## _wp0849

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### Introduction — key arguments and structure
- Central thesis
  - The financial strength of a central bank is an important factor determining policy outcomes.
  - Small changes in central bank finances are not material to macroeconomic policy performance in well-capitalized central banks.
  - Poorly-capitalized central banks are often constrained in their policy choices or may loosen policy to avoid large losses for reputational or political economy reasons.
  - The importance of central bank financial strength for policy outcomes increases exponentially as central bank finances become weaker or policy commitments become more ambitious.
  - A credible and independent central bank’s financial strength must be commensurate with its policy tasks and the risks it faces.
- Sectional overview
  - Section II: concepts of central bank financial strength and policy performance; distinguishes microeconomic efficiency from financial strength; financial strength depends on accounting valuation, policy regime, volatility, and political independence.
  - Section III: overview of central bank financial strength across countries; losses become macroeconomic concerns only when they limit operational capacity and/or damage credibility.
  - Section IV: difficulties in cross-country comparisons due to idiosyncratic and opaque accounting; evidence that accounting is becoming more transparent; quantitative evidence that inflation is significantly worse in countries with financially weak central banks.
  - Section V: ways central banks have been recapitalized or strengthened; method/instruments used for recapitalization can critically affect subsequent policy performance.
  - Section VI: concluding remarks.

### Concepts of central bank financial strength and policy performance
- Definition and interpretation
  - “Financial strength” describes the extent to which an entity is constrained by its financial situation in pursuing its strategic goals or policies. An entity is financially strong when it is relatively unconstrained and weak when financial constraints are binding on policy choices.
  - Microeconomic efficiency (internal cost minimization) should be separated from macro performance (effective guidance of macroeconomic conditions).
- Measurement and accounting issues
  - Central bank financial accounts provide information on cost of achieving policy outcomes but lack a well-defined production function linking inputs to outputs.
  - Operating expenses are often a better indicator of stewardship than net revenue (example quote from Bank of Canada 2005 Annual Report).
  - Financial strength depends on accounting valuation of the balance sheet, the nature of the policy regime, predicted volatility of the economic environment, and the degree of financial independence granted by the political system.
- Credibility and risk assessment
  - If credibility is important for monetary policy success, the central bank must be financially strong.
  - Financial auditors should use risk-based models to assess whether the central bank can survive adverse events without abandoning objectives.
  - The appropriate degree of central bank financial strength should be reevaluated when the objective, policy regime, or environmental volatility changes.
- Conceptual illustration (Figure 1)
  - p = Probability of needing a recapitalization; k = Capital.
  - For a given policy regime and capital, higher volatility increases probability of needing recapitalization.
  - For a given regime, more ambitious objectives increase likelihood of requiring recapitalization.

### Overview of central bank financial strength: country examples and key statistics
- General observation
  - Countries with strong central bank balance sheets include the United States, Canada, and member states of the European System of Central Banks.
- United States (Federal Reserve System)
  - “90 percent of the Federal Reserve System’s assets consist of U.S. Treasury securities and federal agency obligations.”
  - Federal Reserve Notes outstanding amount to 91 percent of total liabilities (excluding capital and surplus); reserves of depository institutions account for a further 3 percent.
  - Profits during 2002–2006 averaged US$25.6 billion.
  - Table 1 (selected entries preserved exactly as presented):
    - 1981: Capital 2.6, Profit Transfer to Treasury 14.2, 14.0, Total Assets 176.8
    - 1986: Capital 3.7, Profit Transfer to Treasury 18.0, 17.8, Total Assets 267.4
    - 1991: Capital 5.3, Profit Transfer to Treasury 21.2, 20.8, Total Assets 353.1
    - 1996: Capital 9.1, Profit Transfer to Treasury 21.0, 20.1, Total Assets 481.5
    - 2001: Capital 14.7, Profit Transfer to Treasury 28.0, 27.1, Total Assets 654.9
    - 2004: Capital 23.5, Profit Transfer to Treasury 21.4, 18.1, Total Assets 810.9
    - 2006: Capital 30.6, Profit Transfer to Treasury 34.2, 29.1, Total Assets 873.4
  - U.S. General Accounting Office found no compelling reason for the Fed to hold capital; quotation in source: “a central bank with the nation's currency franchise does not need to hold capital... the central bank can always create additional currency to meet any obligation denominated in that currency.”
- Canada (Bank of Canada)
  - Authorized capital: Can$5 million; statutory reserve (“rest fund”) reached Can$25 million in 1955.
  - “Out of total assets of Can$48 billion, the Bank holds Can$43 billion (92 percent) in securities issued or guaranteed by Canada.”
  - Bank virtually assured a profit under steady state conditions; Bank of Canada Act amended in 2006 to allow Board to retain as much as CAN$400 million to offset unrealized valuation losses; initial retention of CAN$100 million approved in September 2007.
  - Table 2 (selected entries preserved exactly as presented):
    - 1955: Capital 5, Profit 1308, Total Assets (value shown in source)
    - 1965: Capital 30, Profit (value shown), Total Assets 1563,956
    - 1975: Capital 30, Profit (value shown), Total Assets 62910,496
    - 1985: Capital 30, Profit 1,880, Total Assets 21,135
    - 1995: Capital 30, Profit 1,816, Total Assets 30,201
    - 2005: Capital 30, Profit 1,732, Total Assets 48,320
    - 2006: Capital 30, Profit 1,896, Total Assets 51,626
- European Central Bank (ECB)
  - Established with capital of €5 billion; foreign exchange assets of €39.5 billion transferred to ECB in early 1999.
  - “90 percent of its assets are in foreign exchange and gold,” creating exposure to losses offset by liabilities to national governments.
  - Table 3 (European Central Bank Profits/Losses, In Billions of Euro; In Percent of 2003 Euro Area GDP):
    - 1999: 0.67, .00
    - 2000: 1.99, .03
    - 2001: 1.82, .02
    - 2002: 1.22, .02
    - 2003: -0.48, -.00
    - 2004: -1.64, -.02
    - 2005: 0.00, .00
    - 2006: 0.00, .00
  - Losses have not been of macroeconomic significance nor part of ECB monetary policy debate.
- Contrasting central banker views
  - Bundesbank President Axel Weber: “The Bundesbank profit is a residual issue for me and my colleagues...I don't enter into any strategic considerations about Bundesbank profits...”
  - Governor Laurence H. Meyer (testimony): central bank can create money to meet obligations—carries presumption that losses might require a change in policy.

### Cases where losses affected policy and substantial historical episodes
- Venezuela (1997): aggressive issuance of central bank obligations for sterilization; drawdown of treasury deposits; eventual easing of monetary policy owing to quasi-fiscal losses.
- Costa Rica: nearly two decades of central bank losses; by end-2000 negative capital exceeding 6 percent of GDP; interest-bearing liabilities almost double interest-bearing assets by end-2002; reluctance to lower inflation target due to balance sheet sustainability concerns.
  - Quote from Central Bank of Costa Rica governor: “We, the central bank, have a negative net worth...and this remains our greatest challenge.”
- Jamaica (early 1990s): Bank of Jamaica negative net equity of US$1½ billion at end-1991; losses from quasi-fiscal activities and servicing external debt; losses averaged 53 percent of reserve money during fiscal years 1988/89–1991/92; consumer price inflation exceeded 80 percent at end-1991.
- Uruguay: central bank losses averaged 3 percent of GDP in late 1980s.
- Nicaragua: cost of resolving four failed banks in August 2000–2001 led Central Bank of Nicaragua to issue dollar-indexed bonds totaling 20 percent of GDP.
- Bank of Japan (late 2002–early 2003): market doubts about continued purchases of long-term government debt due to risk of capital losses raised credibility concerns.
- Czech National Bank: negative equity from revaluation losses but ability to achieve policy objectives not impaired; government participation in sterilization costs and falling domestic interest rates helped financial sustainability.
- Central Bank of Armenia: large revaluation losses on foreign reserves but these followed successful policy (low inflation, strong fiscal situation, rapid growth); expected increasing seigniorage over time.
- South African Reserve Bank (SARB): negative net open foreign currency position of US$23.2 billion at end-September 1998; resolved to eliminate position to stabilize rand and improve credit rating prospects.

### Evidence for the impact of financial strength on policy performance
- Measurement challenges emphasized
  - Market capitalization not available for central banks; capital is a poor proxy for financial strength because it depends on accounting and profit distribution rules that vary widely.
  - Revaluation gains/losses treatment varies widely (example: IMF IFS data on gold valuation at end 2002).
  - Off-balance-sheet items (present discounted value of future seigniorage; potential bailout costs) can be enormous.
  - Bank of Canada example: annual profits generally 60 times capital and reserves; operating expenses covered even if interest rates fell below 1 percent.
  - Counterexamples: Peru in 1980s and Argentina in 1988 had positive capital but dire financial situations.
- Use of “Other Items Net (OIN)” from IFS as indicator
  - OIN is the residual after explicit asset and liability items; correlated with reporting transparency and central bank financial strength.
  - Distributional observations for OIN to total assets (samples):
    - 1992 (sample of 148): 60 monetary authorities (41 percent) reported OIN within ±5 percent of total assets; 46 (31 percent) had OIN in excess of ±15 percent of total assets.
    - 2005 (sample of 157): 104 out of 157 monetary authorities (around two-thirds) were within ±5 percent; only 19 (12 percent) remained beyond the 15 percent threshold.
    - Negative OIN improvement: 1992 had 47 with negative OIN in excess of 5 percent of assets (24 had negative OIN in excess of 15 percent); 2005 had only 26 with negative OIN exceeding 5 percent, and those exceeding 15 percent decreased to 5 percent.
- Cross-country empirical observations
  - Countries where sum of capital and other items net was negative in 1992, 1997, or 2004 (“weak” central banks) had an average inflation rate more than twice as high as countries with financially “strong” central banks (sum positive).
  - Ize (2006): countries where central banks made losses had inflation levels almost three times as high as countries with profitable central banks (9.2 percent versus 3.7 percent in 2003).
  - Stella (2003) presents similar evidence for earlier samples and years.
  - A more comprehensive econometric analysis is forthcoming in Klüh and Stella (2008).
- Time-series/case evidence
  - Hungary: three years prior to NBH recapitalization (pre-1997) average inflation 23.5 percent and average 90 day treasury yield 27.6 percent; in the three years following recapitalization inflation averaged 11.4 percent and 90 day treasury rate averaged (data truncated in source).

### Country case findings: inflation, central bank losses, and recoveries
- Aggregate excerpted statistic
  - 14.4 percent. Real growth also increased from an average of 1.9 percent to 4.8 percent.
- Jamaica
  - Inflation averaged 31 percent during the years 1987–1993 while the central bank was registering significant losses.
  - Central bank losses stopped in 1995 following a recapitalization with government securities.
  - Inflation averaged 12 percent during the period 1995–2000.
- Peru
  - Following a recapitalization and a new central bank law in 1992 eliminating central bank quasi-fiscal activities, losses as a percentage of central bank liabilities to the private sector fell from close to 31 percent in 1991 to 2½ percent in 1994.
  - Broad money to GDP rose from 12 percent at the end of 1991 to 21½ percent in 1997.
  - The central bank’s operating balance turned positive in 1996 and has remained so in recent years at low, single-digit inflation rates.
- Uruguay
  - Losses averaging 3 percent of GDP in the late 1980s were brought down to ½ percent of GDP by 1995.
  - Inflation averaged 81 percent in the years 1986–1992 when the central bank’s capital position was negative.
  - Inflation averaged 18 percent during 1994–2000 when capital was positive.
  - Central bank losses reached a trough of 0.2 percent of GDP in 1999 before rising to 0.4 percent of GDP in 2003.
- Nicaragua
  - In 1995 the central bank’s operating position came into balance for the first time in a decade after the central bank suspended financing of state-owned banks and the government began making significant debt-service payments on its central bank debt.
  - Banking problems in 1998 led to central bank interventions and losses; resolution costs in August 2000–2001 led the central bank to issue dollar-indexed bonds totaling 20 percent of GDP.

### Methods and instruments used to enhance central bank financial strength
- Policy and institutional reforms
  - Eliminate or reduce quasi-fiscal operations (notably commercial bank rescue operations).
  - Strengthen bank supervision and the prudential framework, especially for state-owned commercial banks.
  - Legal reforms to central bank organic laws to eliminate below-market-rate lending to government and public enterprises.
- Exchange rate and reserve management
  - Accept greater exchange rate flexibility to reduce costly reserve accumulation and the need for domestic sterilization.
  - Alternatives include government ownership of foreign reserves or derivative transfers of reserve-related risks from the central bank to government.
- Debt instruments and recapitalization approaches
  - Recapitalization via transfer of cash and securities is the most straightforward approach; promises to provide securities in the future are often not kept in crisis situations.
  - Example arrangements:
    - India: RBI–government agreement allowing the RBI to issue government debt to sterilize liquidity from foreign exchange purchases, with domestic currency proceeds deposited at the RBI in a non-interest bearing account (government bears sterilization cost).
    - Czech Republic: similar arrangement noted by Holub (2004).
    - Norway: cash transfer to Norges Bank equivalent to 0.6 percent of GDP (2002).
    - Costa Rica: in 2004 government borrowed on international markets in foreign exchange and provided proceeds to the central bank (BCCR); transfer not sufficient to eliminate negative equity or central bank losses.
    - Chile: Congress approved transfers amounting to 0.5 percent of GDP for 5 years beginning with US$606 million in December 2006.
  - Use of government securities
    - Marketable securities can be provided in portfolios that match the currencies and cash flows of central bank obligations (example: Hungary).
    - Marketable securities can help develop domestic money and government debt markets, strengthening monetary operations.
- Cautions about nonmarketable and cosmetic solutions
  - Nonmarketable, non-interest-bearing, or extremely long-maturity securities (examples noted in source):
    - Peru’s 100 year treasury bonds at 0.1 percent under the “Budget financing law”.
    - Ghana’s nontransferable certificates.
    - Honduras’ 50-year non-accruing, non-tradable bond (face value over 1 percent of GDP but economic value close to zero).
  - Such instruments do not improve real financial strength and undermine transparency and fiscal credibility.

### Operational and market-development benefits of recapitalization
- Recapitalization with marketable securities can:
  - Provide the central bank with instruments for outright sales or repurchase agreements.
  - Serve as a foundation for an active money market.
  - Facilitate the development of a government debt market and improve the environment for monetary operations.
- Practical considerations for treasury participation
  - Ministries of finance are often reluctant or unable to provide cash recapitalizations due to limited liquidity and market absorption constraints.
  - Coordination of additional treasury issuance with redemption of existing central bank securities can be feasible.

### Concluding findings and implications
- Central bank financial strength is positively associated with good policy performance; financially weak central banks generate losses that undermine macroeconomic stability and policy credibility.
- Assessing central bank financial strength requires careful examination of the policy regime and economic volatility; standard private-enterprise measures can be misleading when applied to central banks.
- The method of strengthening central bank balance sheets matters: marketable securities that support market development are superior to cosmetic nonmarketable claims.

*Source: _wp0849 — Section VI contains concluding remarks.*

### References..............................................................................................................

### _wp0849 - References..............................................................................................................

### Tables and Figures inventory
- Tables
  - 1. United States: Consolidated Federal Reserve System ...........................................................9
  - 2. Bank of Canada....................................................................................................................10
  - 3. European Central Bank ........................................................................................................11
  - 4. Inflation Performance and Financial Strength .....................................................................18
- Figures
  - 1. Impact of Volatility and Nature and Ambitiousness of Policy Regime on Probability of a Recapitalization ..............................................................................................................8
  - 2. Other Items Net to Total Assets, 1992.................................................................................16
  - 3. Other Items Net to Total Assets, 1997.................................................................................16
  - 4. Other Items Net to Total Assets, 2002.................................................................................16
  - 5. Other Items Net to Total Assets, 2005.................................................................................16
  - 6. Ratio of Other Items Net to Total Assets.............................................................................17

### Acronyms (as listed)
- BCCR Central Bank of Costa Rica (Banco Central de Costa Rica)
- BOJ Bank of Jamaica
- CNB Czech National Bank
- EMU European Monetary Union
- IFS International Financial Statistics
- NBH National Bank of Hungary (Magyar Nemzeti Bank)
- OIN Other Items Net
- RBI Reserve Bank of India
- SARB South African Reserve Bank

### Introduction — key arguments and structure (Sections I–V)
- Central thesis
  - The financial strength of a central bank is an important factor determining policy outcomes.
  - Small changes in central bank finances are not material to macroeconomic policy performance in well-capitalized central banks.
  - Poorly-capitalized central banks are often constrained in their policy choices or may loosen policy to avoid large losses for reputational or political economy reasons.
  - The importance of central bank financial strength for policy outcomes increases exponentially as central bank finances become weaker or policy commitments become more ambitious.
  - A credible and independent central bank’s financial strength must be commensurate with its policy tasks and the risks it faces.
- Sectional overview
  - Section II
    - Discusses concepts of central bank financial strength and policy performance.
    - Contrasts these concepts with analogous concepts for private commercial enterprises.
    - Distinguishes microeconomic efficiency (important in all enterprises) from financial strength (a measure of likelihood a central bank will be financially unconstrained when choosing policy instrument settings).
    - States that financial strength depends on accounting valuation of the balance sheet, nature of the policy regime, predicted volatility of the economic environment, and the degree of desired financial independence granted by the political system.
  - Section III
    - Provides an overview of central bank financial strength across countries.
    - Notes different countries emphasize different aspects; microeconomic efficiency is a universal concern.
    - Observes losses become a macroeconomic concern only when they limit operational capacity and/or damage credibility.
  - Section IV
    - Explains difficulties in cross-country comparisons due to idiosyncratic and opaque accounting practices.
    - Presents evidence that central bank accounting is becoming more transparent over time.
    - Provides quantitative evidence that policy performance, as measured by the rate of inflation, is significantly worse in countries with financially weak central banks.
  - Section V
    - Reviews ways central banks have been recapitalized or strengthened in practice.
    - Argues that the method and/or instruments used for recapitalization can critically affect whether policy performance subsequently improves.

*Italic: IMF working paper references section content provided in the source PDF.*

### Section VI contains concluding remarks.

### _wp0849 - Section VI contains concluding remarks.

### Concepts of central bank financial strength and policy performance
- Definition: “Financial strength” describes the extent to which an entity is constrained by its financial situation in pursuing its strategic goals or policies. An entity is financially strong when it is relatively unconstrained and weak when financial constraints are binding on policy choices.
- Contrast with private enterprises:
  - For private enterprises primary metrics: profitability, enterprise book value (capital), market capitalization.
  - Profitability and market capitalization correlate with economic efficiency in competitive markets but can be poor signals in less competitive markets or when affected by random shocks.
- Central bank objectives and performance metrics:
  - Central banks are created by statute; primary benchmark is effective guidance of macroeconomic conditions (economic growth, price stability, financial stability).
  - Secondary consideration: internal efficiency in minimizing the cost of attaining objectives.
  - Profitability is incidental for central banks; revenue generation is not the primary goal.
  - Micro (internal efficiency) and macro (policy outcomes) performance measures should be separated; the paper focuses on macro performance and on situations where financial strength limits primary objectives.
- Financial accounts and measurement issues:
  - Central bank financial accounts provide information on cost of achieving policy outcomes but lack a well-defined production function linking inputs to outputs (price stability, low output volatility, exchange rate sustainability, financial market stability).
  - Operating expenses are often a better indicator of stewardship than net revenue (Bank of Canada 2005 Annual Report quote: “Net revenue is not a good indicator of the bank’s management performance. The bank deals in financial markets to achieve policy goals, not to maximize its revenues. For this reason the level of operating expenses is a better indicator of the bank’s stewardship of public resources.”).
- Relevance of financial strength:
  - In financially strong central banks, marginal deterioration in financial strength is unlikely to impede macroeconomic performance; debates center on insolvency rather than policy constraint.
  - In other countries, losses can limit policy outcomes and influence policy decisions.
  - Common misconceptions:
    - Unlimited domestic currency creation does not remove constraints—at some point created money may cease to be accepted as money.
    - Governments may not provide timely financial aid; quasi-fiscal activities imposed by treasuries can be root causes of central bank problems.
    - Central banks virtually never become legally insolvent, but policy outcomes can deteriorate in times of distress.
- Implication for credibility:
  - If credibility is important for monetary policy success, the central bank must be financially strong.
  - Financial auditors should use risk-based models to assess whether the central bank can survive adverse events without abandoning objectives.
  - The appropriate degree of central bank financial strength should be reevaluated when the objective, policy regime, or environmental volatility changes.
- Conceptual illustration (Figure 1):
  - p = Probability of needing a recapitalization; k = Capital.
  - For a given policy regime and capital, higher volatility increases probability of needing recapitalization.
  - For a given regime, more ambitious objectives increase likelihood of requiring recapitalization.
  - Different policy regimes require different levels of sustainable capital.

### Overview of central bank financial strength in a variety of countries
- Countries with strong central bank balance sheets: United States, Canada, member states of the European System of Central Banks.
- United States (Federal Reserve System):
  - “90 percent of the Federal Reserve System’s assets consist of U.S. Treasury securities and federal agency obligations.”
  - Federal Reserve Notes outstanding amount to 91 percent of total liabilities (excluding capital and surplus); reserves of depository institutions account for a further 3 percent.
  - Profits during 2002–2006 averaged US$25.6 billion (selected years shown in Table 1).
  - Table 1 (United States: Consolidated Federal Reserve System, In billions of U.S. dollars):
    - 1981: Capital 2.6, Profit Transfer to Treasury 14.2, 14.0, Total Assets 176.8
    - 1986: Capital 3.7, Profit Transfer to Treasury 18.0, 17.8, Total Assets 267.4
    - 1991: Capital 5.3, Profit Transfer to Treasury 21.2, 20.8, Total Assets 353.1
    - 1996: Capital 9.1, Profit Transfer to Treasury 21.0, 20.1, Total Assets 481.5
    - 2001: Capital 14.7, Profit Transfer to Treasury 28.0, 27.1, Total Assets 654.9
    - 2004: Capital 23.5, Profit Transfer to Treasury 21.4, 18.1, Total Assets 810.9
    - 2006: Capital 30.6, Profit Transfer to Treasury 34.2, 29.1, Total Assets 873.4
  - U.S. General Accounting Office found no compelling reason for the Fed to hold capital.
  - Quotation: “a central bank with the nation's currency franchise does not need to hold capital... the central bank can always create additional currency to meet any obligation denominated in that currency.”
- Canada (Bank of Canada):
  - Authorized capital: Can$5 million; statutory reserve (“rest fund”) reached Can$25 million in 1955.
  - “Out of total assets of Can$48 billion, the Bank holds Can$43 billion (92 percent) in securities issued or guaranteed by Canada.”
  - Bank virtually assured a profit under steady state conditions; Bank of Canada Act amended in 2006 to allow Board to retain as much as CAN$400 million to offset unrealized valuation losses; initial retention of CAN$100 million approved in September 2007.
  - Table 2 (Bank of Canada, In millions of Can$):
    - 1955: Capital 5, Profit 1308, Total Assets (value shown in source)
    - 1965: Capital 30, Profit (value shown), Total Assets 1563,956 (as in source)
    - 1975: Capital 30, Profit (value shown), Total Assets 62910,496
    - 1985: Capital 30, Profit 1,880, Total Assets 21,135
    - 1995: Capital 30, Profit 1,816, Total Assets 30,201
    - 2005: Capital 30, Profit 1,732, Total Assets 48,320
    - 2006: Capital 30, Profit 1,896, Total Assets 51,626
  - Note: Table entries preserved exactly as presented in source.
- European Central Bank (ECB):
  - Established with capital of €5 billion; foreign exchange assets of €39.5 billion transferred to ECB in early 1999.
  - “90 percent of its assets are in foreign exchange and gold,” creating exposure to losses offset by liabilities to national governments.
  - Table 3 (European Central Bank Profits/Losses, In Billions of Euro; In Percent of 2003 Euro Area GDP):
    - 1999: 0.67, .00
    - 2000: 1.99, .03
    - 2001: 1.82, .02
    - 2002: 1.22, .02
    - 2003: -0.48, -.00
    - 2004: -1.64, -.02
    - 2005: 0.00, .00
    - 2006: 0.00, .00
  - Losses have not been of macroeconomic significance nor part of ECB monetary policy debate.
- Contrasting views among central bankers:
  - Bundesbank President Axel Weber: “The Bundesbank profit is a residual issue for me and my colleagues...I don't enter into any strategic considerations about Bundesbank profits...”
  - Governor Laurence H. Meyer (testimony): central bank can create money to meet obligations—carries presumption that losses might require a change in policy.
- Cases where losses affected policy:
  - Venezuela (1997): aggressive issuance of central bank obligations for sterilization; drawdown of treasury deposits; eventual easing of monetary policy owing to quasi-fiscal losses.
  - Costa Rica: nearly two decades of central bank losses; by end-2000 negative capital exceeding 6 percent of GDP; interest-bearing liabilities almost double interest-bearing assets by end-2002; reluctance to lower inflation target due to balance sheet sustainability concerns.
    - Quote from Central Bank of Costa Rica governor: “We, the central bank, have a negative net worth...and this remains our greatest challenge.”
  - Jamaica (early 1990s): Bank of Jamaica negative net equity of US$1½ billion at end-1991; losses from quasi-fiscal activities and servicing external debt; losses averaged 53 percent of reserve money during fiscal years 1988/89–1991/92; consumer price inflation exceeded 80 percent at end-1991. Later controversies re: foreign reserve accumulation losses; governor argued insurance value of reserves outweighed costs.
  - Uruguay: central bank losses averaged 3 percent of GDP in late 1980s.
  - Nicaragua: cost of resolving four failed banks in August 2000–2001 led Central Bank of Nicaragua to issue dollar-indexed bonds totaling 20 percent of GDP.
  - Bank of Japan (late 2002–early 2003): market doubts about continued purchases of long-term government debt due to risk of capital losses raised credibility concerns.
  - Czech National Bank: negative equity from revaluation losses but ability to achieve policy objectives not impaired; government participation in sterilization costs and falling domestic interest rates helped financial sustainability.
  - Central Bank of Armenia: large revaluation losses on foreign reserves but these followed successful policy (low inflation, strong fiscal situation, rapid growth); expected increasing seigniorage over time.
  - South African Reserve Bank (SARB): negative net open foreign currency position of US$23.2 billion at end-September 1998; resolved to eliminate position to stabilize rand and improve credit rating prospects.

### Evidence for the impact of financial strength on policy performance
- Measurement challenges:
  - Market capitalization of central banks not available; policy environment subjective; capital is a poor proxy for financial strength.
  - Capital depends on accounting and profit distribution rules that vary widely across central banks; dividends are rarely at management's discretion.
  - Revaluation gains/losses treatment varies widely (example: IMF IFS data on gold valuation at end 2002—72 of 113 countries within 10 percent of London spot gold price US$342.75; others used historical US$42 or US$35 per ounce or intermediate values).
  - Off-balance-sheet items are potentially enormous: present discounted value of future seigniorage; potential bailout costs of financial institutions.
  - Bank of Canada example: annual profits generally 60 times capital and reserves; operating expenses covered even if interest rates fell below 1 percent. Conversely, Peru in 1980s and Argentina in 1988 had positive capital but dire financial situations.
- Use of “Other Items Net (OIN)” from IFS as indicator:
  - OIN is the residual after explicit asset and liability items; correlated with reporting transparency and central bank financial strength (OIN often contains accumulated losses or “hidden” reserves).
  - Histograms and distribution analysis for OIN to total assets for 1992, 1997, 2002, 2005 (samples of 148, 171, 162, 157 monetary authorities respectively) show:
    - 1992: 60 monetary authorities (41 percent) reported OIN within ±5 percent of total assets; 46 (31 percent) had OIN in excess of ±15 percent of total assets.
    - 2005: 104 out of 157 monetary authorities (around two-thirds) were within ±5 percent; only 19 (12 percent) remained beyond the 15 percent threshold.
    - Negative OIN (identified assets much less than identified liabilities) improved: in 1992, 47 had negative OIN in excess of 5 percent of assets (24 had negative OIN in excess of 15 percent); in 2005, only 26 had negative OIN exceeding 5 percent, and those exceeding 15 percent decreased to 5 percent.
- Cross-country empirical observations:
  - Countries where the sum of capital and other items net was negative in 1992, 1997, or 2004 (“weak” central banks) had an average inflation rate more than twice as high as countries with financially “strong” central banks (sum positive). (Table 4 referenced in source; one-tail t-test results reported in source.)
  - Stella (2003) presents similar evidence for earlier samples and years.
  - Ize (2006): countries where central banks made losses had inflation levels almost three times as high as countries with profitable central banks (9.2 percent versus 3.7 percent in 2003).
  - A more comprehensive econometric analysis is forthcoming in Klüh and Stella (2008).
- Time-series/case evidence supports the proposition that financial strength matters:
  - Hungary: three years prior to NBH recapitalization (pre-1997) average inflation 23.5 percent and average 90 day treasury yield 27.6 percent; in the three years following recapitalization inflation averaged 11.4 percent and 90 day treasury rate averaged (data truncated in source).

*Source: _wp0849 - Section VI contains concluding remarks.*

### 14.4 percent. Real growth also increased from an average of 1.9 percent to

### _wp0849 - 14.4 percent. Real growth also increased from an average of 1.9 percent to

### Country case findings: inflation, central bank losses, and recoveries
- Overall excerpted statistic: 14.4 percent. Real growth also increased from an average of 1.9 percent to 4.8 percent.
- Jamaica
  - Inflation averaged 31 percent during the years 1987–1993 while the central bank was registering significant losses.
  - Central bank losses stopped in 1995 following a recapitalization with government securities.
  - Inflation averaged 12 percent during the period 1995–2000.
- Peru
  - Following a recapitalization and a new central bank law in 1992 eliminating central bank quasi-fiscal activities, losses as a percentage of central bank liabilities to the private sector fell from close to 31 percent in 1991 to 2½ percent in 1994.
  - Broad money to GDP rose from 12 percent at the end of 1991 to 21½ percent in 1997.
  - The central bank’s operating balance turned positive in 1996 and has remained so in recent years at low, single-digit inflation rates.
- Uruguay
  - Losses averaging 3 percent of GDP in the late 1980s were brought down to ½ percent of GDP by 1995.
  - Inflation averaged 81 percent in the years 1986–1992 when the central bank’s capital position was negative.
  - Inflation averaged 18 percent during 1994–2000 when capital was positive.
  - Central bank losses reached a trough of 0.2 percent of GDP in 1999 before rising to 0.4 percent of GDP in 2003.
- Nicaragua
  - In 1995 the central bank’s operating position came into balance for the first time in a decade after the central bank suspended financing of state-owned banks and the government began making significant debt-service payments on its central bank debt.
  - Banking problems in 1998 led to central bank interventions and losses; resolution costs in August 2000–2001 led the central bank to issue dollar-indexed bonds totaling 20 percent of GDP (part of this debt has recently been restructured).

### Methods and instruments used to enhance central bank financial strength
- Policy and institutional reforms
  - Eliminate or reduce quasi-fiscal operations (notably commercial bank rescue operations) to strengthen central bank finances.
  - Strengthen bank supervision and the prudential framework, especially for state-owned commercial banks.
  - Legal reforms to central bank organic laws to eliminate below-market-rate lending to government and public enterprises.
- Exchange rate and reserve management
  - Accept greater exchange rate flexibility to reduce costly reserve accumulation and the need for domestic sterilization.
  - Alternatives include government ownership of foreign reserves or derivative transfers of reserve-related risks from the central bank to government.
- Debt instruments and recapitalization approaches
  - Recapitalization via transfer of cash and securities is the most straightforward approach; promises to provide securities in the future are often not kept in crisis situations.
  - Example arrangements
    - India: RBI–government agreement allowing the RBI to issue government debt to sterilize liquidity from foreign exchange purchases, with domestic currency proceeds deposited at the RBI in a non-interest bearing account (government bears sterilization cost).
    - Czech Republic: similar arrangement noted by Holub (2004).
    - Norway: cash transfer to Norges Bank equivalent to 0.6 percent of GDP (2002).
    - Costa Rica: in 2004 government borrowed on international markets in foreign exchange and provided proceeds to the central bank (BCCR); transfer not sufficient to eliminate negative equity or central bank losses.
    - Chile: Congress approved transfers amounting to 0.5 percent of GDP for 5 years beginning with US$606 million in December 2006.
  - Use of government securities
    - Marketable securities can be provided in portfolios that match the currencies and cash flows of central bank obligations (example: Hungary).
    - Marketable securities can help develop domestic money and government debt markets, strengthening monetary operations.
- Cautions about nonmarketable and cosmetic solutions
  - Nonmarketable, non-interest-bearing, or extremely long-maturity securities (e.g., 100 year bonds at 0.1 percent interest, or nontransferable certificates with no maturity) do not improve the real financial strength of the central bank and undermine transparency and fiscal credibility.
  - Examples: Peru’s 100 year treasury bonds at 0.1 percent under the “Budget financing law”; Ghana’s nontransferable certificates; Honduras’ 50-year non-accruing, non-tradable bond (face value over 1 percent of GDP but economic value close to zero).

### Operational and market-development benefits of recapitalization
- Recapitalization with marketable securities can:
  - Provide the central bank with instruments for outright sales or repurchase agreements.
  - Serve as a foundation for an active money market.
  - Facilitate the development of a government debt market and improve the environment for monetary operations.
- Practical considerations for treasury participation
  - Ministries of finance are often reluctant or unable to provide cash recapitalizations due to limited liquidity and market absorption constraints.
  - Coordination of additional treasury issuance with redemption of existing central bank securities can be feasible.

### Concluding findings and implications
- Central bank financial strength is positively associated with good policy performance; financially weak central banks generate losses that undermine macroeconomic stability and policy credibility.
- Assessing central bank financial strength requires careful examination of the policy regime and economic volatility; standard private-enterprise measures can be misleading when applied to central banks.
- The method of strengthening central bank balance sheets matters: marketable securities that support market development are superior to cosmetic nonmarketable claims.

*Source: _wp0849*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2008/_wp0849.pdf_