The Evolving Role of Central Banks

6 Implications and Remedies of Central Bank Losses

Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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A central bank should normally make a profit because it is essentially a monopolistic enterprise supplying an essential commodity—that is, currency—the demand for which is inelastic—at least up to a minimum amount. Such privileged enterprises should not, under normal circumstances, make losses. Indeed, the notion of a loss seems so alien to the nature of central banking that its emergence on the books of a central bank may give the impression of a serious breakdown in financial discipline and raise doubts about the soundness of the entire financial system, and even the economy as a whole. Such an impression may not be fully justified, however. It is not necessarily a lack of financial discipline by the central bank that leads to losses; they often represent a hidden form of fiscal deficit, and, depending on how they are treated, they do not necessarily spell disaster.

A loss is, in principle, a possible outcome of central banking operations and can arise even in connection with the most basic of all central banking functions: currency issue. A loss will occur when the interest rate charged by the central bank on its loans is not sufficiently high to cover the printing, minting, and administrative costs of currency issue. More generally, losses could arise from a multitude of factors, and, in practice, many central banks have incurred persistent losses, for example, the Bank of Jamaica and the central banks of Argentina, Brazil, Chile, Gambia, Ghana, the Philippines, and Turkey.1

In some countries, central banks have found themselves unprepared to deal with the losses, reflecting, in part, the inadequacies of the central banking laws. Indeed, many central banking laws do not incorporate adequate provisions regarding the financing of central bank losses.2 Even where the provisions of the law are adequate, the practice in countries where the central bank has experienced losses has been to ignore them until their size becomes a significant macroeconomic and political issue.

This complacency in dealing with central bank losses could reflect the improbability of such losses in developed countries and a view that a central bank cannot become insolvent. According to this view, central banks, unlike other banks, can have a persistently negative net worth, so that their losses need not be funded.3 The statement could be interpreted to mean that central bank losses are not important because they can be financed through creation of additional losses.4

This paper considers this proposition and concludes that central bank losses do matter, as they influence economic aggregates both directly and through their impact on monetary management. The sources from which central bank losses originate are reviewed in the next section. This is followed by a discussion of the problems posed by the losses and a few suggestions for preventing their emergence. Conclusions of the paper are summarized in the last section.

Sources of Central Bank Losses

In a discussion of the origins of central bank losses, it would be useful to distinguish current losses from capital losses. Current losses arise from imbalances in revenues and expenditures and capital losses result from differential changes in the value of assets and liabilities. Current losses (or gains)—whether realized or accrued—are always calculated into the financial results of the central bank, but certain capital losses are not. For example, a capital loss arising from an increase in net foreign liabilities due to a change in the exchange rate is usually excluded from the computation of annual profits and losses. It is attributed to a valuation account, which is an item in the balance sheet. This approach allows the central bank’s net worth and its reserves to remain intact as a result of such a loss until it is realized.

Current Losses

As in any kind of business activity, central bank current losses occur when earnings from assets are lower than the cost of operations. This observation can be translated into a relationship between the spread between average return on earning assets and the average charge on remunerable liabilities, the nonearning assets, and the base money.5 To prevent losses, at any level of capital, the spread has to be larger, the larger are the nonearning assets and the smaller is the base money.6 In other words, to prevent losses, the ratio of base money to nonearning assets would have to increase as the spread is reduced. This can be seen from the balance sheet relationships.7 In a simplified and approximate form, the financial results of the central bank can be explained in the following way:


  • RES = the financial result of the central bank (i.e., its profit or loss);
  • i = the average interest rate paid by the central bank on its remunerated liabilities;
  • s = the spread between the average return on earning assets and i;
  • EA = the stock of earning assets; and
  • RL = remunerated liabilities composed usually of foreign liabilities, deposits of government agencies and financial institutions, and financial instruments issued by the central bank.

Total assets can be decomposed into earning (EA) and nonearning assets (NEA). Total liabilities can be divided between remunerated liabilities, capital and reserves (K), and the base money (RM).8 The balance sheet identity then becomes

so that

This equation indicates that any factor that constrains the ability of the central bank to vary its spread or the base money, or to contain its nonearning assets, contributes to the emergence of current losses.

The statement should not be interpreted as recommending that the central bank operate primarily to avoid losses. Even if it could control the factors that affect its losses, it should not behave as a profit-maximizing or cost-minimizing enterprise. By manipulating its spread, the base money, and nonearning assets, the central bank may reduce its losses, but at the same time, it may trigger undesirable changes in interest rates throughout the financial system, generate more inflation, or cause a depletion of foreign exchange reserves. Such developments are usually contrary to the objectives of economic policy, and their cost should be taken into account when formulating any policy to contain the losses of the central bank. This qualification notwithstanding, some of the factors that constrain the ability of the central bank to avert current losses are reviewed below.

Influencing the Spread

No central bank can exercise full control on the components of average spread, but it is fair to say that the central bank can exercise more control on the return on its assets than on the charges paid on its liabilities.9 The charges on foreign liabilities are determined by developments in foreign financial markets and by the rate of change in the exchange rate; the latter determines the variations in domestic currency value of these liabilities. The charges on domestic liabilities are determined to a large extent—in the absence of any coercion for holding financial instruments issued by the central bank—by public demand for such instruments. The central bank can usually manipulate the amount of such instruments in order to achieve the price it wants; however, the possibility becomes less probable as the size of its domestic debt grows.

The ability of the central bank to influence the return on its assets is, therefore, crucial to averting losses. The scope for such control is typically constrained by such factors as administrative restrictions on interest rates charged by the central bank. Such restrictions typically include an arbitrarily fixed discount rate, an obligation to provide subsidized loans to priority sectors, and low interest loans to the government. The latter is a common problem in many developing countries.10

Control of the Base Money

The central bank’s ability to vary the base money in order to prevent losses could be constrained by its monetary policy objectives. For example, following a period of rapid monetary expansion, it may become necessary to withdraw large amounts of liquidity from the system. In the process, the central bank’s income may fall, while its expenditure could rise, possibly resulting in overall losses. The decline in the central bank’s income would result from a reduction in credit granted by the central bank, reflecting its contractionary stance. The increase in expenditure would reflect the rise in interest payments by the central bank, which would come about irrespective of whether absorption is carried out through the sale of the central bank’s own financial instruments or through the sale of government securities.11

The above discussion points to the fiscal nature of central bank losses and to the inseparability of the central bank’s activities from budgetary operations. For example, the sale of treasury bills from the central bank’s own portfolio decreases its earning assets and, therefore, its income. If new treasury bills are issued for this purpose, the proceeds of the sale have to be deposited in the government’s account at the central bank for the contractionary impact to be realized. The central bank may have to pay interest on these deposits to neutralize the adverse impact of the sale of new treasury bills on budgetary interest costs, and, thereby, on the budgetary deficit. The central bank’s expenditure would increase and adversely affect its financial results.

Sources of Nonearning Assets

Activities that increase the nonearning assets of the central bank contribute to current losses. The sources of nonearning assets are usually non-interest-bearing government loans and securities held by the central bank, and its so-called quasi-fiscal activities carried out at the request of the government to support economic policies. These activities generally refer to central bank functions that are not directly related to the objective of safeguarding the value of the currency. They include such functions as domestic debt management, foreign reserves and exchange rate management, prudential supervision and deposit insurance, financial sector development, economic development, and improving income distribution.12 For example, the takeover of nonperforming loans of bankrupt institutions as part of the supervisory functions of the central bank (as was the case in Chile and Uruguay) could contribute to the growth of nonearning assets of the central bank.

Foreign Exchange Operations

The above discussion of cash flow losses ignores the impact of what may be called trading activities of the central bank. These operations, especially those conducted in foreign currencies, could be a source of substantial losses for the central bank. In many countries, exchange control regulations give the central bank a virtual monopoly on foreign exchange operations. Exporters are required to surrender their foreign exchange receipts to the central bank—which is in turn obliged to purchase them—and the public can only purchase foreign exchange from the central bank. This monopoly position can be potentially profitable for the central bank as it can purchase foreign exchange from exporters at lower prices than it sells to importers. Exchange rate fluctuations, however, can erode such benefits and make the task of managing the foreign reserves of the country expensive for the central bank. The costs are higher if the central bank is also entrusted with the responsibility of defending the exchange rate. Many central banks also engage in forward operations in foreign exchange and borrow abroad in support of this policy, further exposing themselves to risk of capital losses arising from exchange rate variations.

Capital Losses

Capital losses usually originate from such factors as the impact of changes in the exchange rate on the foreign assets and liabilities of the central bank; the effect of fluctuations in foreign exchange parities on a diversified portfolio of foreign assets and liabilities held by the central bank; granting of exchange rate guarantees that are realized; rescue of troubled institutions by the central bank involving the purchase of their bad assets at inflated prices; and, generally, granting of loans and advances that turn out to be uncollectible. The most common sources of such losses for central banks in developing countries relate to their role in foreign exchange management. In implementing this role, many central banks accumulate large foreign liabilities, making them vulnerable to exchange rate fluctuations;13 Jamaica, Argentina, and Turkey provide good examples of this problem.

The Bank of Jamaica has accumulated substantial net foreign liabilities in order to support the Government’s exchange rate policy. These liabilities have made the Bank of Jamaica vulnerable to exchange rate movements, and the large devaluations of the Jamaican dollar during 1983–85 resulted in substantial losses for the bank.14 At the end of March 1989, the bank’s nonearning assets, which represent the counterpart of its losses, amounted to 78 percent of its assets.

In Argentina, the foreign assets of the central bank are sold to the Government in exchange for a government security denominated in foreign currency. The operation does not affect the central bank’s net foreign assets as they appear in the balance sheet but does increase nonearning assets and reduce the central bank’s income. This is because no interest is usually paid by the Government on its securities held by the central bank, nor can these securities be redeemed in foreign currency when they mature. The potential loss is not reflected in the accounts of the central bank.

A capital loss could also be associated with the exchange rate guarantees or insurance schemes offered by the central bank that fix the debt service in terms of domestic currency. In Turkey, for example, the central bank’s foreign exchange insurance scheme led to substantial losses during 1984–88. Under the scheme, the central bank on-lent funds borrowed abroad to domestic borrowers at interest rates that were substantially below the average rate of depreciation of the Turkish lira, thereby providing a large subsidy to them.

Impact of Losses

The losses of the central bank are likely to have an impact on its prestige and authority and may also influence macroeconomic developments. The perception that it may not be financially sound, however simplistic the view, could erode its authority to supervise the financial system and limit its ability to use moral suasion as an instrument of policy. Its independence in managing its internal affairs may be diluted by, for example, pressures to make the central bank’s administrative budget subject to approval by the government or the legislature, as a way to limit its losses. Except in such extreme cases, the erosion of the central bank’s authority would be difficult to measure. The losses would have a more tangible impact on economic aggregates and on monetary management. The macroeconomic effects could come about both directly—through the effects of the losses on monetary expansion—and indirectly—through their impact on the efficiency of monetary management.

Macroeconomic Impact

The expenditure of the central bank constitutes an injection of liquidity into the economy and its revenues, a withdrawal of liquidity. This statement holds for the central bank’s operations in both domestic and foreign currency, but the impact of foreign currency operations on domestic liquidity may take time to materialize. Whenever foreign exchange resources used for a particular transaction are obtained from, or flow to, the domestic economy, the impact of the transaction on domestic liquidity will occur immediately. If, however, the central bank uses foreign exchange resources from its own stock, or borrows abroad, for a transaction, the operation will not immediately generate a domestic currency counterpart, nor will the impact on domestic liquidity be felt at the time of transaction. Nevertheless, even in this case, a monetary impact can occur over time if the use of foreign exchange for that transaction creates or widens excess demand for foreign exchange, forcing the public to hold more reserve money than desired, thereby putting pressure on the exchange rate and interest rates.15

From a macroeconomic point of view, losses of the central bank are a problem only if they endanger attainment of monetary targets. As the losses represent an injection of liquidity, the central bank may have to sterilize their impact partially or entirely in order to achieve money growth objectives. This would be the case if, in any period, losses lead to more rapid growth in the base money than desired, making it necessary for the central bank to issue interest-bearing liabilities, such as central bank certificates of deposit, to absorb the additional liquidity in the system.16 This type of sterilization embodies a risk that future losses may grow exponentially. The point is further examined in Appendix I.

The vicious circle of rising losses and rising remunerated liabilities would be accompanied by increases in interest rates in each round. This would be necessary to reduce private demand and encourage the holding of certificates of deposit by the private sector. The prospect can be avoided as long as losses of the central bank are compensated by surpluses in other parts of the public sector. Surpluses may not be able to match the growing losses, however, and interest rates would have to rise, eventually leading to a reduction in profitability, investment, and growth.17

Problems Posed for Monetary Management

Losses of the central bank, especially if they are large relative to the monetary base, could erode the ability of the central bank to conduct monetary management efficiently, further compounding the adverse macroeconomic effects mentioned above. The experience of countries such as Jamaica indicates that persistent losses of the central bank could lead to inconsistent use of monetary policy instruments.

Growing losses create an environment in which the central bank would face the continuous task of sterilizing the monetary impact of its losses by absorbing liquidity from the financial institutions. To a large extent, this could be done through open market operations, but—as was the case in Jamaica—it may become necessary to reinforce the operations by raising the cost of access by financial institutions to the central bank’s facilities. The Bank of Jamaica—which had accumulated substantial domestic interest-bearing liabilities (certificates of deposit) in order to contain monetary growth—raised the penalty rate on its liquidity support facility to 60 percent a year in 1989 and currently penalizes redemption of securities at very high rates. These measures made the management of day-to-day fluctuations in liquidity more difficult for the banking system and impeded the development of the money market. They were not, however, adequate to reduce liquidity to the desired level so that the Bank of Jamaica had to continue issuance of its own certificates of deposit.

At the same time as the central bank’s domestic remunerable liabilities grow, so do pressures for expansionary monetary policy as a way to reduce losses, which would conflict with the objective of reducing liquidity in the system. Through an expansionary policy, the central bank can increase the proportion of nonremunerated debt in its liabilities portfolio, thereby reducing its losses. Thus, central bank losses embody an inherent bias toward generating inflationary surprises.

An analysis of the components of the term i.RM in equation (3) shows that existence of nonearning assets on the central bank balance sheet increases the risk of inflationary bias in the central bank’s behavior. This term represents seigniorage profits, that is, the amount that the central bank saves because of the public’s willingness to hold the central bank’s non-interest-bearing debt.18 It can be decomposed into two elements by replacing the nominal interest rate, i, with the sum of the real interest rate, r, and the inflation rate, p, in equation (3):

Equation (4) shows the inflation tax, p.RM, as a component of seigniorage. Thus, the higher the nonearning assets, the stronger would be the incentive for the central bank to generate surprise bursts of inflation to finance its losses. Such policies, however, are likely to be self-defeating as they may lead the public to expect future inflations and devaluations, thereby helping to keep interest rates high.

Central bank losses are likely to complicate monetary management whether the central bank relies on market-oriented indirect instruments of monetary control or on direct instruments, such as bank-specific credit ceilings and administratively fixed interest rates. Under the indirect approach, as the losses lead to progressively higher interest rates and increase their volatility, interest rate management and financial programming become more complex. Interest rate volatility will also impede the development of the money market. These problems may eventually force the central bank to depart from its indirect approach, at the cost of distorting interest rates and impeding efficient resource allocation.

If the central bank relies primarily on direct instruments of monetary control, it can finance its losses through base money creation and then sterilize the impact by tightening the ceilings appropriately. The resulting excess reserve will lead to lower deposit rates, higher lending rates, or both, and pressures will intensify for evading the ceilings. To prevent this, the central bank may have to pay interest on the banking system deposits it holds, or to increase reserve requirements. The former will further increase its losses; the latter could have well-known undesirable effects on the financial system.

Possible Remedies

A conclusion of the discussion of the previous sections is that central bank losses are usually a substitute for larger fiscal deficits, and that their impact is the same as that associated with monetization of the budgetary deficits. Therefore, just as it would be necessary to contain the budget deficit to the levels that can be financed in a manner consistent with monetary targets, and just as this may require a transfer of resources from the public to the government, the losses of the central bank may have to be compensated through transfers from the public to the central bank. Against this background, a two-step approach to resolving the problem of the losses should be adopted. The first step would be aimed at eliminating the existing nonearning assets and improperly priced off-balance sheet items. The second would consist of putting in place procedures to avert emergence of losses due to increases in remunerated liabilities and assumption of nonearning and high-risk assets and exposures.

Dealing with Existing Nonearning Assets

The nonearning assets already on the balance sheet of the central bank should be eliminated by a transfer of negotiable treasury bills and longer-term government securities to the central bank in the amount of the latter’s nonearning assets. It would be preferable if the transfer of these securities were intermediated through the private sector. This would ensure that the returns on these assets are market related and that the securities will be marketable—a characteristic that is important to preserve the integrity of the central bank’s accounts. The mechanism could be for the government to raise cash by issuing securities through auctions or other appropriate selling techniques. The cash is then transferred to the central bank, and the latter will reduce its valuation account or other nonearning assets (or advances to the government, if past losses have been imputed to such an account) as well as its liabilities in the form of currency. The central bank can then sterilize the transaction by purchasing government securities on the secondary market as needed for monetary policy purposes.

In case this procedure cannot be implemented owing to the thinness of the secondary market for government securities relative to the size of the requisite transfer, negotiable securities should be transferred directly to the central bank, but the interest rates they carry should be market related. They can be set at a level consistent with the weighted average interest rate obtained from the latest treasury bill auction, if an auction mechanism is in effect. Otherwise, they should reflect international interest rates adjusted for expected rate of depreciation of domestic currency.

Many central banking laws would have to be amended to specifically permit and call for such transfers. Only a few of the central banking laws examined envisaged the possibility that the reserves of the central bank would not be sufficient to cover its losses, thus requiring a transfer from the government. Among these, only two require cash payments by the government (Jamaica and Solomon Islands), which is the only procedure that would guarantee a reduction in nonearning assets (canceled against a reduction in currency liabilities).19 Others make the government responsible for compensating the central bank without specifying the mechanism (Japan, Nepal, Oman, the United Arab Emirates), or, as in Belize, require imputing the losses to a government advance account. In France, the law allows deduction of past central bank losses in calculating current year’s net profits for distribution. In Somalia and Yemen, the law obliges the central bank to subsequently repay the amounts paid by the government to finance the losses. Neither of these operations would guarantee the elimination of nonearning assets.

Preventing Future Losses

The second step in addressing the problem of central bank losses consists of putting in place procedures that would help prevent the emergence of annual losses. A general principle in this regard is that, in its financial activities, the central bank should behave as much as possible like a well-functioning private institution. This does not necessarily mean that it should behave as a profit maximizer but that it should adequately cover its risks and adopt, as much as possible, a market-oriented approach to its operations.

Amalgamation of Central Bank Losses and Budgetary Deficits

The most important component of the above procedures is to rationalize the financial relationship between the government and the central bank.20 This can be done by recognizing the fiscal nature of central bank losses by amalgamating them with the outcome of the government budget, thereby explicitly requiring government policies to cover the losses.21 This procedure would impose a strong degree of budgetary discipline, as the government would have to choose an appropriate tax-spending mix to keep its debt on a nonexplosive path.22 The separation of the government budget deficit from the central bank’s profits and losses does not alter the fact that, as noted by Fry (1990, pp. 13–14), what government saves today as a result of the expenditure incurred by the central bank, it will lose in the future through reduced transfers of central bank profits to the treasury.

Amalgamation has a further benefit in that it may reduce the incentive for the central bank to occasionally use such monetary policy instruments as the reserve requirement, for the sole purpose of reducing losses. For example, the presence of losses on the accounts of the central bank may create the impression that the primary beneficiaries of the losses are the main customers of the central bank, that is, the financial institutions. This could increase pressure to solve the problem of losses by taxing the financial sector—through, for example, an increase in reserve requirements.

Apart from the likely disruption of monetary management, such a policy would have other disadvantages. First, a one-time increase in the reserve requirement is unlikely to be sufficient to avert future losses since the bulk of the expenditure reduction due to a higher reserve ratio only occurs once, at the time of the increase. Further increases of similar proportions would be necessary in following years. Second, the cost of higher reserve requirements, would place a heavy burden on intermediation, with detrimental consequences for savings mobilization, investment, and economic growth.23 Third, an increase in reserve requirements—which would allow the central bank to issue a larger volume of base money to support a given volume of deposits—for the sole purpose of reducing central bank losses could disrupt monetary management.

For the amalgamation of the losses into the budget to be more than a simple accounting arrangement, two additional procedures should be put in place.24 First, at the time of the preparation of the budget, central bank losses should be included in the projected deficit. The magnitude of the combined deficit has to be judged on the basis of the implication of its financing for overall credit expansion and, if relevant, for domestic and foreign debt-service payments. If the deficit is deemed to be too large on these grounds the tax-spending mix may have to be changed to reduce the deficit. Second, in case the configuration of the budget is such that the losses of the central bank are to be compensated by surpluses generated in other parts of the public sector for the deficit target not to be exceeded, these surpluses should be deposited in the accounts of these agencies at the central bank as they are realized. In this way the requisite sterilization would occur and there would be no need for further measures by the central bank. If the surpluses are left elsewhere in the financial system, they would raise the banking system’s liquidity and could lead to further unprogrammed credit expansion.

Complementary Measures

Whether or not central bank losses are incorporated into the budgetary deficit, specific procedures need to be put in place to rationalize the financial relationship of the government with the central bank. These procedures will be needed even more if amalgamation is not carried out. As a minimum, they should include the following.

First, although in practice it would make little difference whether the government receives low interest loans from the central bank or a share of its profits, it would be preferable for the central bank to charge market-related interest on its loans to the government. This would be beneficial from the point of view of maintaining the transparency and integrity of central bank accounts and in order to be able to ensure that the subsidy involved in central bank lending to the government would not result in overall losses for the central bank. The central bank should also rely on the securities issued by the government in conducting open market operations. This would help incorporate the cost of monetary policy implementation directly into the fiscal budget.

Second, in general, the central bank should not be a conduit for channeling financial resources to the priority sectors at below market prices. Such subsidization is best done through the budget, as in this way the cost of subsidies becomes transparent and their growth can be monitored clearly. If the central bank has to carry out such activities, it should impute the risk and the subsidy involved in its quasi-fiscal activities to its prudential reserves, thereby reducing its transfers to the government. The proper measure of these costs is the amount that would have to be paid to the private sector to carry out the function. This will help the central bank to maintain its financial integrity. In some countries, like Brazil, the government does make a provision for subsidies provided indirectly through the central bank. Typically, however, the amounts set aside have been inadequate.

Third, the central bank should not borrow abroad except for short-term balance of payments purposes, and the government should assume the entire exchange rate risk involved in all foreign borrowing by the central bank.25 Central banks borrow abroad practically always in fulfillment of their role to preserve the value of the currency In this sense, they are incurring obligations in support of government policy. Even short-term borrowing for balance of payments purposes is usually undertaken in support of a policy of exchange rate stabilization; an objective that is imposed on the central bank by government policy In these cases, clearly, the government should bear any exchange risks involved.

The obligation of the government in this regard does not derive from the fact that there may be a subsidy involved in on-lending of foreign resources to the government by the central bank. If the central bank on-lends the funds borrowed abroad to the government at a market rate, no subsidy is involved.26 The government should still be responsible, however, for any losses suffered by the central bank as a result of borrowing abroad. Such a loss would come about if actual devaluation exceeds expectations. This is because, in that case, the premium for devaluation expectations incorporated in the interest rate paid by the government on its credit from the central bank would not be sufficient to cover the entire cost to the central bank.

A foreign exchange risk is associated not only with transactions in foreign exchange, but with all the lending activities of the central bank. This is because, at any given level of demand for cash balances, any credit extended by the central bank will eventually create an equivalent demand for foreign exchange that—at an unchanged supply of foreign exchange—will put pressure on the exchange rate. If the exchange rate is then adjusted, the risk materializes. If it is not allowed to adjust, the additional demand will lead to an equivalent decline in the country’s net international reserves, which in many countries are uniquely held by the central bank. Thus, a foreign exchange cost is involved in both cases.

The central bank should be allowed to impute such risks—which are inherent in all its lending operations—to the interest rates it charges. Even if allowed to do so, however, the central bank’s interest rate policy may at times dictate otherwise. For example, if monetary management is based on interest rate targeting, it may not be possible for the central bank to adjust the discount rate in order to take account of all the risks involved in its lending operations. In these circumstances, the likelihood of registering a loss increases, and the central bank should be compensated if a loss is actually realized.

Fourth, the central bank should set aside reserves against potential losses. Some central bank acts give the central bank discretion to set aside profits for this purpose. Thus the onus is placed on central bank management to have the foresight to provide adequately for eventual losses. Some central bank laws allow a (reserve) valuation account on the liabilities side of the balance sheet as a reserve against valuation losses arising from changes in the exchange rate. This account reflects net gains from valuation changes that are not distributed but set aside as reserve against future losses from exchange rate changes. When a valuation loss due to a change in the exchange rate occurs, the amount of the loss is deducted from the balance of the valuation account. In case the balance of this account is insufficient to cover the loss, these laws require a transfer of government securities to the central bank in the amount of the deficiency. In most cases, however, the law specifies that these securities should not be negotiable nor bear interest. Therefore, the transfer of these securities does not reduce the nonearning assets of the central bank, nor does it make it more probable that funds would be available when the foreign liability becomes payable.

An alternative but similar approach is to credit the gains from valuation into an interest-bearing blocked government account at the central bank and settle valuation losses by debiting this account. In case the credit balance is not sufficient to cover the losses, the government could transfer interest-bearing securities to the central bank. This would allow for a prudent distribution of the gains from valuation in the form of interest paid to the treasury and prevent the creation of nonearning assets.

Reserves are also necessary against contingent liabilities, such as foreign exchange guarantees. Under conventional accounting procedures no such provisions are made. There are differing points of view regarding the soundness of this practice. Supporters argue that provisions will reduce the net return on assets, while in fact the guarantee may never be realized. They point to the difficulty of deciding the amount of such provisions that have to be based on an evaluation of future gains and losses from foreign exchange changes. Critics point out, however, that this argument can apply equally to any kind of provisioning against future risk. Moreover, central banks do not usually charge an adequate premium or fee to cover the actuarial value of their liabilities should the guarantee come due. Thus, if the guarantee becomes binding, the central bank will incur an additional expense.

Timing of Transfers to the Central Bank

Should the central bank be compensated for losses at the time of their accrual (or at the time of a valuation change) or when the loss is realized?27 Certainly, earlier payment will help assure the transparency and integrity of the central bank balance sheet—which is a public document. In general, however, the timing of compensation should be determined in a manner consistent with the budgetary cash flow requirements.

Compensation of the losses at the time of accrual will help soften the impact of the transfer on the budget.28 To see this, assume that the payment is in the form of an interest-bearing security.29 If the transfer of the security takes place at the time of accrual of the loss, its amount will be equal to the size of the loss. The government will have to pay interest on the security in regular intervals in an amount of, say, A, until the security matures. This additional interest earned by the central bank in the intervening period will be forgone if the transfer takes place at the time of the realization of the loss. The amount of the transfer at the time of realization will then have to be larger by a multiple of A. Thus, while the government will pay no interest in the period between the accrual and realization, a larger interest payment than A will be required from that point onward, reflecting the larger transfer that should be made.

In order to further ease budgetary cash flow problems, the transfer of central bank profits to the government could also be made more frequently than on an annual basis; however, it would also be most prudent to transfer only realized profits. Regular preparation of profit-and-loss accounts on a cash basis to complement the usual system of accrual accounting would be needed. This would help prevent an overestimation of the profits to be transferred to the treasury, which may raise government expenditure and be expansionary.

Concluding Remarks

A central bank is supposed to make profits because of the seigniorage involved in currency issue. However, many central banks make losses because the costs involved in trying to preserve the value of the currency, and in supporting government policy through quasifiscal activities, outweigh seigniorage.

This paper has argued that central bank losses cannot be ignored: They can undermine monetary management, slow down financial market development, and set back the attainment of such economic objectives as price stability and economic growth. In these regards, the impact of central bank losses is similar to that of the monetization of growing fiscal deficits. Therefore, their fiscal nature should be recognized and they should be incorporated into the government budget either directly, or—if this is not possible—by effectively assuring such an outcome through appropriate reform of central banking laws. At the same time, and especially if amalgamation is not possible, steps should be taken to remove any nonearning assets from the books of the central bank through transfer of earning assets from the government, and to rationalize the financial relationship between the government and the central bank. The latter would imply allowing the central bank to charge market-related interest rates on all its loans, including those to the government. This would mean that it should take the risk of exchange rate changes into account in setting its lending rates, to the extent allowed by monetary policy considerations. It should also rely on securities issued by the government in conducting monetary policy.

Appendix I Path of Future Losses

This appendix considers the conditions under which central bank losses are likely to compound indefinitely to produce a path of future losses that grows explosively.30 We begin by defining a simplified central bank balance sheet.

Central Bank Balance Sheet
Credit to GovernmentNet foreign liabilities (NFL)
Interest-bearing (TB)Reserve money (RM)
Non-interest-bearing (LRS)Other liabilities (OL)
Credit to private sector (CP)Net worth (NW)

Losses are defined as cash income less cash payments:

where each i refers to the interest rate on the appropriate security. To simplify, we net all the interest-bearing securities into an aggregate, represented as the redefined CD.

At the moment that interest payments are made, the entire loss is converted into base money.31 The central bank may need to sterilize a part of this injection in order to meet monetary growth objectives. Thus,

Interest-bearing liabilities grow from period to period if the losses outstrip programmed growth of the money supply. This raises the possibility that losses today lead to more losses tomorrow, resulting in an exponential growth path. The possibility is removed only if a desired money stock eventually becomes large enough to require a reduction of CDs rather than new issuance.

To show this, consider the following simplified system. From equation (2)

where CD is the net quantity of interest-bearing liabilities of the central bank, and i is their average interest rate. Rewriting equation (4),

substituting from equation (5) and rearranging,

defining programmed growth in the monetary base (gt) as

we can rewrite equation (7) as

The solution to this difference equation is

We need to evaluate whether CDt tends to explode or goes below zero as t gets large. This clearly depends on the relationship between money growth and the interest rate, as well as starting values of CD and RM. It is impossible to make any general conclusion about CDt without knowing the exact path of interest rates and money growth; however, several fairly general cases will be considered.

Case 1: g = i; for all t.

That the growth of reserve money (g) and interest rate (i) should be equal is not so unlikely as it might at first appear, assuming a stable money multiplier. It requires that the growth of real GDP be equal to the real interest rate.

Given g = i, equation (10) becomes

As t gets large, CDt must go to zero as the term within brackets goes to zero. Thus, if g = i, no exponential path will develop.

Case 2: g > i; for all t.

In this case, CDt declines even faster than in Case 1 as growth in money financing rises more quickly.

Case 3: g < i; for all t.

This case is mathematically the most interesting because, clearly, there is some value of g—as it goes toward zero—that will allow the quantity of liabilities to explode. Once again, there are infinite possible variants in this case; one representative, restricted solution Is shown here. If g and i are fixed over time, then CDt explodes as t gets large if

As an example, we can construct one possible scenario for the growth of losses in the case of the Bank of Jamaica. Starting values for RM and CD, which roughly approximate their 1989 counterparts, and a possible path for interest rates and money growth are shown below:

CD1989 = $J5 billion (value in CDs of interest-bearing liabilities less interest-bearing assets)

RM1989 = $J4 billion

Parameter 1990199119921993and Beyond

Chart 1, below, shows the paths of the quantity of net liabilities, losses, and the base money that result from the above assumption. As the desired level of reserve money increases, the stock of net liabilities of the central bank starts to decline, reaching zero by 2009. In line with this development, the losses of the central bank decline throughout the period and are eventually eliminated.

Chart 1.Central Bank Losses: Hypothetical Path

(In millions of dollars)

Shortcomings of this analysis rest on its partial description of the macroeconomy, particularly in the assumption that i and g are exogenous to the size of losses. A more general analysis would make the interest rate dependent on the size of the losses and of other government borrowing, while the growth of the money supply might also depend on the size of the losses. Interest rates could depend on the losses in at least two ways: (1) as more public sector securities are held by the private sector, the interest rate on these securities would be expected to rise; and (2) the fact that past losses remain on the books may provide an inducement to raise the growth rate of money and reduce interest rates. Additional inflation might also lead to devaluation, and further valuation losses. Moreover, changes in the money multiplier would change the results. A full model should include all of these mechanisms, each of which would act to extend the period over which losses would be substantial, or even to make losses explosive.


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The author is a Senior Economist in the Central Banking Department of the International Monetary Fund.


In the case of Jamaica, losses in the last five years have exceeded 5 percent of gross domestic product (GDP) in each year. This has occurred at a time when the general government and public entities have recorded surpluses.


A review of the central banking laws in some sixty countries revealed that almost one third did not have any specific provisions regarding the treatment of losses.


See Robinson and Stella (1988) for a recent statement of this view.


Losses could also be financed through inflation, but in that case the net worth will not remain persistently negative.


The nonearning assets could include revaluation accounts, non-interest-bearing government securities and loans, nonperforming loans, etc.


In some countries interest is paid on all or part of financial institutions’ deposits at the central bank, which are included in the base money. Strictly speaking, the relationship mentioned in the text holds for that part of the base money on which no interest is paid. This distinction is ignored in the paper.


The discussion ignores the central bank’s trading activities—such as purchases and sales of foreign exchange—its administrative expenses (including those associated with the provision of free services, such as banking supervision, payments mechanism, etc.), and the cost of issuing high-powered money, including the cost of printing and minting, as well as any interest paid on the interest-bearing part of high-powered money, which usually consists of financial institutions’ deposits at the central bank.


Currency is always considered as a liability of the central bank, but in fact it is not a liability in the usual sense. If currency is not convertible, it does not have to be redeemed and it entails practically no cost for the central bank. The only liability created for the central bank by issuing nonconvertible currency is to replace worn out or damaged notes and coins and to prevent forgery. If currency is not considered a liability, it would follow that the net worth of many central banks is larger than assumed, and that they can increase their net worth simply by issuing currency. See Fry (1990) on this point.


The interest charged and the amount of credit provided by the central bank are, of course, interdependent. Sf there is no excess demand, the central bank’s control on the level of its assets is limited. For example, it can put a ceiling on the access to its discount window, but the actual amount is demand-determined. Similarly, if the central bank overcharges the government, the latter may place its securities directly with the public.


The case of Mexico is interesting in this regard because the rate of interest on government loans is determined ex post, once the cost of funding to the central bank is known.


The above discussion also indicates that carrying out a transition from direct to indirect instruments of monetary policy would entail substantial costs for the central bank if there is a need to absorb large amounts of liquidity. The timing of such transition would have to be determined taking into account the implications of the losses for the attainment of macroeconomic objectives.


These activities also affect price stability, albeit indirectly. Therefore, the distinction between the quasi-fiscal and basic central bank activities may not always be clear-cut.


The effect of devaluation on net foreign liabilities is also a common cause of accumulation of nonearning assets as explained in the following section.


During August 1983–February 1985, the Jamaica dollar was devalued from 1.78 to 5.5 per U.S. dollar, more than tripling the domestic currency value of the Bank of Jamaica’s foreign liabilities.


If resources for the transaction were borrowed abroad, the impact on excess demand for foreign exchange would materialize in connection with the eventual debt-service payments on the foreign loan.


Using treasury bills instead of the central bank’s own certificates of deposit would have a similar effect as the central bank losses, as discussed earlier.


Fry (1990, p.8) defines a central bank to be insolvent “when it can continue to service its liabilities only through accelerating inflation.” This implies that as long as the central bank can service its debt through accumulation of additional debt, thereby avoiding an acceleration of inflation, it cannot be considered insolvent. However, the public will only be willing to hold a growing volume of central bank debt at increasingly higher interest rates, entailing adverse implications for economic growth. A central bank should therefore be considered insolvent if it can only continue to service its debt through accelerating inflation or decelerating growth.


There is some debate in the literature as to the correct measurement of seigniorage (see Molho 1989 for an account of this debate). Nevertheless, it is generally agreed that it refers to the profits of the central bank resulting from its ability to purchase interest-bearing assets (government securities, loans to financial institutions, and foreign assets) by issuing non-interest-bearing (and in a sense nonmaturing), high-powered money. This could imply that the total amount of seigniorage should be the difference between the net amount earned by the central bank if it had to pay interest on its base money liabilities and the amount it earns because it can avoid such costs. These amounts would be equivalent to s.RM and ia.RM, respectively, where ia is the average return on the central bank’s assets. The difference between the two isi.RM.


Transfer of an interest-bearing security will also reduce nonearning assets, but—as experience in some countries shows—there is always a risk that interest due may not be paid by the government if the budgetary situation deteriorates. This would increase the nonearning assets again. This is an important consideration because, in most cases, the persistence of central bank losses are due to noncompliance of the government with its financial obligations to the central bank.


See Leone (1990) for a discussion of the role of the central bank in financing government deficits and the role of the central bank budget constraint.


Many governments may be reluctant to do so because it will inflate the deficit presented to the parliament. Some central banking laws, however, by prohibiting the government from making a further appropriation to pay for the losses of the central bank (Tanzania, Kenya, Republic of Yemen), in effect, call for amalgamating the losses in the government budget.


The optimal size of the government’s domestic debt is a subject of some controversy. It is generally agreed, however, that, sustainability of debt requires that the growth of annual debtservice obligations should not persistently exceed the growth of real GDP.


Moreover, the revenue from the tax would be lower to the extent that deposits shift to the informal financial sector or to the institutions that are not subject to the reserve requirement.


Inclusion of central bank losses in the budget requires defining a proper concept of deficit of the central bank as only losses that lead to a financing need should be included in the budgetary deficit. A devaluation, for example, does not immediately generate a financing need. There may also be a need to adjust the balance sheet of the central bank for the impact of inflation. For a discussion of such an adjustment see Teijeiro (1989).


It would not be practical to expect that foreign borrowing should be done only by the government, although this is the preferable alternative.


As a general rule, as long as the spot price of the foreign exchange at the time of transaction is equivalent to the discounted present value of services derived from it, no subsidy is involved. A market-deter mined exchange rate can be expected to incorporate this characteristic. Thus, if the foreign resources are evaluated at the market-oriented exchange rate and on-lent to the government at a market-related interest rate, no subsidy will be involved even if eventually the central bank makes a loss owing to a change in the exchange rate.


The question of when a profit or loss related to a foreign exchange operation is realized is controversial. Precise determination of the realized loss (or gain) requires relating each individual outflow (a sale or a repayment) of foreign exchange to a specific inflow (a purchase or a loan). This clearly requires detailed and cumbersome accounting. An alternative is to evaluate the unit of foreign exchange paid out on the first-in-first-out (FIFO) or last-in-first-out (LIFO) basis. The losses (or gains) would be larger if the FIFO procedure is used.


Strictly speaking, a distinction should be made between the case where the operations of the central bank become profitable as a result of the transfer, and the case where the central bank continues to make losses following the transfer. The advantage mentioned in the text may not be valid in the former case. In this case, the discussion should also take into account whether or not the profits of the central bank are transferred to the treasury in their entirety.


The transfer can also be in the form of a debit entry in a government deposit account at the central bank, but the impact on the budget remains essentially the same.


This appendix was prepared by Alan MacArthurforthe report: “Jamaica, Improving Monetary Management,” by Reza Vaez-Zadeh, Alan MacArthur, and Ian Lamers, Central Banking Department, International Monetary Fund, May 1990.


Payment of foreign interest by the Bank of Jamaica could also affect the liquidity of the banking system if demand for Bank of Jamaica foreign exchange exceeds supply. When the central bank makes an interest payment in foreign currency, it reduces foreign exchange available to agents outside the central bank. Thus, foreign exchange that would have been sold to other agents is not sold, and extra reserve money remains in the system.

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