Let's start with the curious case of the SNB. Roughly three-and-a-half years back, the central bank decided to put a cap on its exchange rate, the Swiss franc (CHF) to the euro at euro 1.2 to the franc to stem volatility and prevent appreciation. Given the fact that the euro has been a notoriously volatile currency reflecting the ebb and tide of the region's fortunes, there was a strong demand for the CHF. Thus, to maintain the cap, the Swiss monetary bosses had to buy large quantities of the euro, resulting in a massive expansion of its balance sheet. In the middle of January, when it suddenly and entirely unexpectedly jettisoned the cap, its balance sheet had grown to about 80 per cent of the nation's GDP. As the cap went, the CHF somewhat predictably appreciated, sharply rocking the financial markets and pushing both a number of currency investors who had betted on the CHF as well as those who had borrowed in CHF deep into the red. But that's not the end of the story. Since the SNB was holding gazillions of euros on its balance sheet, the depreciation of the euro against its own currency led to a major erosion of its balance sheet. In fact, the losses were so high that it eroded the capital base of the central bank and pushed it into technical insolvency.
The key question to ask here is the following: why did the SNB suddenly renege on its commitment to hold the currency? One simple answer is that it panicked over the growing size of its balance sheet and the potential marked-to-market losses it could incur on it as the euro dropped on the back of the impending QE programme in the euro zone. The bottom line, from our perspective, is that balance sheet concerns and the fear of losses could influence central bank action and goad them into changing course.
Richard Koo, chief economist of the Nomura Research Institute, points out that it's not just the currency interventionists who face this risk ("Is Germany winner or loser under QE?", January 30). Central banks with QE programmes could face the same constraints and predicaments. The European QE operation, particularly the German central bank, the Bundesbank, could be particularly vulnerable. Here's the problem. Germany has refused to follow a risk-sharing arrangement in bond-buying. In short, it means that each country will only buy back its own sovereign and other bonds. This might seem like a victory for the Germans, but here's the risk. The most expensive bonds in the euro zone are German bunds, with negative yields up to a five-year tenor. Remember that bond prices are inversely related to their yields and this means that German debt paper is really expensive. This means is that at some point, when the euro-zone economy starts to recover, the asset facing the largest risk of collapse is German government bonds. To quote Koo, "Because the Germans objected to a risk-sharing plan, most of the losses in such a case will now be borne by the Bundesbank."
But let's not be too harsh on the somewhat inscrutable Germans. As bond prices fall in response to economic recovery and inflation raises its head, all central banks with large bond holdings will have to take a hit on their balance sheets. Thus, we might be in a situation where monetary policy in some regions will be driven by entities that are on the brink of bankruptcy themselves. Whether this triggers another crisis of confidence in the global financial system remains to be seen.
Abheek Barua is Chief Economist, HDFC Bank.
Bidisha Ganguly is Principal Economist, CII