Eva Zamrazilová, CNB Board Member
Speech for the Fifth Annual PwC/CBP Central Bank Working Group meeting
London, 19th – 20th May 2008
In the context of our discussion of the various aspects of central bank independence, I would like to make a few comments on the impact of the exchange rate on the capital of the central bank in the case of the CNB.
The issue is highly relevant to the CNB, as it is currently operating with substantially negative own capital. While under normal circumstances a central bank should operate at a profit, the CNB has been incurring considerable losses since 2000. Just to give you an idea, its accumulated loss amounted to CZK 200 bn at the end of 2007, equivalent to roughly 57% of currency in circulation and 6.7% of nominal GDP. The CNB’s negative own capital was only slightly lower, at CZK 176 bn.
At the same time, it can be said – and this is also generally acknowledged in the literature – that the CNB has so far enjoyed a high level of independence in the legal, operational and management fields, and even a high degree of goal independence. Being a pioneer of inflation targeting in the region, the CNB has set its own inflation targets for the conduct of monetary policy.
Nevertheless, its increasing accumulated loss and its negative own capital raise questions about the implied risks to its independence. Not even a central bank can accumulate losses indefinitely. It seems obvious that without the prospect of a turnaround, i.e. repayment of the losses from future profits, the financial independence of the central bank will be severely undermined. At the same time, any government involvement in central bank financing could constrain the bank’s operational independence and monetary policy-making.
The Causes of the Incurred Losses
What are the causes of the incurred losses, and what factors can be expected to produce a turnaround?
The Czech economy is an example of a catching-up economy, and the convergence conditions have inevitably affected the structure and evolution of the CNB’s balance sheet. As is well known, in the convergence process there is a built-in tendency of real exchange rate appreciation, either through the inflation differential or through nominal exchange rate appreciation. Moreover, the non-zero risk premium plays an important role and the balance sheet of a converging central bank is also as a rule negatively affected by sterilised interventions related to the purchase of foreign exchange reserves.
True, the sources of the loss and their relative weight may differ across countries and over time. Previous literature has focused on the consequences of quasi-fiscal operations. In the Czech case, such operations – related to the rescue of the banking sector – were of considerable importance in the second half of the 1990s. Since 2000, however, the dominant factor has proved to be trend appreciation of the nominal exchange rate.
The Impact of the Exchange Rate on the CNB’s Balance Sheet
Let me briefly discuss the impact of the exchange rate on the CNB balance sheet. I should point out that two entirely different exchange rate regimes have been applied since the beginning of the transition in the early 1990s.
In the first stage, a fixed exchange rate was chosen as a nominal anchor for macroeconomic stabilisation in the early 1990s. Its fluctuation band was initially rather narrow, at ±0.5%, but was later widened to ±7.5%. In order to keep the rate within the fluctuation band and to avoid excessive nominal exchange rate appreciation, the CNB was forced to purchase the inflowing capital and at the same time to sterilise the liquidity issued. Roughly half of the current foreign exchange reserves were accumulated during the fixed exchange rate period.
In May 1997, the exchange rate regime was switched to a flexible one – a version of managed floating. Nevertheless, a substantial amount has been added to the foreign exchange reserves in this period, too. This mainly reflects episodes of foreign exchange interventions when the CNB was trying to fight strong bouts of appreciation.
Real Exchange Rate Appreciation Channels: The Inflation Differential and Nominal Exchange Rate Appreciation
With the benefit of hindsight, two different stages of real exchange rate appreciation can be distinguished in the Czech case.
Up to 1998, the dominant channel was the inflation differential. Between 1993 and 1998, average annual inflation in the Czech Republic amounted to 11.2%, with the inflation differential vis-à-vis the EU fluctuating between 7 and 9%.
On the other hand, there was no sustained nominal exchange rate trend. The average annual nominal appreciation with respect to the DM was virtually zero in this period. Of course, exchange rate volatility was experienced from time to time to a greater or lesser extent, but this had no systematic impact on the balance sheet. Minor balance-sheet losses due to revaluations in 1993, 1996 and 1998 were offset by gains in the preceding or subsequent years. It follows that in this period the exchange rate exhibited no systematic pattern and, accordingly, there was no systematic impact on the CNB’s balance sheet.
The picture has changed totally since 2000. In 1999, Czech inflation dropped to a mere 2.1%, and it has remained low and relatively stable since then. Unlike in the previous stage, real exchange rate appreciation, i.e. the tendency inherent in the convergence process, has started to materialise via persistent nominal exchange rate appreciation. As a result, the nominal appreciation has affected the CNB balance sheet to a substantial degree. Given the marking-to-market of the foreign exchange reserves, we can conclude that the main reason for the CNB’s losses since 2000 has been the exchange rate trend. From the accounting point of view, the losses manifest themselves as revaluation of the foreign exchange reserves.
What are the Likely Solutions?
The answer must be sought again in the context of the economic convergence process. As this progresses, the factors behind the incurred losses – both the trend real exchange rate appreciation and the risk premium – are likely to fade away. Moreover, with increasing monetisation of the Czech economy the foreign exchange reserve ratio will gradually fall, especially if the CNB no longer engages in massive foreign exchange interventions.
Thanks to those arguments it can reasonably be expected that the accumulated losses will be settled out of future profits, without recourse to public budgets and without the operational independence of the CNB and its monetary policy credibility being undermined.