Download Would you trust the Central Bank to borrow Treasury securities for

Feb 19, 2013 11:17 AM
Would you trust the Central Bank to borrow Treasury securities
for monetary policy purposes?
With one exception that I will get to below, central banks using treasury securities for monetary policy "own"
them. That means in some way they need to be acquired before being used.
In the simple textbook model of monetary policy, over time the central bank issues paper and electronic money in
exchange for treasury securities and the central bank balance sheet grows more or less at the same rate as
nominal GDP. Occasionally, when monetary policy calls for a tightening of liquidity, the central bank draws from its
accumulated portfolio of securities. These are sold into the market and money declines.
What happens, however, when liquidity conditions become so loose that the central bank does not have enough
securities to sufficiently tighten? This situation is being seen in most emerging markets today facing large capital
inflows.
In some cases the central bank and treasury reach an agreement where the former is given securities by the latter
against an offsetting accounting/legal obligation. (Brazil: against increased Treasury equity in the central bank;
Mexico, Israel, Singapore: against a Treasury deposit at the central bank earning the same rate of interest that
Treasury securities are paying to the market after being auctioned by the central bank). In other cases the central
bank issues its own debt potentially competing with similar treasury debt already in the domestic market and
causing market fragmentation.
In order to avoid market fragmentation, it has frequently been suggested that mechanisms be found to ensure
that central banks continue to use only treasury debt for monetary policy which implies that the treasury is
required to "overissue", that is, issue in excess of what is necessary only to finance the deficit and rollover existing
debt. Here comes the problem. In many cases Ministries of Finance are reluctant to issue more debt than the
minimum necessary to finance the deficit and rollover debt. Often Congress/Parliament and the Ratings Agencies
keep a close eye on gross debt even though it may not be the most economically meaningful statistic. For example,
in the cases of Mexico, Israel and Singapore, the issuance of treasury debt for monetary policy purposes has no
impact on the deficit (interest paid on the debt so used is exactly offset by interest received on the government
account at the central bank) and, from the standpoint of net debt it could be argued that it does not change when
debt is issued to acquire an offsetting asset (the central bank account balance). An additional potential problem
with the overissuance strategy in some countries is that the issuance by the central bank of treasury debt in the
primary market to fund a government deposit, even though it is "frozen" at the central bank might be viewed as
central bank financing of government which may make it politically impossible to implement.
So suppose we agree that avoiding market fragmentation is something we wish to avoid, but for some reason the
option of overissuing (selling) more treasury debt is off the table. Could the treasury find a solution
through lending securities to the central bank for use in liquidity absorbing repos?
That is, instead of the central bank being provided ownership in the securities, they would merely be lent by
government to the central bank for a fee and the central bank would then use them as collateral for borrowing
money from the market. The cental bank would thus continue to bear the cost of monetary policy (reflected in the
reverse repo rate it is paying to the market plus the fee paid to government), the supply of treasury securities in
the form of collateral would be increased, and overissuing through auctions would not be necessary.
But perhaps the idea of securities lending to the central bank leads us into uncharted waters...would the securities
be lent against a repayment pledge of the central bank or would treasury need to obtain cash collateral from the
central bank? If the latter, might the operation then be considered government financing by the central bank?
Logically speaking you would not think so...it seems more a swap of assets. Or could the treasury swap its own
securities for central bank securities of identical characteristics rather than cash collateral? This would clearly not
be government financing, particularly if the central bank securities were non marketable. But would this raise
other legal/accounting problems? Second, even if the treasury were to retain legal ownership of the securities
lent, would they still be considered part of the public debt if they circulated as collateral in the market? Might this
be viewed as a way to circumvent debt ceilings??
I promised in the first line to mention the "exception" to the general rule. In April 2008 the Bank of England
introduced the Special Liquidity Scheme (SLS) to improve the liquidity position of the banking system by allowing
banks to swap high-quality, but temporarily illiquid, mortgage-backed and other securities for 9 month UK
Treasury bills. By the end of the drawdown period, approximately 185 billion pounds of bills had been lent under
the SLS. The scheme required the UK Debt Management Office to create and lend the additional Treasury bills to
the Bank and for the Treasury to indemnify the Bank of England for any losses that might occur in connection with
the SLS. As the operation was essentially an asset swap, it had no impact on the money supply and following
standard Bank of England accounting practice; it was not shown on the Bank balance sheet.
As to the UK scheme, this is described in more detail in an article published in the Bank of England Quarterly
Bulletin 2012 Q1 March 27, 2012. The authors are John, Roberts and Weeken and it can be found online.
The relevant quote I extracted follows. (There is also a diagram of the scheme in the paper.)
"The Treasury bills used were issued specifically for the Scheme. They were liabilities of the National Loan Fund,
issued to the UK Debt Management Office (DMO) and held by the DMO as retained assets on the Debt
Management Account. The Bank borrowed the Treasury bills from the DMO under an (uncollateralised) stock
lending agreement (Figure A). The Bank paid the DMO a fee based on each transaction to cover administrative and
other costs."
The accounting arrangement essentially had one part of government (the National Loan Fund) issuing the
securities to another part of government (DMO) from where they were loaned to the Bank of England.
I suppose another arrangement might have consisted of a state pension fund lending securities (issued by
Treasury) to the central bank or through the Debt Manager to the central bank.