sou · GVB351 · 2008-01-01 00:00:00 — As long as the currency position is still positive, in so far as the Riksbank has a net worth of foreign currency assets, the floated foreign exchange rate will mean that the open currency position increases in value, i.e. there will be a positive effect when measured in Swedish krona. If, on the other hand, the currency position is neutralised from the outset, the Riksbank will obtain a negative currency position if it intervenes. If the Swedish krona is floated this negative currency position will increase in value, i.e. there will be a negative effect. It is extremely difficult to assess how large this effect could be. It requires an assessment of how large a negative currency position the Riksbank would build up in defence of the krona as well as an assessment of how large the devaluation would be if the defence of the krona was stopped. It is still possible to give some guidance based on experience from the Swedish defence of the krona in 1992, and the experience of the and from their interventions. During the defence of the krona in 1992 the Riksbank bought billion.TPF FPT The fixed exchange rate was floated on . From an initial fall of 20 percent the exchange rate bottomed out after just over a year to a fall of a over 30 percent. So if the Riksbank had had a neutralised currency position at this point, it would have lost something between – 50 billion (20-30 percent of billion). In comparison the , during its defence of in the 1992 crisis, changed its currency position by approximately billion, i.e. in monetary terms more than , but in terms of the size of the British economy and currency, The defence of the Swedish krona in 1992 should be seen as a thorough and extensive defence of a fixed exchange rate with a very high key interest rate, 500 percent, compared to other currency crises. has published a review of the size of its currency interventions in the years between 1986 and 2003.TPF FPT This reveals that the maximum intervention in one day was the equivalent of approximately billion and the maximum intervention in one week was the equivalent of billion. The risk of loss at these levels of intervention, assuming an exchange rate depreciation of 20- 30 percent, would be in the order of magnitude – 13 billion. In summary normally there are advantages to neutralising the currency position in the Riksbanks balance sheet, but the disadvantage is that if the Riksbank needs to intervene in the foreign exchange market the risk of loss can be large. The judgement of the Commission is that the Riksbank should have a matched currency position. The reasons for this are as follows. The discussion on the need for a foreign exchange reserve showed that it would seem improbable that will switch to a fixed exchange rate in the foreseeable future. The exception is if enters into cooperation prior to joining the Euro. This would be for a limited period, in all probability a few years, following a political decision on joining the Euro. It seems unlikely that the fixed exchange rate would be put to the test in such a situation, risking major losses. There is also the possibility of the Riksbank obtaining support from in such circumstances. Both the size of interventions and the risk of having to float the fixed exchange rate seem limited. PT Kokko, A (1999): The crisis: similarities with the Swedish crisis, Ekonomisk Debatt 1999, 27, no. Documentation from the defence of in is available at the Treasury at treasury.gov.uk./about/information/foi_disclosures/2005/foi_erm_2005.cfm. currency position was matched there would be very risk of the Riksbank incurring losses on a scale equivalent to those incurred during the defence of the krona in 1992. Should the Swedish government decide to switch to a fixed exchange rate in circumstances other than those discussed here, the Riksbank could change its currency position, i.e. switch from a neutralised to an open currency position. This would reduce the vulnerability to losses in the event of currency interventions. Further facets of the relationship between the political system and the Riksbank with regards to the management of losses from currency interventions are discussed in Chapter 8. The Commission sees no reason to take a position on whether matching should be achieved through currency lending or positions in derivatives. Probably this choice is mainly influenced by factors related to practicality and efficiency, factors which the Riksbank can be expected to be the best judge of. Neither does this affect the Riksbanks capital need. There are certain constraints to the potential for matching foreign exchange reserve risk. In part due to undertakings made by the Riksbank to the IMF, and in part by central banks being regulated by international agreements in their trading and position-taking in gold. This leads to some, in this context minor, risk, which will be discussed the Section on Other Risks. How large should the foreign exchange reserve be? Judgement of the Commission: The Riksbank should have a neutralised currency position. This would make the size of the foreign exchange reserve of minor importance to the analysis of the Riksbanks capital need. It appears improbable that will switch to a fixed exchange rate in the foreseeable future, so the risk of loss can be restricted to those interventions which could arise for a short period of time in conjunction with any entry into the Euro. A buffer capital of billion should be sufficient to cover this risk. The table below shows the size of the Riksbanks foreign exchange reserve today compared to other countries. It specifies the size of the foreign exchange reserve in absolute amounts (Swedish krona) and in relation to GDP. and have by far the largest foreign exchange reserves in relation to GDP of the countries in the comparison, while is relatively close to the average. However, has the largest proportion of its foreign exchange reserve in its balance sheet. The foreign exchange reserve in a number of selected countries reserve as a % Fixed (+/- 2.25 Source: Annual reports, , World Fact Book wwwHTU .cia.govUTH 7 *GDP estimated for 2005 Currency interventions are made by buying or selling Swedish krona on the foreign exchange market. The intention of holding assets in foreign currency is that these can be exchanged for Swedish krona when the currency trade is made. This is necessary if the currency intervention is to be made on the spot market. In the past twenty to thirty years trading on the foreign exchange market has increasingly been carried out in derivative markets. According to the Riksbanks statistics covering the trade in Swedish krona, total daily turnover was billion a day in 2005, of which billion (21 percent) was on the spot market. So most trade was carried out on derivative markets where currency swaps were mainly used. The daily turnover in these instruments was up to billion. This pattern is in no way unique in the Swedish foreign exchange market, the same is true for other developed markets. So much of the trade and price development on the foreign exchange markets takes place in the derivative markets. Because of this, central banks need not take action in the spot markets in order to manipulate the foreign exchange rate. Just as for other foreign exchange market actors it is now normal for central banks to use the derivative markets for their currency interventions. According to a 1997 study, 7 out of 14 participating central banks used derivative markets for their currency interventionsTPF FPT, among them the Riksbank. In view of this we can discuss whether there is a need for a foreign exchange reserve in the form of nominal currency assets in order for a central bank to be able to conduct currency interventions. One reason that a need might exist after all, is the possibility that derivative markets would not work well in times of turbulence. In the majority of the extensive exchange rate defences of recent times however, the derivative markets have been used, and have been shown to work, even in periods of turbulence. There is no known case in which a central bank in a developed economy has not been able to act in the derivative markets. 31TP PT BIS (1997) Implementation and Tactics of for No. 3, () p 332. The Commissions view that the Riksbank should have a neutralised currency position means however, that the size of the foreign exchange reserve is secondary in the analysis of the Riksbanks capital need. As discussed in the previous section it is the size of intervention which is crucial to any risk of loss. In turn this is not dependent of the size of the foreign exchange reserve in the form of the value of the currency assets in the Riksbanks balance sheet. The Commission is therefore refraining from making a judgement of how large the foreign exchange reserve should be. It would seem more suitable for the Riksbank to make an assessment as to whether it is appropriate to have currency assets on the balance sheet, how large these assets should be, and whether they should be neutralised by borrowing in foreign currency or if this should take place on the derivative markets. None of these assessments has other than marginal impact on the Riksbanks capital need. In summary the Commission believes that the Riksbank should have a matched foreign exchange reserve, the size of which has no bearing on the Riksbanks capital need. The risk of loss which needs to be taken into account in order to assess the Riksbanks capital need should, in this case, be based on the risk of incurring losses in conjunction with interventions on the foreign exchange market to defend any future fixed exchange rate. As a switch to a fixed exchange rate seems unlikely in the foreseeable future, other than in conjunction with entry into the Euro, the risk of large currency interventions and the risk of major losses associated with them, seems limited. Because of this, the Commission considers that the capital needed by the Riksbank to cover losses associated with management of the foreign exchange reserve is relatively small. risk of loss in the interventions reported above, were estimated to be 6-13 billion. In this case interventions went on for an extended period of time. As the Commission does not see this as probable in , it seems realistic to consider a risk of loss of no greater than approximately billion when evaluating the Riksbanks capital need for the management of the foreign exchange reserve. 4.3.Reduced currency in circulation Judgement of the Commission: If the currency in circulation decreases, the Riksbanks earning capacity also decreases. While this risk exists, it is improbable that a sudden and heavy fall in the currency in circulation will occur. One of the risks identified for the Riksbank is a decrease in the currency in circulation. In contrast to the two previously identified risks, this is not a risk of loss but a risk of reduced earning capacity. It arises because the free financing represented by the currency in circulation could decrease. However, the effect on financial independence would be the same. What governs the size of the currency in circulation is the public demand for banknotes and coin, which is difficult for the Riksbank to influence. Cash payments have to an ever greater extent been replaced by electronic payment methods, above all card payments. There has been an expectation that this would lead to a reduced demand for cash, so that there would be a reduction in outstanding banknotes and coin.TPF FPT Outstanding banknotes and coin have fallen as a share of Swedish GDP (see Figure 8). However, the change mainly took place prior the 1990s, before the wide acceptance of electronic payments. The Riksbank has estimated that the proportion of commerce paid for with cash decreased from 76 to 58 percent in the 1990s.TPF FPT There was no corresponding reduction in outstanding banknotes and coin. It is uncertain to what extent the increasing proportion of electronic payments in normal commerce will actually lead to reduced currency in circulation, this is because the public demands banknotes for other reasons than to carry out payments. Outstanding banknotes and coin (M0) as a proportion of GDP 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Source: Reuters EcoWin By using a model to estimate how much cash use can be explained legitimately we can obtain the converse unexplained proportion of cash use. This can be seen as a measure of how much cash is required in the shadow economy, primarily untaxed or otherwise criminal activities. The unexplained volume of outstanding cash increased from 3.8 to 6.5 percent of GDP between 1990 and 2004.TPF FPT Taking into account that there is an increased focus on economic criminality, money laundering etc. and thus on the importance of cash to the shadow economy, measures to hinder the use of cash for such ends are 32TP PT For a discussion on this, see , L & Guibourg, G. (2003): Card payments in , 2/2003. 33TP PT , M. & Guibourg, G., (2001): The use of cash in the Swedish economy, Riksbank, 2001/4. TP PT Guibourg, G. & Segendorff, B. (2007): The Use of Cash and the Size of the Shadow Economy in , The Riksbank Working Paper Series No. 204, 2007. If such measures were taken and proved successful, currency in circulation could be reduced. There could be grounds to pay particular attention to the development of the size of currency in circulation in such cases. From our perspective it is relevant to look at whether outstanding banknotes and coin may decrease in nominal terms, not as a proportion of GDP. The reason for this is that the fundamental issue facing the Commission is whether currency in circulation could decrease in such a way that the Riksbanks earning capacity from seigniorage would be radically weakened. Figure 9 shows the percentage annual change in currency in circulation for three countries. Annual percentage change in currency in circulation for three countries. -2,5 -5,0 Source: Reuters EcoWin In the 1970s and 1980s currency in circulation increased. This is natural taking into account the high inflation in those decades. In the 1990s the average rate of change decreased across the board, probably in the first instance as a result of the reduction in inflation, but was in most cases positive. negative changes, in the order of magnitude of 1 percent, occurred in three different years in . showed a more steady reduction in the rate of currency in circulation at the end of the 1990s, and at the beginning of the 2000s it was negative for several years, at most by almost 4 percent in 2002. The accumulated change in the years 2000-2002 was over 6 percent. It should be noted that there was a greater demand towards the end of 1999, in all probability caused by worries about the millennium bug. One reason for developments in in last part of the 1990s and the beginning of the 2000s was that took steps to reduce the use of cash, in particular by introducing fees on cash In recent years this development has been reversed and currency in circulation has increased faster in than in the other two countries. It is, of course, difficult to draw concrete conclusions about the risk of a decrease in currency in circulation from historical developments. However, it can be established that up to now currency in circulation has not shown any negative change from one year to another. There is a fairly large variation in the year to year rate of growth, but this is about differences in a positive rate of growth rather than negative change. In light of this it is difficult to see that the risk of a dramatic fall in currency in circulation is great in the short-term. If there is a change it is more likely to occur gradually, over a number of years. As shown above own capital and currency in circulation are in part exchangeable as both provide free financing. The currency in circulation is currently substantial, about 112 billion. Consequently if seigniorage is used to finance current operating costs, there is a substantial for financial independence, even in the event of a severe reduction in currency in circulation. The Riksbank also has risks other than that discussed up to now, not of the same importance but still needing discussion. These consist of credit risk other than for emergency liquidity assistance, operational risk and the remaining risk in asset management, which cannot be neutralised in the same way as currency risk in general. Credit risk in operational activities Judgement of the Commission: The Riksbanks credit risk in its operational activities is not of a scale that it affects the Riksbanks capital need. The Riksbank provides credit to banks in its operational activities. This is credit given in the framework of the central payment system which the Riksbank provides, the system, and credit through repo transactions used in order to implement monetary policy. The system is used to manage payment and liquidity equalisation between the banks. For the system to work, the banks need to have substantial surpluses or deficits in their accounts with the Riksbank for short periods during the day. A deficit means that the Riksbank provides a credit to the bank in question. However, the account is equalised at the end of the day and overnight lending is minimal, only SEK one or two million. All banks in are connected to , either directly or indirectly via an account with one of the connected banks. The system offers the banks an effective way of managing their cash flows. The banks are allowed to have surpluses and deficits in their accounts. In practice having a deficit in the account means that the bank has received credit from the Riksbank. This credit may be large, tens of billions of krona, but consequently it has a very short maturity. In order to limit the credit risk inherent in this type of credit, the Riksbank requires the bank to provide collateral in the form of securities with particularly low credit riskTPF FPT. This collateral limits the credit risk in this business significantly. If the collateral is made up of government securities issued by the Swedish central government, or by central governments with an equivalent credit worthiness, the remaining credit risk can be deemed so low as to be negligible in the view of the Commission. Even securities issued by companies are approved as collateral. However, in this case several conditions are imposed which mean that the credit risk can also be deemed very limited. In the first place the Riksbank only accepts securities with very high credit worthiness. And secondly there is a daily marking to market of the securities. If their value is below 99 percent of the value of the credit, the Riksbank requires further collateral. This means that the Riksbank only the risk of a decrease in value in the collateral for one day. Thirdly, the Riksbank will only appropriate the collateral if and when the debtor itself defaults. The probability that the debtor defaults at the same time as the collateral falls in value significantly is extremely small. With regard to its task of evaluating the Riksbanks capital need, the Commission judges the credit risk arising from lending operations in to be negligible. In its 2006 financial statement, the Riksbanks monetary policy repo transactions amounted to approximately billion. In practice a monetary policy repo works like a collateralised loan. The Riksbank sets the same high credit worthiness requirements for the counterparties and collateral in repo transactions as in lending in the system. The maturity of these transactions is also very short, one week. These factors limit the risk inherent in this type of credit, which is not considered to entail risk on a scale that need be taken into account when evaluating the Riksbanks capital need. Judgement of the Commission: The Riksbanks operational risk generates a very limited capital need. According to the II rules, operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. In practice this can mean many different types of loss such as that arising from fires in , IT system failures, fraud and negligence. But common to all types of operational risk is that it all arises inevitably from undertaking specific activities. Many other types of risk such as financial risk are part of conscious risk-taking, but not operational risk. Nevertheless, it is possible for an organisation to a degree to affect the scale of the operational risk to which it is exposed. Investing in new IT systems can reduce the risk of IT failure and introducing extra checks on staff can reduce the risk of internal fraud and negligence. Some operational risk can be underwritten. However, it is extremely difficult to quantify the implications of this type of risk reducing measure, and there will always be some residual level of operational risk. 35TP PT The securities accepted as collateral are regulated in the Rules and Regulations for laid down by the Riksbank. The latest version of these came into force 1 2005. The scale of operational risk in an organisation depends to a large extent on its operational activities. An example would be that a company that on operational activities that could be dangerous for others may run a serious risk of becoming liable to pay damages, or that a company that handles large financial flows risks being defrauded, robbed or otherwise subjected to attempts to steal the companys funds. The Riksbank has several identifiable activities incurring this type of risk. The system entails the handling of large financial flows, as does the financial trade carried on for the management of the foreign exchange reserve. This means exposure to embezzlement by personnel managing these activities. Handling cash incurs the risk of robbery. The system is central to the functionality of the entire payment system and because of this, there is an intense vulnerability to operational stoppages of a technical nature. This means that reliability requirements are also very high. In the first instance operational problems in the system do not constitute a risk of financial losses, but it cannot be precluded that the Riksbank would be liable to pay serious damages if shortcomings in the system lead to participants or their incurring large losses. It is not possible in any meaningful way to more specifically quantify this risk for the Riksbank. Some guidance can be obtained from how the regulation of operational risk is managed for the banking sector. In itself the operational activity of the Riksbank is significantly different to that of a bank, but some risk indicators can still be obtained from it. According to the new capital adequacy rules that came into force globally in 2007, banks must hold capital to cover operational risk. The easiest method of calculating this capital need specifies that a bank must hold capital for operational risk corresponding to 15 percent of turnover (for a bank this is operating income, i.e. net income after interest and provisions, IT costs, credit losses etc.). The Riksbank has had highly variable revenues due to changes in the value of the Swedish krona. normal levels of revenue, measured in the same way as those of the banks, are around - 10 billion in recent years. So 15 percent of this would give a capital need in the order of magnitude of billion. This is a fairly small amount in relation to the size of the balance sheet. Other financial risks in asset management. Judgement of the Commission: The financial risk related to the gold reserve decreases over time but is initially calculated to incur a capital need of billion. Other risks are limited.