Reserve Bank’s plunge into negative equity

Similarly, there is not a counterparty in foreign exchange and derivative markets that will question the creditworthiness of the RBA.

But that is not the end of the matter. Not by a long stretch.

A failure of risk management

One issue the RBA will need to address is risk management.

The starting point is its Risk Management Framework (RMF), which is a central component of its broader Risk Management Policy.

Within the RMF, there is an extensive capital provisioning regime, that underpins the risks the RBA takes in financial markets. It also informs the RBA’s dividend policy in respect of Treasury.

Last year the RBA conducted its typical stress tests on foreign exchange exposure (a 25 per cent appreciation of the Australian dollar) and interest rate exposure (a 200 basis point rise across the yield curve).

It also started provisioning for “earnings at risk”, reflecting payments the RBA would make on exchange settlement balances in the event of a tightening cycle.

Importantly, the RBA decided to no longer provision capital for its domestic interest rate exposure.

The required amount was $27.4 billion. The main justification for the change was that the RBA intended to hold the bonds until maturity. The RBA highlighted that “fluctuations in yields alter the timing of any valuation gain or loss over time, but do not change the ultimate return the Bank will earn on these bonds”.

The RBA also paid a dividend to Treasury of $2.7 billion. This reflected underlying cash earnings of $4.2 billion, in turn a function of the cash rate being near zero for most of the financial year of 2020-21.

Putting this together, the RBA provisioned $15.4 billion, held in the Reserve Bank Reserve Fund (RBRF). Its total capital was $23.0 billion, bolstered by the Asset Revaluation Reserve on non-traded assets, such as gold and property.

The shortcomings of these various decisions have been brutally exposed this year.

We estimate mark-to-market losses on the domestic interest rate portfolio of around $50 billion. This can be derived line by line, and cross-referenced, albeit with some accounting adjustments, to the Statement of Assets and Liabilities that the RBA publishes each week.

It includes bonds purchased to establish the yield curve target, as well as the program of quantitative easing. It does not include the fixed rate loans extended to banks under the Term Funding Facility (TFF).

Against this, the RBA will again post underlying cash earnings in the current fiscal year, of around $8 billion by our estimate. This reflects exchange settlement balances being renumerated at zero for most of the period, along with the coupon income earned and increased.

However, this dynamic is set to change. The tightening cycle will see a sharp increase in payments on exchange settlement balances, likely sufficient to shift the RBA’s cash earnings negative, and for many years ahead.

The negative carry that the RBA faces is particularly acute in respect of the TFF, with the main maturities not due until Q3 2023 and Q2 2024.

At the balance sheet level, the losses the RBA is sitting on clearly exceed the provision held in the RBRF, and the broader measure of total capital. While we are not expecting the RBA to acknowledge this constitutes a failure of risk management, others will disagree.

In any event, the RBA will have to formally acknowledge it is in negative equity as part of its Annual Report.

Absent a massive recapitalization from the government, some creative accounting will be required to balance the books. The capital provisioning regime will also require wholesale review, not least for the forward-looking risks that the RBA still faces.

The fiscal cost is real

A second issue is the fiscal cost.

There is some room for debate here, given that most of the RBA’s domestic interest rate portfolio represent claims on federal, state and territory governments.

At the fringy extreme lies Modern Monetary Theory, which regards quantitative easing (and its variants) as merely an asset swap between the government and central bank.

In an Australian context it is certainly the case that higher yields have benefitted the various governments against fiscal baselines. In the 2022-23 Federal Budget, for example, net debt fell by $58.2 billion, against that reported in the Mid-Year Economic and Fiscal Outlook.

Higher yields on Australian Government Securities (AGS) contributed to savings of $27 billion against forecast.

But this, and the similar revision that is likely to occur in the October budget, is an accounting gain that will be eroded on the stock of AGS as the bonds pull back to par value in the years ahead.

The RBA will also benefit from this effect, yet faces a persistent drain on financing these holdings at higher cash rates.

It could mitigate this by selling bonds back to the Australian Office of Financial Management (AOFM). But so far it remains resistant to this ‘active’ form of quantitative tightening, and the scale would need to be very large to make a material difference.

In short, higher yields reflect a one-time gain for the government, that is also facing higher borrowing costs going forward.

Meanwhile, the RBA’s ability to earn its way out of negative equity is being undermined by the abrupt tightening cycle that is priced, especially in respect of the TFF. This is the crux of why the fiscal cost is real.

Independent review

In October last year we contended in this newspaper that the RBA may need to be recapitalised. The key precedent remains 2013, when the then Treasurer, Joe Hockey, appropriated $8.8 billion, at the request of the RBA.

This grant, being a direct fiscal cost, was to “enhance the Bank’s capacity to conduct its monetary policy and foreign exchange operations”.

Given the much more significant deterioration in its balance sheet this past year, it would seem incongruous for the RBA not to make a similar request.

However, we are told that the incoming ALP government does not want to go there, given the broader pressures on the budget. We will have to wait and see what transpires in October.

Before then, a third issue looms for the RBA, with the government likely to announce the terms and the timing of its independent review.

There is no doubt that all aspects of the RBA’s unconventional monetary policy will be heavily scrutinized through this process. The RBA is looking to get ahead of this, with its own ‘Review of the Yield Target’ set for media release next week.

But there are many battles ahead, including whether Governor Lowe will be invited to extend his seven-year term, which ends in September next year.

An extended term, in line with his two predecessors, was a central expectation of market participants when Deputy Governor, Guy Debelle, resigned back in March.

While there is a long way to go, it is getting harder to see how that happens.

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