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Central banks will make a substantial loss in the coming years due to rising interest rates. Although the Dutch Central Bank (DNB) has built up reserves to cover the losses, it is still possible that the state will have to step in if the losses increase further. As a result, DNB could also consider drawing on the revaluation reserves of the gold stock, according to the letter Jan Nieuwenhuijs recently. But how exactly do these revaluation reserves work and how can these reserves remedy the bank's negative equity?
In a Earlier article we have already described where DNB's loss comes from. Just briefly; central banks pay interest on the excess reserves held by commercial banks such as Rabobank or ABN AMRO with DNB. The interest rate that DNB has to pay on these reserves has risen sharply in recent months. The deposit rate now stands at four percent, considerably higher than the negative interest rate that was previously levied.
On the other hand, central banks receive money, including through the income from purchased government bonds. Over the past decade, central banks have been buying up a lot of bonds to stimulate the economy. The income from this item did not increase in line with the costs due to the higher interest rates. As a result, there is now a loss at the central bank. In his article, Jan Nieuwenhuijs showed the simplified central bank balance sheet. On the left are possessions and on the right are liabilities and capital.
The central bank balance sheet. (Source: Grainsvillecoins)
Now that central banks are going to make losses in the coming years, solutions are also being sought. A central bank can operate with negative equity, but this does affect confidence. Central banks also have gold on their balance sheets. On the contrary, this post is a source of confidence. In recent months, gold purchases have been including China already in the news. Other countries, such as the Netherlands, have Traditionally, already have a large gold reserve. We recently described why DNB still clinging to gold.
DNB's revaluation reserves arose because DNB bought gold in previous years. In the meantime, especially after 1971, the Gold price has risen sharply. Suppose that in 1950 DNB bought a large amount of gold worth one billion. If the price of gold triples in the meantime, a revaluation reserve of two billion euros will be created. The two billion revaluation reserves, together with the original value of the gold, value the amount of gold that DNB owns back to market value.
The revaluation reserves are currently held mainly in case the gold price falls. But recently, Joachim Wuermeling, a member of the Bundesbank's board, indicated that the Bundesbank could also call on the 180 billion euros in revaluation reserves that the bank has built up in the meantime. The balance sheet of the Bundesbank is healthy due to the revaluation reserves and allows the Bundesbank to be loss-making for a while, Jan Nieuwenhuijs quotes the board member in his article.
If, after several loss-making years, so much of central banks' capital had disappeared, the central bank could, in theory, simply create money to meet its obligations. If negative equity arises, this is in fact also a form of money creation. Jan Nieuwenhuijs' article outlines a situation in which commercial bank reserves increase due to interest payments to the commercial banks, while equity falls below zero. However, this is risky; The printing press is an addictive substance, has no brakes whatsoever and causes a huge break in the trust that people have in the central bank.
Money creation by the central bank. (Source: Grainsvillecoins)
Another solution would be for the central bank to use the revaluation reserves to cushion financial blows. The central bank can quite easily transfer revaluation reserves to the item capital. In doing so, central banks are throwing the accounting rules overboard, since the revaluation reserves are normally only used when gold is actually sold. Jan Nieuwenhuijs also wrote in his article about central banks in Curaçao and Sint Maarten that sold gold and immediately bought it back in order to comply with the rules.
Strengthening capital. (Source: Grainsvillecoins)
But if revaluation reserves can be used to absorb central bank losses, then the reserves can also be used to help governments. Since the start of the central bank purchase policy, a large part of the public debt has been on the balance sheet of the central bank of the country in question. In particular, if a country's government has a large public debt, the central bank could choose to write off part of the public debt. In such a case, the sovereign bond item on the left side of the balance sheet decreases, as these bonds are forgiven. This is accompanied by a decrease in the item revaluation reserves. This can also be combined with a strengthening of the bank's capital if more reserves are written off than bonds.
The government is helped by the central bank. (Source: Grainsvillecoins)
Jan Nieuwenhuijs' article also discusses unconventional measures. The central bank could start a new bond-buying program. Instead of bonds, the bank can buy gold from the private sector. The gold price will then rise further due to the increased demand for gold, which will also increase the item revaluation reserves. This seems like an unlikely scenario. The purchase policy of recent years has been aimed at providing liquidity to banks. The purchase policy gave banks a lot of liquidity, which gave them a lot of room to provide loans. In addition, this policy depressed interest rates on the capital market.
However, a gold buying policy in the private sector is much more akin to helicopter money, as the central bank then buys directly from households. And since households save some of their money and may hold it in the form of cash, helicopter money is less effective than if the liquidity ends up in the hands of banks that use that money to provide loans to businesses, or so the thinking goes. Therefore, central banks are likely to continue to prefer quantitative easing through the commercial banks.
So there are several ways to absorb central banks' losses. There is no doubt that the revaluation reserves can play a role in this. However, this also opens the door to using the reserves for the benefit of the governments and that is not a long-term solution, as the reserves will run out at some point. You can also ask yourself how bad it is that central banks make losses for a while and possibly operate with negative equity for a while. In Eastern Europe, for example, there are already central banks with negative equity. It will be interesting to see who will bear the central banks' losses.
