A few weeks ago I wrote a fairly discursive post on the losses the Reserve Bank had run up on its Large Scale Asset Purchase programme. I know some readers found the basic point a little hard to grasp (no doubt a reflection on my storytelling), so today I’m going to do a very stylised representation of what has gone on.
But first, as I noted in that post, as market interest rates rise losses mount. The Bank has now released its end-October balance sheet and this is the line item representing their claim on the Crown (the Minister of Finance indemnified the Bank for losses incurred).
So the losses have now reached $5.7 billion (roughly 1.6% of annual GDP). Market interest rates fluctuate each day, but as of yesterday’s rate current losses are likely to be very similar to those as at 31 October. Perhaps Covid has inured us to big numbers, but these are really large losses, which were quite avoidable.
Now I want to step you through a very stylised illustration of roughly what has gone on.
A severe shock hits (call it Covid, but it could be anything) and the government determines that it needs to run a large fiscal deficit. Say that (cash) deficit totals $70 billion. The government finances that deficit prudently by issuing (selling) long-term bonds, issuing $70 billion at par, and thus raising $70 billion in cash.
Once the government has borrowed and spent, its bank account balance (at the Reserve Bank) isn’t changed. And after recipients of the deficit spending and purchasers of the government bonds have all made their transactions, the aggregate balances held by banks in their settlement accounts at the Reserve Bank also haven’t changed.
But now assume the Reserve Bank enters the fray, deciding that it will launch a large scale bond purchase programme, in which it buys $50 billion of long-term government bonds (for simplicity, assume the same bonds the government just issued on market). The Bank pays for those bonds by issuing on-call liabilities (settlement cash balances), on which it pays the OCR interest rate.
What does the Crown’s overall debt exposure look like under those two stages?
Financing the fiscal deficit
Floating rate debt held by the private sector (settlement cash) $0
Long-term government bonds held by private sector $70bn
Add in the effect of the LSAP
Floating rate debt held by the private sector (settlement cash) $50bn
Long-term government bonds held by the private sector $20bn
The total amount owed by the Crown (government plus Reserve Bank) is $70 billion in both cases, but the risk to the Crown is substantially different.
The emergency having finished (by assumption in this stylised example), the Reserve Bank now has two choices. It can hold the bonds it purchased to maturity or it can sell them back to the market. One choices closes out the risky position they chose (rightly or wrongly) to run during the emergency, while the other leaves it running (for years).
Now assume that market interest rates rise sharply, across the curve (so long-term bond yields rise but so – perhaps gradually – does the OCR itself.
When market interest rates rise, the market value of a portfolio of long-term bonds falls. That is what has happened in New Zealand over the last year or so, reflected (in respect of the LSAP portfolio) in the chart at the start of this post.
If the bonds were sold back to the market, the Reserve Bank (and Crown as a whole) would realise less on the sale than they paid for the bonds. On present rates, a lot less. Selling the bonds back to the market would, however, restore the balance sheets as under the “Financing the fiscal deficit” scenario above. The private sector would hold no floating rate government debt (settlement cash) but lots of long-term bonds. All the risk would be with the private sector, although the Crown would have crystallised the large loss it let the Reserve Bank run up.
But what if, instead, the Reserve Bank just stuck the bonds in the bottom drawer and held them to maturity (last maturities not for 20 years)? The bonds would mature at par, and there might be little or no claim under the indemnity (depends on the initial purchase price relative to the face value). But, if things play out as current market prices envisage, the OCR would rise by quite a lot and (on average) stay much higher over the remaining life of the portfolio. Since the Bank is still holding the bonds, settlement cash would also stay high, and the Bank pays the full OCR on all settlement cash balances. Under that scenario, the Reserve Bank – having issued lots of floating rate debt, and having no matching floating rate asset – will be up for much higher interest costs.
Either way, the Crown (the taxpayer) has lost a great deal of money. If market rates play out as the yield curve currently predicts, either there will be a large payout under the indemnity, or the Reserve Bank’s future dividends to the Crown will be reduced. But the loss has already happened, it is just a matter of how it ends up being recorded/realised. $5.7 billion dollars of it. The Crown could probably have funded quite a few ICU beds for quite a few years with that sort of money…..but it has gone.
You’ll notice that I bolded some words in the previous paragraph. Even if the best estimate of future short-term rates is something like what the market currently prices, that is a very weak standard, and it is exceptionally unlike that actual short-term rates will follow exactly that path. They could be lower, but they could be higher (perhaps quite a bit higher or lower).
If the Reserve Bank sold the bonds it holds back to the market we (taxpayers) wouldn’t need to worry. The overall Crown would be back to having funded itself with long-term debt, and fluctuations in rates wouldn’t affect us (at least unless/until the bonds need rolling over years down the track).
But if the Reserve Bank keeps the bonds, we (taxpayers) keep the risk. Having had them drop $5.7 billion of our money so far, they keep the position open. From here, they could make us a bit of money, or they could lose a bit of money (well, actually “a lot” in either direction). But there is no obvious reason to have some bureaucrats speculating on bond markets – because that is what the LSAP portfolio now purely is – at our risk. It isn’t even as if these people – the MPC – have some demonstrated track record of generating attractive Sharpe ratios (returns relative to risk) for their punts. And if as individuals we do want to take punts, the market already has products for us.
Perhaps the key point here is that the $5.7 billion has already gone – that is what mark-to-market accounting measures – but the risk remains. From here we could lose another (say) $5.7 billion, or make a great deal of money, but there seems to be no effective accountability, for activities which – at this point, well beyond the crisis – is simply not a natural business of government. Monetary policy in a floating exchange rate system like ours normally involves next to no financial risk to the taxpayer.
Are there caveats to all this, or alternative approaches?
One possibility is that the government chooses to neutralise the risk the Reserve Bank continues to run. They could do that relatively easily, by issuing new bonds on market with the same maturity dates as those the Bank holds. All else equal that would eliminate the future floating rate exposure. They could probably do something similar (but hedging less effectively) with interest rate swaps. But it doesn’t seem terribly likely, or terribly sensible (including because it would simply further inflate balance sheets).
Since this is an entirely stylised exercise, I’ve been able to dwell in the simplified air of “sell” or hold”, as if “sell” was akin to selling a single excess car or house. But the Bank has more than $50 billion in bonds and it would not make sense to offload them all at once (doing so would be likely to push the price unnecessarily against the Bank/Crown). So when I say “sell” what I really have in mind is a steady pre-announced programme that would unwind the entire portfolio over 1-2 years. That means assuming quite a lot of risk in the menatime, but unfortunately that is the hole Orr and his colleagues dug for us.
Observant readers will have noticed that so far I’ve not mentioned at all any macroeconomic effects of the LSAP programme. The LSAP was launched with the intention of having stimulatory macroeconomic effects. I’ve always been sceptical there was much to the story, especially in the New Zealand context. The proceeds of the bond purchases were fully sterilised (that is what paying the OCR on all balances does), short-term rates were held low by (a) the OCR itself, and (b) some mix of RB statements and market expectations about the economic/inflation outlook, and long-term rates just don’t matter much to the transmission mechanism in New Zealand. But remember that the LSAP was explicitly sold as a substitute for the Bank last year not having been able (so it said) to take the OCR negative. It is now quite clear – even if it wasn’t at the time – that any such need had dissipated by this time last year. This year, inflation and unemployment have been overshooting and the OCR has begun to be raised. So even if you think – with the Bank – that the LSAP had a useful macroeconomic effect, any useful bits must have been concentrated in a few months last year. And it simply isn’t credible that any such gains were as large as the 1.6 per cent of GDP of our money that the Bank has….. lost. (Note that the literature on LSAPs suggests that any beneficial effects come from the stock of bonds hold not the flow of purchases, but the Reserve Bank continued its purchase programme well after it was clear the OCR itself could take any slack and now – when looking to tighten conditions – refuses to reduce risk to the taxpayer by making a start on reducing the Bank’s bond holdings.)
And all this from a weak and not very transparent, or accountable, institution. As per yesterday’s post, two of those responsible – MPC members – are moving on, and the Minister has to make various new appointments shortly. One of those most responsible – the MPC member responsible for monetary policy and financial markets – has just been given a big promotion. But none of them – internal, external, Governor or more specialist expert – has given any sort of adequate accounting for the public money they have lost.
(Where does the Minister himself fit into all this? I’m not particularly sympathetic to Robertson, who seems the epitome of a minister uninterested in holding anyone to account, but realistically on the dawn of a crisis, no Minister of Finance was likely to have turned down the Bank’s request for an indemnity, at least if The Treasury was onside with the Bank. No, the substantive blame here rests first and foremost with the Governor, the MPC, secondarily with the Bank’s Board and the Secretary to the Treasury, and only then with the Minister of Finance. But it is the Minister who is accountable to Parliament and the public, and who had failed to ensure that the Reserve Bank was fit for purpose (people, preparedness) going into a crisis like Covid.)
UPDATE: For those who have pointed out, or noticed, that I did not discuss here issues around actual settlement account balances over the last 20 months (or developments in the Crown account), they are discussed in the earlier post linked to above.