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Message: <blockquote data-quote="imhotep" data-source="post: 28832386" data-attributes="member: 562115">Contd....Monetary liabilities of a CBBy acquiring assets, both domestic and foreign, a central bank creates monetary liabilities known as reserve money or monetary base. They are of two types, currency which is a sight liability – because a central bank is required to pay value on sight – and demand deposits held for commercial banks and other institutions which are demand liabilities – because the bank is required to pay its value on demand. When the assets go up, these liabilities also go up. But in the case of foreign assets, there is protection because the central bank has a claim on a foreigner who is required to pay value in foreign currencies. Therefore, the risks arise from two sides. One is the loss of the foreign reserves by wasting them unnecessarily to protect the exchange rate or to make payments which are not of any benefit to the country.But it leads to the reduction in the monetary liabilities or the reserve money creating a liquidity shortage in the system. To overcome this, the bank will have to create new reserve money by creating domestic assets. To restrain the bank from doing this extravagantly, the MLA has tied the creation of domestic assets to the capital funds of the bank. The prescribed 15% is the minimum and it should strive to maintain a high and a safe ratio.Maintaining a 100% capital ratio under CB modernisation projectUnder the Central Bank Modernisation Project which was in operation during 2000-4, the Bank had agreed with the funding agency, the World Bank, that it would bring the ratio gradually to 100% over time. This was a protective measure introduced by the World Bank to see that the money lent to the central bank will be used properly. It required the central bank to refrain itself from making annual profit transfers or if it is done, to keep it at a low level and transfer the entire surplus to the capital funds. As the figure shows, the central bank was able to attain this goal by building the capital funds from 25% of the domestic assets to 97% by 2007. However, as the figure shows, in the subsequent years, this goal was abandoned by the central bank and as a result, it fell below even the 15% in 2015. The advantage of maintaining up to 100% of domestic assets as capital funds is converting the operation of the central bank to a virtual currency board. Accordingly, a part of the reserve money is covered by foreign assets and the rest by capital funds.Depletion of capital ratio to 2% in 2022The thumping losses made by the central bank in 2022 causing the depletion of the capital funds to a bare minimum level has reduced the ratio from 20% in 2021 to 2% in 2022. But as the graph shows, it is a deterioration started a few years back. In 2019, the ratio was 52%. But since the central bank transferred the entirety of its profits to the government in 2020 and 2021 without concern for the need of building capital funds, on one side, and the increase of domestic assets dramatically, the ratio began to fall. Strangely, the Monetary Board at that time did not think it necessary to protect the solvency of the bank.New central bank bill has diluted CB’s capital requirementIn the proposed new central bank bill, the procedure of protecting the capital adequacy of the bank has been changed from 15% of domestic assets to 6% of monetary liabilities which are called reserve money or the monetary base. In the existing MLA, it is related to the monetary base via the domestic assets, the source of the creation of such base. This has been avoided in the new bill by directly connecting it to the base. What this means is that a minimum of 6% of the monetary base is covered by capital funds. This is a too low protection, and it would have been better had it remained at the original level of 15% prescribed in the MLA.Present capital level is even below the diluted ratio of new central bank billThe currently depleted capital base of Rs. 82 billion is just 6% of the monetary base of Rs. 1,349 billion as at the end of 2022. But since then, the monetary base has expanded to Rs. 1,643 billion by end April 2023 causing the ratio to fall to 5%, below the minimum level prescribed in the new central bank bill. This presents a high solvency risk for the Central Bank and the Monetary Board under MLA or its successor, the Governing Board, under the new central bank act should not take it lightly. It may require the Central Bank to go for austerity measures just like it has recommended to the rest of the nation under the current readjustment program with IMF.Since the bank is not able to create domestic assets under the IMF program and even the existing interest earning investments in Treasury bills amounting to Rs. 2.8 trillion are to be converted to a negotiable 10-year bond under the new central bank act as a part of the domestic debt restructuring, its income base in the next 5 years will be drastically reduced. The bank has a committed expenditure of Rs. 10 billion as personnel expenses and another Rs. 2 billion as other expenses, it will face a serious solvency problem in the next few years.CB is not insolvent as yet, but may be if prudent policies are not adoptedAs it is the Central Bank is not insolvent. But it may if it does not adopt a suitable strategy to cut its expenses and keep its books balanced in the next few years. This is a malaise which the Monetary Board should avoid.</blockquote>

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