sou · GVB351 · 2008-01-01 00:00:00 — The governance of the Riksbank has been formulated to be compatible with the fundamental requirement that central banks be autonomous and independent, which is now the ambition of many developed countries, and which is described in more detail in Chapter 5. Pursuant to Chapter 9, section 13 of the Instrument of Government, the Riksbank is an authority responsible to Parliament. The Riksbank has an eleven-member elected by Parliament. The Riksbank is managed by an , which is appointed by the . This section also states that the may dismiss a member of from their appointment only if they no longer meet the requirements made of them to carry out their duties or they if have been guilty of serious misconduct. In accordance with Chapter 1 section 4 of the Riksbank Act is to consist of six members, appointed for a period of six years. appoints the Chairman of , who at the same time shall be the Governor of the Riksbank. The Riksbank may only carry out tasks specified in law. This is one way of clarifying and limiting its operational activities, which is motivated by the Riksbank having been granted significantly greater independence than other authorities. PT This task is regulated in Chapter 6, section 8, of the Riksbank Act. PT The basis of this can be found in Chapter 6, section 7, of the Riksbank Act. 2.4.The Riksbanks balance sheet Table 1 shows the Riksbanks balance sheet at the end of 2006. The Riksbanks balance sheet on Other liabilities and provisions Monetary policy repo transactions The Riksbanks assets are predominantly in foreign currency and gold - the foreign exchange reserve (92 percent). Currency assets consist of securities with high credit worthiness in foreign currency and investments in foreign banks. The currencies in which there were investments at the end of 2006 were: Euro (50 percent), US dollars (20 percent), (10 percent), Norwegian krona (10 percent), Australian dollars (5 percent) and Canadian dollars (5 percent).TPF FPT Gold made up 11 percent of the balance sheet. Monetary policy lending being carried on in the form of repo transactions with Swedish banksTPF FPT makes up a limited component of the balance sheet (3.5 per cent). In addition, the Riksbank has claims on the (), corresponding to 2.4 percent of the balance sheet total. For some of these claims there is a counterpart on the liabilities side of the balance sheet (in the table part of the item Other liabilities and provisions), which is why the net position is somewhat lower than 2.4 percent. Other assets include accruals and prepaid expenditure and fixed assets. half of the liabilities side of the balance sheet consists of currency in circulation, which makes up a liability item in the balance sheet (this is discussed in detail in the following section). Within the framework of the management of the foreign exchange reserve the Riksbank may enter into repo transactions. This means that the Riksbank lends securities in its own asset base and receives a cash payment. This is reported as a form of deposit in the balance sheet, i.e. as a liability. At the end of 2006 this corresponded to 7 percent of the balance sheet total. Other liabilities and provisions are limited in extent (1.6 percent of the balance sheet total). These repo transactions should be seen as a part of the management of the foreign exchange reserve, undertaken in order 6TP PT The currency mix reported here reflects the currency position of the Riksbank, taking into account both positions in derivatives and repo transactions on the passive side (see next footnote). It is somewhat different to the portfolio of assets reported gross on the asset side of the Riksbanks balance sheet. 7TP PT Repo transactions are reported as lending (with securities as collateral), despite this formally being a repo transaction. This is because repo transactions have the same financial properties as a collateralised loan, despite them being not considered legally as loans. to increase the return on the asset portfolio. This business activity inflatesTPF FPT the balance sheet to a certain extent. Own capital, including annual profit was 31 percent of the balance sheet total. The remaining item on the liabilities side, revaluation accounts, consists of unrealised profits in foreign securities and gold. The Riksbank marks its assets to market, but in accordance with the accounting principles applied, may not carry over unrealised profit to this years profit and own capital making them distributable. On the other hand, unrealised losses are reported against own capital, if they exceed the accumulated profit in the revaluation accounts. In general the accounting principles are governed by the collective rules for the EU national central banks in System of Central Banks (ESCB), of which the Riksbank is one. The revaluation accounts are bond specific in such a way that unrealised losses in one bond may only be carried over against previously unrealised profits in the same bond. This means that unrealised losses can affect net income to a relatively large degree, even when there are unrealised profits in the revaluation accounts. At the end of 2006 most of the revaluation accounts could be assigned to unrealised profits in gold (87 percent). For the purposes of analysis by this Commission there is cause to simplify the balance sheet and focus on components of a size and significance such that they are critically important to the structure of the Riksbanks balance sheet and its financial independence. Figure 1 shows such a simplified picture of the balance sheet. 8TP PT By inflate we mean that when the Riksbank enters into a repo transaction of this type it increases its liabilities, in the form of an increase in the item covering repo transactions in foreign currency, as well as the corresponding increase in assets when payment for the repo transactions is converted into the purchase of new securities. Typically the profit from this type of transaction is small, just a few points, but because the transaction expenses and risk (when handled correctly) are low, there are good reasons to carry on this type of activity when one has a substantial portfolio of securities like the Riksbank. Simplified picture of the Riksbanks balance sheet at the end of 2006 At present the currency and gold reserve is the asset base that generates returns for the Riksbank and is the basis of the Riksbanks ability to fund its activities and remain financially independent. It is not self evident for the Riksbank to invest all of its capital in currency assets (over and above the smaller asset items left out for the time being). Nevertheless, until now the Riksbank has chosen to place its available capital in these assets. The need for the foreign exchange reserve, its size and the level of risk it contains are discussed in more detail in Chapter 6. In the Figure the revaluation accounts have been included in own capital. The reason for this is that, in principle, because they can be used to cover certain foreign exchange losses, the revaluation accounts constitute risk-bearing capital. The accounting restrictions contained here have only a minor bearing on the essential argument of this Commission (see further Chapter 6). This means that own capital, as defined by the Commission, was billion, after the deduction of the dividend of almost billion. The item currency in circulation is, in many respects, unique, and there is good reason to discuss in more detail the properties of this item on the liability side of the balance sheet and its significance to the Riksbank. This is done in the next section. After that the chapter ends with some definitions. These are important if the Commission is to have a functional and understandable conceptual framework for the Commissions assignment, which is to analyse how the Riksbanks financial independence should be guaranteed. Currency in circulation is reported as a liability item in the Riksbanks balance sheet. However, from a financial point of view it is not necessarily clear that currency in circulation should be seen as a liability for the Riksbank. One reflection of this is that currency in circulation has no interest cost for the Riksbank. For this reason there is cause to discuss, in fundamental terms, the economic properties of currency in circulation and how it affects the situation of the Riksbank and its financial independence. In order to understand the current situation it is necessary to provide a historical When banknotes were first used (in in the 17P P century), these were legally debt instruments. The holder of such a debt instrument could redeem it for metal coin (gold, silver or copper), i.e. a banknote was a claim on an asset with a real value. Because of this the central bank was forced to hold reserves in the form of metals so that it could change banknotes for coin on demand. Until 1931 the Riksbank was liable to redeem banknotes for gold coin, and as long as this was the case banknotes could be viewed as a real claim on the Riksbank. Under the Bretton system there was an indirect link between banknotes and gold because the American central bank had pledged to redeem dollar banknotes for gold and the Swedish krona was tied to the dollar through a fixed exchange rate. Nowadays all such links are gone. Despite this, private individuals and companies are prepared to hold banknotes. The explanation for this is that the holder knows that the banknotes are accepted as legal tender. This means that banknotes can be exchanged for all types of goods and services, without any significant transaction expenses. The use of banknotes as a means of payment can be regarded as a convention. It is maintained because when a large group of people start using a certain type of goods as a medium of exchange, it is efficient to continue using it. From this perspective, banknotes have a value primarily because they facilitate the purchase of goods and services. This can be defined as a transaction motive for holding banknotes. As long as citizens have confidence that, in the long term, they will still be able to use banknotes in exchange for about the same amount of goods and services as they do today, they will also be prepared to use banknotes for savings. there is also a savings motive for holding banknotes. Because banknotes do not have a direct yield, the willingness to hold banknotes is dependent on the interest that citizens can receive on other assets. High interest rates and high inflation, which reduce the value of banknotes in terms of goods and services, therefore reduce the demand for banknotes. However, experience shows that very high rates of inflation are required before banknotes are displaced as a means of payment. This illustrates the power of the convention of using banknotes as legal tender. It would not have been possible for the current system to have become established unless the issuer of the banknotes had initially been prepared to redeem them for gold coin. However, when the convention has become established the need for such a link ceases to exist, and the demand for banknotes is based on confidence in their value as a means of transaction and savings. From an economic perspective this is more efficient as the central bank need not store a large amounts of gold in its vaults. The gold can then be used in other parts of the economy where it will provide greater benefit (or at least give more pleasure). Abandoning gold has had even more fundamental consequences for the financial position of the central bank. Because banknotes are only exchangeable for other banknotes, the central bank need not hold gold in reserve in any relation to currency in circulation. Instead it can invest the equivalent value of currency in circulation into assets which provide the bank with a return. Thus the central bank finds itself in the favourable position of being able to finance an interest-bearing asset portfolio without having to bear any costs other than those of printing and distributing banknotes. The return from assets equivalent to currency in circulation is usually called seigniorage. This is mainly derived from the positive net interest income arising from the central bank having assets that provide a return and interest-free credit. With more than billion in circulation the seigniorage is currently a satisfactory source of finance for the Riksbank. Even using cautious assumptions about the return on the Riksbanks assets, the revenue from seigniorage is many times the Riksbanks annual operating costs. Thus seigniorage provides the Riksbank with underlying financial independence, irrespective of whether it has own capital as well. However, from the Riksbanks point of view, currency in circulation also has certain disadvantages. One such is that the Riksbank has ability to affect the amount of currency in circulation. As we have shown above, currency in circulation is governed by public demand. A person who wants to reduce their holding in banknotes can go to their bank and convert the banknotes into a holding in a bank account. The bank can then redeem these banknotes for a holding in their account with the Riksbank. In this case the Riksbank must either pay interest to the bank, or, which has the same effect on seigniorage, reduce its assets by a corresponding amount.TPF FPT This means that if for some reason the demand for banknotes decreases, the seigniorage income of the Riksbank is also affected. Here, the development of electronic payment technologies is probably a significant factor, however it is difficult to find factors that explain the amount of currency in circulation with any degree of precision.TPF FPT Nevertheless it is important for the deliberations of this Commission to take into account the degree to which banknotes constitute a sustainable long-term source of financial independence for the Riksbank. The Commission will therefore return to this issue in a later section. In summary we can state that, for the purposes of ensuring financial independence through the Riksbanks net interest income, currency in circulation and own capital are interchangeable. However, from an accounting standpoint they are affected by different 9TP PT The Riksbank must also accommodate those who want banknotes. This is because a national central bank must help the banks maintain full interchangeability between bank deposits and banknotes. Otherwise a bank may be forced to say no to a depositor who wants to take money out of their bank account, which would have serious consequences for the stability of the banking system. 10TP PT For a detailed discussion regarding this, see , M. & Guibourg, G. (2001): The use of cash in the Swedish economy, 2001:4 factors: currency in circulation is affected by public demand, and own capital is affected by the Riksbanks income and the extent to which profit is allocated to central government. This can affect their properties as a source of financial independence. In its continued analysis this Commission will take into consideration the specific properties of currency in circulation which have been identified. To facilitate further analysis we felt it useful to define some concepts used in the Commission Report. The total nominal value in SEK of the banknotes and coin in circulation. Can be made up of both currency in circulation and own Funds on the liabilities side of the balance sheet which are therefore available for the Riksbank to invest. Returns from these investments make the Riksbank financially independent as long as they cover the banks Sometimes buffer capital is used to mean cost-free capital, when it is primarily the ability to bear capital losses which is being referred to. Cost-free capital generates cost-free funding. Riksbank can use the return on its assets in order to pay For the purpose of this Commissions analysis, it will be useful to have a more detailed definition of own capital than that of what is called paid-up capital, reserves and surplus in accounting terms. This definition will include items that can clearly be characterized as own capital. Own capital can then be said to be made up of the collective value of items that can be characterized as own capital in the Riksbanks balance sheet, including In a foreign comparison certain provisions can be considered to be included in own Sometimes there is cause to discuss only the capital that actually is reported as own capital. If that is the case, then the concept reported own capital will be used. The financial result reported in the profit and loss account as distributable to central government. The total value of the Riksbanks assets in securities and bank deposits denominated in foreign currency and gold. Positions in derivatives and repo transactions used to hedge or take positions in foreign currency are also included in the foreign exchange reserve. The amount of capital that the Riksbank needs to finance costs, i.e. fulfil its obligations. In this Commission of Inquiry the Riksbank's capital need is normally discussed only in terms of a capital need as defined above, without specifying whether it is own capital or currency in circulation that is being referred to. 3.The autonomy and financial independence of the Riksbank Independent central banks - background and motive In many countries central banks have historically had a unique position in comparison to other agencies in the central government administration. There are also central banks that are not public authorities which are managed as limited companies or with other organisational forms. To a great degree this is associated with the task of issuing banknotes and coin. Historically, issuing banknotes was not the sole domain of central banks, commercial banks could also issue banknotes. Many central banks have also carried on commercial banking activities, for example lending to private individuals and companies. In most countries these activities have decreased dramatically recently, to be replaced by statutory tasks. However, there are still elements of banking activity in the central banks of many countries. In this unique position has been most clearly demonstrated in that the Riksbank is one of the few public agencies directly responsible to Parliament, as opposed to responsible to government, which is normally the case. Originally this unique position protected Parliament from the king using the banknote printing presses for policies that Parliament did not support. This would naturally have led to high inflation and the undermining of the value of the Swedish krona. For similar reasons the Debt Office () was also established as a public authority responsible to Parliament, so that Parliament could control central government borrowing. The risk of central government using the banknote printing presses to resolve fiscal problems is a well-recognised one, and there are many examples of this throughout history. Creating some independence from government (previously seen as the kings men) and central government finance for the central bank is not a new invention. However, the high inflation of the 1970s and 1980s in many developed economies has made the issue very topical for economic policy research and debate. After the Second World War the focus of economic policy was largely characterised by Keynesian stabilisation policy.TPF FPT Simply put, this is based on the idea that central government should use the central government budget to counteract fluctuations in the business cycle. By increasing expenditure or reducing the tax burden, central government can strengthen demand in the economy in a recession. The status of Keynesian politics was strengthened in the 1960s and 1970s when the curve theory gained a foothold with economic policy makers. The curve indicates a negative correlation between inflation and unemployment. Economic policy measures would allow central government to create high demand for 11TP PT Apel. & Viotti, S. (1998): Why is an independent central bank a good idea? See also , V. (2001): Independent central banks in democracies? labour and therefore low unemployment, but this would be at the cost of rising inflation. Inversely, combating inflation effectively would lead to higher unemployment. One interpretation of the curve was that economic policy decision-makers must make a choice between combating inflation or unemployment. This interpretation influenced many decision-makers, especially in the 1970s. However, the curve was called into question fairly quickly, especially with regard to the validity of the long-term correlation between inflation and unemployment.TPF FPT Critics pointed out that this correlation was dependent on inflation expectations in the economy. When an accommodating fiscal policy was used to counteract unemployment the public would see this as inflationary, and adapt their inflation expectations to a higher level. As the publics inflation expectations grew, and this affected behaviour, in the form of nominal wage demands for example, the effect of expansionary fiscal policy would decrease. The conclusion was that the curve did not apply in the longer term and that there was no long-term correlation between inflation and unemployment. Substantial inflation, and the fact that it was persistent in the 1970s and 1980s, became a major economic problem for many countries. Criticism of the correlation increased becoming fairly widely accepted in the 1980s by academics as well as economic policy makers. However, the short-term correlation of the curve was not called into question. The existence of this correlation in the short-term meant that government economic policy incentives came under scrutiny. Attention was drawn to the risk of politicians attempting to reduce unemployment with over expansive economic policies, to win votes before an election for example. This would damage the economy in the long term by raising inflation expectations, but the risk is that politicians ignore long-term effects. The solution to this problem, developed theoretically in the 1980s and initially used in the 1990s, was to hand over the fight against inflation to an autonomous central bank. The idea was to remove the risk of inflationary, expansive economic policies by giving the central bank a clear mandate to fight inflation and by ensuring that its management had no incentive for other objectives. Certainly the political system retained one of the two important economic policy instruments, fiscal policy. But the other, monetary policy, would be handled by the independent central bank. If fiscal policy became inflationary, the central bank would be forced to tighten monetary policy by raising interest rates, and this would mean that the fiscal policy measures would not lead to the planned increase in demand. This would therefore remove the temptation to use the short-term curve. The idea of creating long-term stable inflation through independent central banks had its breakthrough in the 1990s, although central banks had had a certain degree of independence before that. A number of countries reformed their economic policy systems along these lines. This happened in through amendments to the Riksbank Act and Instrument of Government of 1999 which created the independent Riksbank we have today. 12TP PT One of the foremost critics was the 2006 Laureate in economics, , who has mainly awarded the prize for this criticism. The 1976 Laureate was one of the early critics of the correlation. This reform was due in part to 's membership of the EU. When the EU decided to create a common currency, the requirement for independent central banks was introduced into the . As a result the requirement for independent central banks has been accepted by all EU countries. When adapting the Riksbank Act it was the intention that would meet these requirements.