sou · GVB351 · 2008-01-01 00:00:00 — Thirdly we need to discuss how the Riksbank should invest in the Swedish fixed income market, in part because the supply of interest-bearing securities is currently decreasing, and in part how the conflict of interest arising from the Riksbanks control of the short- term rates can be managed. The Commission believes that these transitional issues do not warrant any specific transitional provisions in law. The legislative proposals made by the Commission can be carried out without specifying in detail how the transition from the current balance sheet structure to that proposed by the Commission will take place. The aim of the discussion about transitional issues is to show that the transitional issues arising from the Commission proposals are manageable, not through legislation but by the Riksbank, which has full legal capacity to manage them independently. 8.1.Effects of the extraordinary dividend in alternative 1 Judgement of the Commission: The extraordinary dividend of approximately billion can be divided into several portions in order to avoid any impact on the foreign exchange market caused by the Riksbank selling currency assets. No specific transitional provisions are needed for this. Parliament is able to decide on a suitable rate within the framework of the Commissions proposed legislation. Alternative 1 imposes special requirements on the transition in that approximately billion must be repaid to central government. billion is a considerable amount. Because the Riksbanks realisable assets consist almost exclusively of assets in foreign currency, these must either be changed into Swedish krona before being paid to central government, or the repayment must be made in foreign currency and then changed by the Debt Office. An exchange of this order of magnitude, regardless of whether it is carried out by the Riksbank or the Debt Office, risks having a major effect on the foreign exchange market if it is carried out in a short period of time. This means that potentially the entire repayment should not be made on one occasion and instead divided up over several years. Alternatively the Debt Office, if commissioned by the government, could neutralise the foreign exchange effects by adjusting loans in foreign currency (see also Section 8.2.1 for a discussion about this). However, no specific transitional provisions would be needed because of this. Because the Commissions proposed legislation sets the capital in alternative 1 to at least billion, Parliament can split this up into several portions. Thus the dividends could be made slowly enough for the sale of foreign currency assets no to affect the exchange rate of the Swedish krona. One further limiting factor could be that the ERM2 agreement obliges the Riksbank to restrict its transactions in Euros to million a day. However, the need to carry out the transition slowly, so as not to affect the Swedish krona, is probably more limiting than this rule. Effects on the foreign exchange market of a change in the management of the foreign exchange reserve Judgement of the Commission: The transition to a matched foreign exchange reserve should take place slowly, probably over several years, so as not to affect the exchange rate of the Swedish krona. The cost-free capital of billion calculated by the Commission for risk in the foreign exchange reserve is adequate for potential losses during the transitional period. So irrespective of the method the Riksbank decides to use, no specific transitional provisions are required. With regard to the currency risk it is proposed that the Riksbank switches to a matched foreign exchange reserve. This is an important component in the Commissions assessment of the Riksbanks capital requirement in so far as it affects the need to maintain capital for financial risk-taking. There are problems inherent to a rapid change in the currency position. This raises the question of whether transitional provisions are required to manage the transition to a matched currency position. This is developed in Section 8.2.1. The Commission has taken no position as to whether a neutralising of the Riksbanks currency position should be carried out with positions in derivatives or through matched borrowing in foreign currency. Furthermore the Commission has not taken a position on whether the Riksbank should have a certain size of foreign exchange reserve, or whether the Riksbank will manage with a very limited volume of foreign currency; to meet the requirements of the ECB for example. The various alternatives have different consequences. Simplifying the alternatives allows us to identify the following possibilities. Naturally they can be combined but to illustrate their consequences it is useful to simplify them. 1.The Riksbank retains its currency assets and borrows an equivalent volume of matched foreign currency. 2.The Riksbank retains its currency assets and the currency risk on the derivative markets. 3.The Riksbank sells its currency assets and has no need to match the currency risk. Sections 8.2.2 – 4 develop the consequences of these three courses of action. The need for transitional provisions Common to the different courses of action is that there will be an increased demand for Swedish krona when the repositioning of the foreign exchange reserve is carried out. If matching is carried out through borrowing in foreign currency the funds borrowed will need to be placed in assets in Swedish krona. If this is carried out through derivative instruments a demand for Swedish krona will arise in the futures market. And if it is carried out through a reduction in the size of the foreign exchange reserve the revenue from the sale of foreign assets will be invested in assets in Swedish krona. So in principle demand for Swedish krona arises in the same way regardless of how this repositioning is achieved. In total a sum in the order of magnitude billionTPF FPT in foreign currency assets will be converted into a position in Swedish krona. This is a significant redistribution which will result in a major demand for the Swedish krona. It can be seen as a comprehensive currency intervention which will potentially strengthen the Swedish krona. To avoid such an effect, the transition would need to take place over a relatively long period of time. The Commission has considered whether there are grounds to propose a specific transitional period before the proposals come into force. This would be so the Riksbank could implement the redisposition of the currency risk in the balance sheet at a rate that would cushion the exchange rate from the increased demand for Swedish krona. However, the Commission does not consider this necessary for the following reasons. It is difficult to accurately assess how great the effect will be on the foreign exchange market. If a very cautious approach is taken the transitional period may need to be several years. However, the Commission has set out a need for cost-free capital corresponding to billion for risk associated with foreign exchange interventions. In the foreseeable future the need for such risk capital seems negligible. Partly because nothing in the current focus of monetary policy indicates that the Riksbank would want to carry out interventions on the foreign exchange market. And partly because the probability of a switch to a fixed exchange rate in the foreseeable future is practically non-existent when one takes into account the lack of political discussion about entering the EMU in the next few years. In addition there is cost-free capital for other risks that could be used to absorb losses arising from changes in the exchange rate. The Commission´s grounds for allocating a cost-free capital for currency interventions are above all that its proposals must be applicable over a long period, and in the long-term the transition to a fixed exchange rate must be taken into account, if only in terms of accession to the EMU. Thus it should be acceptable to view the currency risk as bearable during the transition from an open to a matched currency position. The currency position will decrease continuously and with it the currency risk remaining in the balance sheet. 43TP PT At the end of 2006 net currency assets, i.e. with deductions for repo transactions on the liabilities side of the balance sheet, and with the gold reserve excepted, amounted to billion. Not setting a specific transitional period also has the advantage that the Riksbank will have greater freedom to structure the transition in such a way that the effects on the market of this transition are as small as possible. Because transitional provisions are deemed unnecessary for the redisposition of the foreign exchange reserve, there is no reason to go into the implementation of the redisposition in greater detail. The purpose of the discussion in the following sections is solely to show that there are several alternative methods of implementing it, and that it is fully possible to carry out the change, so long as it does not happen too rapidly. Direct borrowing on foreign markets One possibility for the Riksbank to neutralise its currency position is to borrow equivalent funds in foreign currency in such a way that the assets in foreign currency are directly matched with the corresponding loans in the same currency. To a certain extent has borrowing in foreign currency on its balance sheet, although it has an additional task to those discussed for the Riksbank, in that it must administer the entire Danish central governments overseas borrowing. The Riksbank can borrow foreign currency, either by issuing securities or through direct loans. Which is more suitable is determined by balancing different factors, such as what type of instrument generates the lowest interest rates, how great the transaction costs are etc. The Commission sees no reason to go into this question in more detail, apart from the discussion related to the Debt Office borrowing in Section 8.3. Hedging the foreign exchange reserve on derivative markets Because the derivative markets in the currency pairs that the Riksbank would need to hedge (i.e. the Swedish krona against the Euro, , and the American, Canadian and Australian dollars - all currently currency risks in the foreign exchange reserve) are liquid, there should be no major practical problems or costs in entering derivative contracts to match the currency risk. To a certain extent the Riksbank already adjusts the currency risk in its portfolio using positions in derivatives, rather than just using the spot markets. Should the Riksbank choose to enter into derivative contracts to hedge a major part of its currency assets, the outstanding positions against the derivative counterparties would be substantial. Because of this the Riksbank must have a strict control of the counterparty risk, which means having agreements on collateral with all counterparties for example. With good risk management this counterparty risk is fully manageable. In this case there is no reason for the Riksbank to maintain a specific cost-free capital for counterparty risk of a magnitude that would make it worth considering within the framework of the work of this Commission. of the foreign exchange reserve If the foreign exchange reserve is sold the revenue will be used to purchase Swedish interest-bearing securities. The supply effect on the price should be limited as these are assets in liquid currencies. Largest are the Euro assets at over billion, which it should be possible to sell without any significant effect on the price if this is carried out over a period of time. It would be most advantageous if the Debt Office and the Riksbank could swap assets, i.e. if the Swedish National Debt Office could issue paper that the Riksbank exchanged for currency assets. However, taking into account the EU prohibition against direct government borrowing from central banks, it is not possible to conduct such a swap in the opinion of the Commission. Thus the Riksbank needs to invest the revenue from sales of foreign currency assets in the secondary market for Swedish interest-bearing securities. Besides the potential impact on the Swedish kronas exchange rate when the foreign currency assets are converted into to Swedish krona, the increased demand for interest-bearing securities must be taken into account. One further limiting factor is that according to EU rules for the acquisition of government securities by central banks, the net acquisition of Swedish government securities may not exceed 0.1 percent of GDP per quarter. This means that government securities to a value of billion can be acquired every year. If the Riksbank implemented neutralisation only by selling foreign assets and by purchasing Swedish government securities the neutralisation would take a long time, about 10 years in alternative 1 and 15 years in alternative 2. This indicates that this alternative needs to be combined with one of the other alternatives so that the transitional period is not too long. The consequences of this alternative are some transaction costs and a lack of currency assets to sell on the spot market if currency interventions need to be undertaken. If there are no currency assets any interventions must be made in the derivative markets, which of course is still the established procedure. As stated above the ECB also sets requirements for central banks within the ESCB on maintaining foreign exchange reserves of a specific size. So this is also a restriction on how much of the foreign exchange reserve can be sold off. 8.3.The Riksbank as investor in the fixed income market Judgement of the Commission: A switch to asset management in Swedish krona means that the Riksbank must manage the conflict of interest in both setting the interest rate and being an investor. Furthermore, this transition must take into account the supply of Swedish interest-bearing securities and the impact on market prices. Managing issues of supply and demand in the fixed income market In both of the Commissions proposals the Riksbank will become a major investor in low risk assets in Swedish krona, first and foremost interest-bearing securities. In the first and third courses of action above, the revenue from borrowing in foreign currency, or from the sale of currency assets, will be invested directly in the Swedish fixed income market. In the second course of action there is no direct investment in interest-bearing securities, the position in Swedish krona will jointly consist of holdings in foreign assets and an offset position in derivatives. The in which redisposition takes place is of no critical importance. However, it is clear that the Riksbank will cause a substantial demand for Swedish government securities, a demand corresponding to approximately billion. In 2007 the total stock of outstanding government bonds and treasury bills amounted to billion. The current strong central government finances and the privatisations of state-owned companies planned at the time of writing, are reducing the supply of government securities. There is a discussion today about whether the supply of government bonds is beginning to be too small for the needs of investors. In the Commissions proposals this effect risks being mixed up with the high demand for assets in Swedish krona which the Riksbank obtains. In Section 8.1.1 we said that the change to a new balance sheet structure should take place slowly so that the exchange rate of the Swedish krona would not be affected. It is at least as important that the Riksbank does not switch to a position in Swedish krona faster than the market can absorb the increased demand for government securities without seriously impacting interest rate levels. So this also backs a slow and flexible transition. In this context the Riksbank also has the opportunity to adjust its transition to any major changes in the supply of government securities, for example braking the transition in periods when there are major influxes into the central government budget, so that the Riksbank does not boost the demand shock. While the conditions of supply and demand are important for a transition they should not be seen as an obstacle to it. There are, notwithstanding, countries that have a much smaller central government debt than , and these also have government securities markets that work, though not as liquid as the Swedish market, and perhaps not with such long maturities. At the same time there are market mechanisms that mean that the interest rate should not be stabilised too far below a price which is reasonable in relation to other assets, for example Euro interest rates for corresponding amounts. In light of this, the transition should be seen as manageable, but it may need to be carried out slowly so that the impact on price is minimised. One possibility would be for central government through the Debt Office to try to neutralise the impact so that central governments aggregated balance sheet (i.e. including the Riksbank) will remain unchanged. Currently the Riksbank has foreign currency assets equivalent to billion while the Debt Office has foreign currency debt of approximately billion, i.e. they have a joint foreign currency debt of about billion. Loans in foreign currency could be converted to Swedish krona securities at the same tempo as the Riksbank reduced its open currency position. The advantage of this would be that the Riksbanks increased demand for assets in Swedish krona would be met by the Debt Office, with a neutralising effect on interest rates. A corresponding effect would also arise in the foreign exchange market so that the pressure on the Swedish krona would decrease and the currency intervention discussed above would be neutralised. From a central government finance perspective it should be the aggregated net foreign currency position that is important. If the Debt Office is tasked to cooperate with the Riksbank to neutralise the impact of the reduced currency position, it should be possible to make the transition much quicker than has been outlined out above. According to the governments current guidelines for the administration of the central government debt the currency debt should also be reduced to 15 percent, approximating billion given the current size of the central government debt. Thus the Debt Office currency borrowing must be reduced by about billion according to decisions already taken. This could neutralise the effect of change to the Riksbanks currency position, both in the event of the extraordinary dividend according to alternative 1 and a redisposition of the Riksbanks currency position. However, because the adjustment in the Debt Office has already started the change may already have been largely carried out by the time a decision is made on the Commissions proposals. The Commission cannot say how any such coordination could be adjusted chronologically. The aim has only been to call attention to the possibility of adjustment. There are also points to take into account regarding how central government governance is to be organised if this sort of coordination is to be carried out. With regard to any extraordinary dividend in alternative 1, it is Parliament which must take this decision. The central government debt administration guidelines are decided by the government, and the Debt Office implements any changes. With regards a redisposition of the foreign exchange reserve it is the Riksbank that this out independently. So there needs to be coordination between Parliament, the government, the Riksbank and the Debt Office. Currently the Riksbank has a relatively high interest rate risk in currency assets. The objective set by its executive board for the Riksbanks currency assets is currently an average modified duration of 4.0. This Commission has chosen not to directly specify how large an interest rate risk the Riksbank should have in its portfolio. What is important from the perspective of this Commission is that the Riksbank is not exposed to interest rate risk to the extent that it must be provided with a separate buffer capital to cover it. The redistribution of interest rate risk which may be required should not cause any demand issues regarding market interest rates. Conflicts of interest for the Riksbank as an actor in the fixed income market In addition to the impact on market interest rates we need to explain how the Riksbank can act as an investor in the fixed income market at the same time as it determines interest rates, a state of affairs that could be used to make profits on the fixed income market. This conflict of interest arises and must be dealt with regardless of whether the Riksbank trades directly in Swedish interest-bearing securities, or if it converts foreign assets into a position in Swedish krona using positions in derivatives (see also 6.4). Two main methods of managing this conflict of interest can be identified. One is to ensure that there are very strict Chinese walls between fixed income trading and monetary policy. Potentially this can only be adequately credible if the administration is placed outside the Riksbank. Another way would be to have strict mechanical rules for what the Riksbank should buy. However, this exposes the Riksbank to the risk of being squeezed by the market (the market knows that it must buy certain instruments at certain times). The Commission sees no reason to settle in more detail how this conflict of interest should be managed. The changes to legislation proposed by the Commission state that the Riksbank may invest in fixed interest assets, but at the same time it is clear that monetary policy comes first. The Commission believes that the Riksbank has every reason to ensure that there is no suspicion that the conflict of interest is being exploited, thereby risking the credibility of monetary policy being called into question. In the view of the Commission there are no grounds for specifying in statute how conflict of interest should be managed. 9.Consequences for central government finance The Commissions proposals have certain effects on central government finance. These effects depend on the extent to which central government borrowing through the Debt Office is adjusted in accordance with the Commissions proposals and the rate at which the redisposition of the foreign exchange reserve takes place. Both of these aspects are kept open in the Commissions proposals because neither is of critical importance for the legislation regarding the Riksbanks capital structure. This Chapter first describes how the Riksbanks transfers to the treasury will be affected by the proposals. A second section discusses the effects on central government finance from a broader perspective, and here any adjustment of central government borrowing becomes important. Both descriptions assume an immediate neutralisation of the currency position. While unrealistic, this assumption works well in the relevant context, as it is the long-term changes in central government finance, after the proposal has been completely implemented, that are of interest. 9.1.The Riksbank´s transfers to central government Judgement of the Commission: In alternative 1 there is a one-off payment to central government of approximately billion, along with a forecast annual transfer to central government of over billion. In alternative 2 the balance sheet is unchanged and the forecast annual transfer to central government amounts to over billion. After its transfer to the treasury for the 2006 financial result, the Riksbanks own capital amounted to million. Calculations that have been made by the Commission are based on this reported value, rounded down to billion. The Commission has made its calculations as if the changes were to be made immediately – during 2007.