When umpires turn players

S. GURUMURTHY | Updated on March 09, 2018

When market players got into difficulties, central banks would bail them out. But if central bankers play the stock market, who will bail them out?

“Reserve Bank of India has started buying and selling stocks of listed private corporates in Dalal Street for profit”.

Can one imagine Business Line carrying a news headline like this? Obviously not. But this unimaginable news of today may soon become a reality tomorrow. Well, if not in the case of the RBI, at least of a few other central banks. Indeed, it is already a reality in the advanced world of finance that has set the model for the rest in the last two decades. Shocked? Read on.

Bloomberg Business Week [25.4.2013] reported in the news headlined “Central Banks load upon equities” that “guardians of $11 trillion in forex reserves are buying stocks as the falling interest rates push the risk averse investors to equity”. But this shocking news doesn’t seem to shock the paralysed guild of professional economists or the drifting modern world of finance.

The bewildered profession that has run out of ideas and a market in search of a financial logic since the global crisis of 2008 seem to be too dazed to see and keep the line of distinction between market players and monitoring authorities who are supposed to oversee the former.

The US Fed started buying corporate bonds first in 2008. Now the others are getting into equity buying. Central banks entering the stocks markets is more like an umpire suddenly jumping into the play ground and starting to play! With the trend among monetary umpires to become market players, it is necessary first to recall what a central bank is to national economy and global monetary order.

Central banks’ role

As their role is understood in monetary economics now, central banks are, in principle, character and practice, different from commercial banks. The latter are market players. The former monitor them.

The central bank is the banker to the State. In that capacity it has the monopoly power to print the national currency. It implements and manages monetary policies, including rates of interest, volume of money and credit. It manages the country’s forex and gold reserves. It monitors the commercial banks.

The commercial banks deal with the public, businesses and corporates but central banks deal only with the commercial banks.

A central bank is a bankers’ bank and is their lender of last resort in case of a dire need or emergency. The central bank traditionally performs two core functions. One, it sets the benchmark interest [the bank rate] rate and two, influences the quantum of money and credit in the market.

The two functions together influence the growth and price levels in the economy. Its participation in the market is limited only to the fulfilment of its larger objectives of growth and price stability in the economy.

It is the commercial banking system that mobilises deposits and borrows at the rates influenced by the ‘benchmark’ rates of the central bank and invests/lends these monies for a profit. This has been the traditional domain of operations between central banks and commercial banks.

Three key developments

But three significant developments in the global monetary and financial order and model since the 1970s have complicated the traditional functions of central banks.

First, the advent of the convertible currencies in the 1970s changed the character of forex reserves and their management. Second, cross-border flow of currencies and the expansion of international trade increasingly made money supply and interest rates beyond the capacity of the national central banks to handle.

Three, with the evolution of shadow banks such as mutual fund hedge funds, commodity funds as financial intermediators, more monies began to be dealt with outside the commercial banks under the care of the central bank. For example, in the US, the total financial assets of shadow banks constitute 35 per cent and commercial banks’ just 22 per cent.

The three developments have made the job of the central banks more difficult, more complex and less and less sovereign. The central banks’ domain function of handling forex reserves too has undergone drastic changes. The forex assets consist of currencies of other countries and some gold. With the growth of foreign trade and cross-border financial flows, the forex assets of central banks have grown phenomenally more in the last decade.

Huge forex reserves

The official forex reserves of a country, being the public assets of the government, are, by law and custom, kept invested in the sovereign securities of other countries.

As much as 60 per cent of the world’s total forex reserves of $11 trillion are in held in US Dollar assets. The US, which prints the Dollars kept by the others as forex reserves, itself needs, therefore keeps, very little forex reserves. Just $146 billion. Out of that, more than $100 billion is kept in IMF reserves and in gold and the balance in foreign sovereign securities of the IMF and Bank of International Settlements. But the rest of the world nations hold huge forex reserves — and mostly in US dollars.

According to the CIA Factbook, the major holders of forex reserves are: China [$3.3 trillion], Japan [$1.3 trillion], Euro Zone [$864 billion], Saudi Arabia [$657 billion], Russia [$538 billion], Switzerland [$531 billion], Taiwan [$408 billion], Brazil [$373 billion], South Korea [$327 billion], Hong Kong [$317 billion], India [$298 billion] and Singapore [$259 billion].

The world’s forex reserves, just $3 trillion in 2001, are now $11 trillion — up by 267 per cent. The huge reserves are partly the outcome of the tsunami of huge phony monies swarming the world [ Business Line dated June 14 and 28 and July 12 and 26, 2013].

This so-called reserve assets, forced on the central banks for lack of a common currency for global commerce, are actually becoming a gargantuan economic liability. [see: “The $7 trillion that could sink Asia”. Opinion. Bloomberg 2.8.2013]. This stark message is hidden in the Bloomberg news exposure of April 25, 2013. But, why do the traditional, conservative central banks run to stock markets?

Says Bloomberg, while the annual consumer prices are rising at 1.5 per cent [in the US] and 1.7 per cent [in Euro area], the average yield to maturity on government securities has fallen to an all-time low of 1.34 per cent. Here is the illustration of average yield to maturity.

A 10-year government security may fetch coupon rate 6 per cent. But if the short-term interest rate is zero, the high yielding security will sell in the market at higher than face value which reduces the effective rate of interest below 6 per cent. That reduced rate of interest according to Merrill Lynch’s Global Broad Market Sovereign Fund Index is 1.34 per cent. In contrast, S&P’s 500 [equity] Index pays 2.2 per cent of their combined share prices and dividends.

As the central banks keep their funds in sovereign bonds, the return that they will be getting is the low return of 1.34 per cent (G-Secs) mentioned earlier. The perplexed central banks are, therefore, shifting a significant part of their funds to stock indices.

According to Bloomberg, in a survey by Central Banking Publications and Royal Bank of Scotland Group Plc, 23 per cent of 60 central bankers said that they own shares or plan to buy them. The Bank of Japan, the second biggest forex reserve holder, said on April 4 that it plans to double its investment in equity exchange traded funds to $35 billion by 2014.

The Bank of Israel entered the stock market for the first time last year while the Swiss National Bank and the Czech National Bank have boosted their holdings to at least a tenth of their reserves. Out of the 60 banks, which control $6.9 trillion reserve, half of them said that prompted by low returns they would take more risk and 14 of them said that they have either invested or would do so in the next five years.

Honey bee in honey pot

But what is the effect of central banks’ foray into stock indices? According to Profit Confidential attached to the Lombardi Financial, the key stock indices are climbing not because of fundamental reasons, but due to the harsh reality that the yields from other investments are too low — forcing the investors into taking risks.

It cites the central banks, the most conservative investors, rushing towards the stock market as a reason for the rise in stock indices without justifying fundamentals. The message is clear. With increasing central bank funds in stocks, the stock indices will go up and give more immediate returns through artificial index appreciation. This is the repeat of the game financial market players play with central bank money.

Now the central banks themselves are beginning to play the game directly. If it intensifies, it will be soon like the honey-bee in the honey-pot case. When the market players got into difficulties the central banks bailed them out. If the central bankers land in difficulties, who will bail them out?

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(The author is a commentator on political and economic affairs and a corporate advisor)

Published on August 22, 2013

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