Figure 5.2). This is because a reduction in inflation tax would need to be replaced by genuine sources of income.7

  • Fundamentals of debt dynamics. Since capital is meant to provide a central bank with balance sheet stability in the context of a dynamic debt exercise, similar factors and assumptions determine the outcome as in conventional debt-sustainability analyses. These assumptions relate to (1) the expected growth rate of the economy and (2) domestic and foreign real interest rates, including the country risk premium.8

Figure 5.2.Inflation Rate Needed to Maintain Constant the Initial Level of Central Bank Capital

(Baseline assumptions)

Source: IMF staff estimates and simulations.

Note: NIR= Net international reserves.

Even with stable policy objectives and behavioral parameters, central bank capital and debt can become highly unstable. Assume that the central bank’s policy objective is broadly related to (or at least consistent with) a certain stable ratio of the monetary base to GDP, international reserves and other foreign currency—denominated items also bear a stable GDP ratio. But central bank capital will be determined by profits and losses and is not bound by any GDP ratio.9 Therefore, central bank debt can explode within certain parameter ranges. If the central bank wishes to maintain a stable ratio of the monetary base to GDP in the face of shrinking capital, it will need to issue additional debt. But growing interest payments on central bank debt will accelerate the decay of its capital. As a result, central bank debt explodes, and capital will become infinitively negative unless the debt is inflated away through surprise inflation.10 A sufficient (though not necessary) condition for this outcome is that the domestic real interest rate exceeds the economy’s growth rate.11

Central Bank Debt and Capital Assuming No Action Is Taken

In this section, the framework introduced so far will be used to generate simulations of future capital paths for the Central Bank of Paraguay (BCP). For defining the initial conditions in this exercise, values were chosen such that they appear broadly in line with BCP data toward the end of 2006 (Table 5.1). Assumptions regarding future interest rates and growth rates in this baseline scenario are conservative (Figure 5.3 includes a number of the different scenarios).

Figure 5.3Passive Long-Term Simulations for Central Bank Capital, 2006–99

(Percentage of GDP)

Source: IMF staff estimates and simulations.

In the mechanical baseline scenario BCP losses would accumulate, driving capital to minus 69 percent of GDP and central bank debt up to 75 percent of GDP by the end of the century. This would clearly not be a sustainable outcome. Most likely, a public debt crisis would erupt long before, or the BCP would need to resort to inflation tax on the monetary base to reduce its losses.

However, the dynamics could get considerably worse if the BCP continues to purchase net international reserves at a rate faster than GDP growth. Large purchases of foreign exchange are often undertaken to maintain a competitive exchange rate in the face of a strong balance of payments. Central bank debt then needs to be issued to sterilize the monetary impact and prevent inflationary pressures from rising. In the context of the baseline scenario, an increase in the NIR-to-GDP ratio to 25 percent over the next seven years would accelerate the explosion of debt, which would reach 178 percent of GDP by the end of the century.12

External shocks, interest rate hikes, or a rise in dollarization would also accelerate the explosion of central bank debt. The most interesting of these scenarios appears to be the case of rising dollarization, which would both erode the monetary base as a source of inflation tax and requires a higher NIR target to cover against potential foreign currency outflows from the banking system. It is likely that this scenario would be aggravated by negative second-order effects that could result in a vicious cycle: continued capital losses might favor an inflationary response, which leads to a rise in dollarization and a decay in the monetary base. This might, in turn, raise the country risk premium and the real interest rate, which could over time reduce investment and economic growth, accelerating capital losses and leading to more inflation. This scenario illustrates the need to address central bank losses early on.

The Amount of Capital Needed

Achieving a sustainable financial situation at low inflation may require a capitalization of the BCP. The steady-state version of the model produces a trade-off between more ambitious (that is, lower) inflation rates and higher levels of capital, if financial equilibrium of the central bank is to be sustained over time (Figure 5.2). 13

For the parameters chosen for the baseline scenario, this trade-off would imply constant capital at an inflation rate of 6.3 percent. At higher levels of international reserves (25 percent of GDP), the inflation tax needed to compensate for central bank losses would require permanent inflation on the order of 9½ percent. But these mechanic scenarios rest on optimistic assumptions on the external environment and on a stable money demand at comparatively high levels of inflation. It is rather more likely that the current level of negative capital cannot be financed over the long run through inflation tax without provoking deleterious knock-on effects.

To achieve an inflation rate comparable to industrial country levels, central bank capital would need to be raised substantially. According to the assumptions of the baseline scenario, a permanent inflation rate of 2 percent could require central bank capital as high as 10 percent of GDP. However, this scenario would not take into account the positive second-order effects that would arise from the credibility gains of a sustainable monetary policy framework. A sufficiently strong recapitalization would engender a virtuous cycle: risk premiums would fall over time, demand for domestic currency would pick up, dollarization would recede, and the optimal precautionary level of net international reserves would subside. All these factors would contribute to a substantial improvement of the central bank’s profit and loss account. By comparing different methodologies and benchmarks, a recent technical assistance report by the IMF concluded that an initial capital endowment of 2½ percent of GDP could be sufficient to maintain a sustainable capital base for the BCP. With an estimated negative initial BCP capital of 3.7 percent of GDP from the balance sheet, this would require a financial strengthening of the BCP through a capital injection on the order of 6¼ percent of GDP (IMF, 2006).

Policy Options for Financial Strengthening

Experience in various countries suggests that there are many different ways to strengthen financially a central bank.14 While the case for a fast and comprehensive recapitalization is unambiguous in economic terms, in reality the process often takes many years and is arduous and complicated. Given the political ramifications of a central bank recapitalization, this should not be surprising.

The economic case for an immediate recapitalization through a transfer of short-term bonds is clear-cut, as this measure involves zero fiscal costs for the public sector as a whole (including the central bank accounts). An undercapitalized central bank that pays interest on its domestic debt by issuing money or debt taxes the economy exactly in the same way as a Ministry of Finance that orders the printing press or issues debt titles. The shift of this debt to the treasury does not increase public debt by a cent, it just makes it more visible and enhances the transparency of the fiscal accounts. Moreover, a straight and fast recapitalization will lock in the credibility gains for the central bank’s monetary policies at an early stage. This should actually produce a fiscal dividend over the longer term, as equilibrium real interest rates consistent with expectations of low and stable inflation (including on public debt) will be lower. The immediate recapitalization approach provides the guidance and serves as a benchmark against which all other approaches would have to be measured.

But promoting a fast central bank recapitalization is a daunting task for policymakers. First, it opens up a Pandora’s Box of explaining the sources of the central bank’s capital shortfall. In many countries, these are related to bank bailouts in the midst of financial crises of the past that were caused by inadequate supervision and regulation. The obvious first question by the interested citizen tends to be, “Who stole all the money, and why do we now have to come up with it by tax payments on public debt?” Second, the transfer of interest payments on public debt from the central bank to the central government rectifies the reported budget numbers, but it enhances the central government’s “true” deficit. This is hard to explain in countries suffering from widespread poverty, because the interest paid on debt appears to compete with social expenditures. Third, there is often confusion between central bank assets and central bank capital. How can it be that a central bank that holds record amounts of international reserves is poor? (Ironically, it is in many cases precisely the accumulation of international reserves that exacerbates central bank losses.) On the other hand, the costs of not solving the problem appear very abstract and indirect: higher inflation and high real interest rates can always easily be blamed on other factors not under the control of the politician who speaks.

To take on such a thorny debate requires not only vision but also political courage. It is therefore no wonder that the fast solution favored by economic engineering has not always been followed. In some countries (for example, Chile), more gradualist strategies were adopted, and they can also succeed whenever they are bolstered by long-term policy commitment and huge fiscal surpluses. The remainder of this section presents both the benchmark approach of a fast recapitalization and a more gradualist strategy designed by the Paraguayan authorities.

Recapitalization through Transfer of Short-Term Treasury Bills

The most straightforward way to implement a recapitalization is a transfer of short-term central government treasury bills at market value to the central bank. The infusion of assets will lift capital as the residual in the balance sheet, and the immediate receipt of income through interest paid by the treasury will eliminate losses. What is more, the use of short-term treasury bills that are renewable on a rollover basis reestablishes the central bank’s control over the structure of its balance sheet, as treasury bills can be used short term for monetary policy operations and in the medium term to retire sterilization bills from the market.15

The retirement of sterilization bills and their replacement by treasury bills has several advantages. First, the burden of servicing the interest would directly fall on the treasury, which is a transparent way of informing about the “true” size of public debt. Second, it would give a clear signal that the costs of monetary policy operations are ultimately to be borne by the treasury. Given the identical nature of such papers (in particular if the central bank, as banker of the government, guarantees the redemption and rollover of short-term treasury bills), the interest paid on treasury bills should be identical to the interest paid on sterilization bills of the same maturities and characteristics, so there should be no fiscal extra costs.

This assumption is not always borne out by reality. Market imperfections and local idiosyncrasies (as well as differential tax treatment) may induce an interest differential between treasury bills and sterilization bills. Arguably, a gradual and hands-on strategy of “testing the waters” by offering and introducing treasury bills alongside sterilization bills, in a continuously increasing amount, may be the preferable venue for the central bank to pursue.

To preserve financial soundness of the central bank, a recapitalization should be complemented by the introduction of rules for the retention and distribution of central bank profits and losses to the treasury. Unexpected losses, owing to monetary operations or to revaluations of the exchange rate, would ideally be covered by a rather automatic compensation mechanism (which could, for example, be defined in terms of a target central bank capital—to-GDP ratio that is considered a prudent buffer). The reassurance to the treasury (and its potential boon) is that the risk is one-sided: if central bank capital is too low, treasury would have to face the bill anyway. However, if it turns out to be too high, the excess profits of central bank operations will be automatically transferred to the budget.16

The Idiosyncratic Solution: Shoring up Central Bank Income

Transferring assets and liabilities from one public entity to the other may seem trivial in economic terms, but it can entail substantial political and legal difficulties. To overcome such constraints, technicians at the Ministry of Finance and the central bank in 2007 devised a homegrown alternative strategy for financial strengthening of the BCP that would broadly achieve the objectives of the benchmark approach, but would respond better to constraints as seen at the time. It consists of the following elements:

  • Step 1: Shore up central bank income by a permanent guarantee to cover losses up to 0.5 percent of GDP by transfers from the central government budget.

  • Step 2: Quickly regularize claims between the central bank and the Ministry of Finance that are uncontroversial and not subject to legal dispute.

  • Step 3: Get cooperation between the central bank and Ministry of Finance to obtain with the judicial system the quantification and resolution of disputed claims.

  • Step 4: Once legal clarification has been obtained, write off nonperforming assets from the central bank balance sheet and recapitalize the central bank with bonds, in a magnitude that responds to the country’s needs and prospects.

A permanent income support guarantee of up to 0.5 percent of GDP would indeed give the BCP breathing space and shore up its financial situation until the legal status of the claims within the public sector is revised. But it would not obviate the need to make up with a bonds transfer for any shortfall remaining after legal clarification, because the income support would only prevent a further deterioration of central bank capital rather than fix the problem. A further disadvantage of the approach is that central bank debt would continue ballooning in real and nominal terms.17

Concluding Remarks

The advantage of a quick transfer of bonds to the central bank is that it is inherently forward looking. It is informed by what the central bank needs to successfully implement monetary policies for the long-term future. The “idiosyncratic approach” appears attractive in political terms, as it delays the recognition of interest paid on public debt in the budget. But it relies on a legal process that is backward looking, and that may hold up the fourth step that would finally resolve the underlying economic problem of the central bank’s financial weakness. This legal uncertainty translates into ongoing distrust regarding the central bank’s capacity to pursue the monetary policies that are best for the country. To strengthen the idiosyncratic approach, one could reverse steps 4 to 1, and it would actually resemble the quick benchmark approach of bond transfers.

The problem of negative central bank capital is economic in nature. It cannot be defined away by shifting legal definitions as to what does and what does not constitute public debt. Because the central bank cannot properly perform its functions under impaired financial conditions, its situation needs to be rectified quickly, for the benefit of the country. The economic nature of the problem also implies that the approach to fix it must be forward looking rather than backward looking. Certainly, Paraguay’s arduous transition from an authoritarian regime to democracy, which includes the pain of a series of financial crises, has left many accounts from the past that need to be settled. But this institution is too valuable for the country to be damaged by being held hostage to the legal resolution of claims and losses from the past.

Appendix 5.1: Dynamics of Central Bank Capital

Balance Sheet Identity of the Central Bank:

where (nda) = “net domestic assets” = interest-bearing domestic assets minus interest-yielding domestic liabilities; nir = net international reserves; k = central bank capital; mb = monetary base = currency issued plus non-interest-bearing domestic currency liabilities of the central bank; and fc = non-interest-bearing foreign currency liabilities of the central bank; all variables are expressed as share of GDP).

Central Bank Profit Equation in Real Terms:

where θ = real central bank profits as share of GDP; r* = real foreign interest rate; r = real domestic interest rate; π = domestic inflation; and oc = central bank operating costs as share of GDP.

Dynamic Path of Central Bank Capital (Equations (1), (1a) in main text):

where k-1 = central bank capital of the previous period; and g = real GDP growth rate.

where ρ = risk premium on domestic currency assets.

Substituting (A-4) for r* and (A-1) for nda in (A-3) yields

Setting k = k-1 =k(s) and solving for k(s) or for π transforms (A-5) in

Steady State Conditions (Equations (2), (2a) in main text):

References

    DaltonJohn andClaudiaDziobek2005“Central Bank Losses and Experiences in Selected Countries,”IMF Working Paper 05/72 (Washington: International Monetary Fund).

    IzeAlain2005“Capitalizing Central Banks: A Net Worth Approach,”IMF Staff PapersVol. 52 (September) pp. 289310.

    IzeAlain2006“Spending Seigniorage: Do Central Banks Have a Governance Problem?”IMF Working Paper 06/58 (Washington: International Monetary Fund).

    KlühUlrich andPeterStella2008“Central Bank Financial Strength and Policy Performance: An Econometric Evaluation,”IMF Working Paper 08/176 (Washington: International Monetary Fund).

    LeidermanLeonardoRodolfoMainoEricParrado2006“Inflation Targeting in Dollarized Economies,”IMF Working Paper 06/157 (Washington: International Monetary Fund).

    LönnbergÅke andPeterStella2007“Who Signs Banknotes and Why? Issues in Central Bank Finance,” conference paper for “Fiscal Policy and Monetary/Fiscal Policy Interactions,”Federal Reserve Bank of Atlanta, AtlantaApril 19–20. Available via the Internet: www.frbatlanta.org/news/conferen/07FiscalPolicy/Stella.pdf.

    SimsChristopher2003“Limits to Inflation Targeting” (unpublished). Available via the Internet: http://sims.princeton.edu/yftp/Targeting/TargetingFiscalPaper.pdf.

    SteinerRoberto1994Afluencia de Capitales y Estabilización en América Latina (Bogotá: Fedesarrollo).

    StellaPeter1997“Do Central Banks Need Capital?”IMF Working Paper 97/83 (Washington: International Monetary Fund).

    StellaPeter2002“Central Bank Financial Strength, Transparency, and Policy Credibility,”IMF Working Paper 02/137 (Washington: International Monetary Fund).

    StellaPeterforthcoming“Varieties of Central Bank Recapitalization Experience,”IMF Working Paper (Washington: International Monetary Fund).

The author would like to thank José Giancarlo Gasha and participants in a seminar on structural reforms at the Central Bank of Paraguay (December 2006) for their useful comments and suggestions.

There is an asymmetry in treatment of central bank losses and profits. The actual transfer of central bank profits to the budget does not need to be preapproved by parliament. Because of this technicality, it is prudent to keep the central bank well capitalized, even though the level of central bank capital is fiscally neutral for the central government.

Lack of capital would not have an impact on inflationary performance if central bank losses were completely covered by the fiscal authorities.

A financially weak central bank facing excess liquidity in the system will need to raise interest rates on its debt securities to mop up liquidity. But this will increase both the amount of central bank debt outstanding and the interest rate paid, elevating interest costs and central bank losses. At the risk of fueling inflationary pressures, the central bank might instead opt for higher currency growth. Whenever there is uncertainty about the behavior of money demand, central bank incentives may be tilted toward erring on the incautious side, permitting too much currency growth.

In principle, a commitment by the treasury to bear annual central bank losses could be thought of as being equivalent to a capitalization. However, such an arrangement is generally regarded as a weaker commitment to central bank independence from the treasury and may not be sufficiently flexible (Stella, 2002).

The level of operating costs also depends on country-specific assignments of tasks to the central bank regarding the production of public services (for example, in the areas of statistics, economic information, and the provision of infrastructure for payments and transactions).

This simple comparative-static relation does not capture dynamic and second-order effects, such as the erosion of the real monetary base under higher and more volatile inflation, or an increase in the risk premium. It would therefore be wrong to conclude that there is a long-run policy trade-off between low inflation and low costs of monetary policy operations (see Sims, 2003).

Following the methodology developed in IMF (2006) and Ize (2005), the impact of these factors can be captured in a single dynamic equation that expresses the path of central bank capital, measured as GDP ratio, as a function of key macroeconomic variables:

where k-1 = central bank capital of the previous period; g = real GDP growth rate; r* = foreign real interest rate; nir = net international reserves as a share of GDP (a target rate that depends on the degree of openness and financial vulnerability of the economy); r = real domestic interest rate; nda = interest-bearing domestic assets minus interest-yielding domestic liabilities (net domestic assets are negative for central banks that issue large amounts of debt for sterilization purposes); π = domestic inflation; mb = monetary base = currency issued plus non-interest-bearing liabilities of the central bank; π* = foreign inflation; fc = non-interest-bearing foreign currency liabilities of the central bank (for example, the nonremunerated part of the legal minimum reserve required for foreign currency deposits); and oc = central bank operating costs (all variables expressed as share of GDP, where applicable). See Appendix 5.1 for a derivation of the equation.

Given the central bank’s balance sheet identity (nda + nir = mb + fc + k), net domestic assets (which include central bank debt) become the residual and can be substituted in equation (1). Introducing further carrying costs of international reserves by means of a country risk premium ρ such that r* = r-ρ1 the path of central bank capital will become

Anticipated inflation will improve central bank net profit flows in real terms through imposing a tax on the (non-interest-bearing) monetary base. Holders of central bank bills would be protected from taxation as long as inflationary expectations are fully included in the nominal interest rate, but even they can be taxed through surprise inflation.

An explosion of central bank debt can also be triggered by excessive purchases of international reserves, a case discussed in more detail further below.

In addition to generating considerable fiscal costs, sterilization can even turn out to be self-defeating whenever the placement of a substantial amount of additional central bank debt requires an increase in the interest rate. In the context of an open capital account, this may stimulate inflows and enhance the pressure on the central bank to buy foreign exchange. See Steiner (1994) for a discussion of experiences in Latin American countries.

This can be illustrated by deriving the steady-state condition for equation (1a):

Solving for inflation yields

where πk0 if r > g, that is, the lower the initial capital, the higher is the inflation rate that is needed to maintain a constant capital-to-GDP ratio, assuming the domestic real interest rate exceeds the economic growth rate. Note that the reverse is not true, that is, higher capital does not always require higher inflation if growth exceeds the interest rate.

For a presentation and discussion of country experiences see Dalton and Dzlobek (2005) as well as Stella (forthcoming).

An alternative but unlikely solution would be the outright transfer of cash from the treasury to the central bank. The central bank would use the cash to buy back its sterilization bills. But such a cash transfer would need to be financed by issuance of treasury bills to be placed with the private sector (which would be highly contractive). This solution is identical to the case of recapitalization through treasury bills followed by an immediate buyback of all sterilization bills through the sales of treasury bills. But this solution leaves the treasury and central bank no discretion over how and at which speed to transition the retirement of sterilization bills.

However, special provisions need to be made for profits based on valuation gains on assets, to make sure that book-value gains from a depreciated currency would not accrue to the government. Safeguards against this are fairly common and internationally considered as best practice, but they may need to be anchored in the Central Bank Law.

The global financial crisis, which started to affect Paraguay in September 2008, increased banks need for liquidity and reduced their demand for interest-bearing LRMs. This shift in portfolio preference is likely to temporarily ease the pressure on the BCPs net income, but this relief will dissipate quickly once the financial situation gets back to normal.

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