ABSTRACT
One of the crucial features of the world financial system over the last ten years has been a steady increase in foreign exchange reserve holdings in emerging market economies. This phenomenon reflects the changing patterns of international capital flows, as well as policies in a number of countries addressing specific domestic challenges. Figure 7.1 shows that the volume of world exchange reserves has quadrupled compared to 1990, and that developing countries account for most of the increase. Over the last decade the Asian economies have played a big part, while Europe as a whole has tried to hold back. Nonetheless, foreign exchange reserves have also increased considerably in some European countries. The accumulation of foreign exchange reserves in emerging economies is exposing a number of central banks to the risk of unrealized losses (due to falling value in domestic currency) if their currency appreciates in nominal terms. This risk is particularly high in a converging economy that has successfully achieved price stability. Such an economy could exhibit real appreciation, and set a low inflation target. Under these conditions, nominal appreciation may become a long-term phenomenon, reflected in a build-up of large negative capital in its central bank.2 So far, this has happened in just a few central banks that experienced large enough nominal appreciation for the losses to lead to negative capital. However, others (especially in Asia) could follow. This has prompted questions. Is negative capital a problem? Can the losses be offset by future profits? When, if ever, should the government step in? It is no surprise that much has been said about central banks that are financially fragile due to inflationary policies and quasifiscal operations. Nevertheless, negative capital for a successful central bank is a different story. So it is apt to open a discussion on this now. That is the main objective of this chapter. Our discussion relates primarily to countries with relatively high foreign exchange reserves. Not all these economies are exposed to the risk of major valuation losses. That risk is greatest where foreign exchange reserves constitute a dominant component of the central bank’s balance sheets. Among them, the
most vulnerable are those that have achieved disinflation, face nominal appreciation pressures and have to sterilize excess liquidity by accepting deposits from commercial banks or by issuing their own debt securities. Some of these countries are listed in the Annex (Table 7.a.1, Table 7.a.2, Figure 7.a.1). We discuss the issue by first providing a survey of the literature on negative central bank capital. Then we present a study of the Czech National Bank, which is a clearcut case of a successful central bank with negative capital. Finally, we deliver some conclusions, which are also based on the Czech National Bank’s case, but can be generalized to some extent.
