sou · GVB351 · 2008-01-01 00:00:00 — The convergence reports discussed above, which are one of the main reasons for this Commission being set up, form the EUs assessment of fulfilment of the requirements for independent central banks. The Riksbanks independence relates primarily to its terms of reference and governance In the previous section we showed that the motives behind the independence of central banks were, above all, based on the need to hand over monetary policy to an organisation which would not be inclined to act in conflict with the fight against inflation, separating decision-making regarding monetary and fiscal policy as a result. To achieve this, the legislation safeguarding independence has focused on issues regarding the governance and management of the Riksbank. This relates to the three forms of independence laid out in Chapter 1 – functional, institutional and personal independence. In practice, it relates to the Riksbank having clear terms of reference and its management having the right conditions to act independently. At the same time there is a conflict between independence and the fact that the Riksbank as a public authority must, to some extent, be governed by the political system. From a democratic viewpoint this goes without saying. Independence cannot be so extreme that the political system cannot under any circumstances change the Riksbanks terms of reference and management. Thus the present regulations should be seen as striking a balance between ensuring that monetary policy is handled independently and for the long- term, and making sure that the Riksbanks terms of reference and management can be changed democratically. The fundamental provisions regarding the Riksbank are laid down in the Instrument of Government and thus are constitutional, this means that they can only be changed by resolutions in two Parliaments with an election between them. However, the constitutionally guaranteed provisions essential for independence are fairly limited. These aim to prevent other public authorities from deciding how the Riksbank should make decisions on monetary policy issues; determine how the Riksbank is governed through its which appoints an ; and ensure that members of can only be severed from their appointments in extraordinary circumstances. Other provisions advancing independence take the form of normal legislation, in the first instance the Riksbank Act, and so can be changed by a single parliamentary decision. The most important rules governing independence can be said to be the following: -The objective of fighting inflation is established by specifying that the Riksbanks objective is price stability. Thus the Riksbank can reject pressure to act for other objectives or carry out other tasks. -The Riksbank may only conduct, or participate in, such activities for which it has been authorised by Swedish law. -The Riksbank may not accept instructions from other authorities or from the government. -Members of are appointed for a relatively long period, six years. -Members of may only be severed from their appointments in exceptional circumstances. -Regulations limiting the opportunity of members of the and to hold other assignments along with rules of disqualification. Thus, firstly, the provisions are intended to ensure that the Riksbank is primarily engaged in the fight against inflation, and that its other tasks are confirmed in law. Proper scrutiny by Parliament and the general public of the Riksbanks activities ensure that the Riksbank will always fight against inflation. Secondly, independence is guaranteed by the relatively long period of appointment of members, and, while they can be dismissed, this is very difficult to do. As appointments to expire at different times, one every year unless there are resignations, neither can a large part of be replaced at the same time. This strikes the balance between the natural need for the renewal of the Riksbanks management and the to limit direct influence from the political system. is selected by Parliament for the electoral period. 3.3.The need for financial independence 3.3.1.General points on the need for financial independence Judgement of the Commission: Financial independence supplements functional, institutional and personal independence. Its aim is for the Riksbank to have sufficient financial resources to independently carry out its task and fulfil its obligations. The need for financial independence is based on the fact that for an organisation to be independent it needs not only to be protected with regard to its task and management, but also needs financial resources to carry out its task independently. In the previous section we showed how, through legislation, the Riksbank had been made independent from the political system with regard to its task and governance. With the creation of the independent Riksbank in 1999 less attention was paid to financial independence. One reason was probably that central banks normally have a natural earning capacity through seigniorage. For the Riksbank these earnings from seigniorage have easily covered current operating costs. Normally, other public authorities are dependent on annual appropriations and are therefore dependent on Parliament to allocate enough funds in the budget for them to be able to carry out their task. Because of its own earning capacity the discussion regarding financial independence is not about whether the Riksbank should be financed with appropriations or not, and whether, in that case those appropriations are sufficient. Instead the discussion focuses on two different risks that could threaten the Riksbanks ability to finance its current costs. One risk is that Parliament, more or less arbitrarily, decides that funds should be transferred from the Riksbank to the central government budget. This was what took place with the extra dividends of 2001 and 2002 (this is not to say that these transfers threatened the Riksbanks position, capitalisation was good even after the transfers). This issue can be handled by setting out in law the size of the Riksbanks own capital and the allocation of the Riksbanks profits. This is also the primary task of this Commission. The other risk is that the Riksbank makes losses so large that the remaining funds are not enough to finance current costs. Its earning capacity could also be weakened should the basis for seigniorage change suddenly. This could happen if the inclination of the general public to hold banknotes and coin decreased considerably for example. In such a situation the Riksbank could be dependent on central government allocating new funds to continue to fund its activities. As this Commission sees it, these two risks and the terms of reference of this Commission are linked as follows. In order to manage the first risk, the size of the Riksbanks capital and the method of distributing profits must be set out in law. The material content of these statutory provisions will be governed by how great the capital need be in order to be able to manage the risk of major losses or a weakened earning capacity. What the risks are, and their magnitude, will be affected by the Riksbanks tasks and the structure of its balance sheet. this must also be discussed by the Commission. In turn, the content of the statutory provisions on profit distribution will be a function of how profits are to be managed in order to maintain the level of the statutory capital. Thus the need for financial independence arises because the central bank must not risk being subject to pressure from the political system because of constraints on its financial independence. To that extent financial independence complements the independence given to the Riksbank in the current legislation with respect to its task and governance. In assessing how large its capital should be, the Riksbank must have a long-term earning capacity such that if it suffers sudden losses, it will not need new funding from central government. Assessing how sure one needs to be that the Riksbank will not need to turn to central government for financing is also one of this Commissions tasks. However, the mere fact that the Riksbank may need additional funding from central government at some point, need not itself be an issue with regard to independence. The probability of the Riksbank having financial problems at the same time as the Riksbank and Parliament are at variance on monetary policy is not great. It should also be emphasised that strong financial independence can in no way supplant the other forms of independence more important with regard to monetary policy decisions. In addition, a parallel can be drawn with other public sector entities, where it has been highly prioritised to safeguard independence from political influence. For example the courts and the Audit Office, which are dependent on annual appropriations from the central government budget, but can still be considered to act independently. The courts are even responsible to the government, as opposed to the Riksbank and the Audit Office. As we discussed above, the starting point must be that a democratically elected Parliament has determined that the Riksbanks primary task is to fight inflation. In most cases the political system has an interest in creating suitable conditions for the central bank to carry out its tasks in the best possible way. Accordingly the system will create good economic conditions for the central bank, providing funding if this is not in place for any reason for example. However, due to the risk that governments (with support in Parliament) are sometimes too short-termist, the Riksbank has been given statutory independence. The aim is to manage the governments conflict of interest between long- term low inflation and the short-term objective of winning elections by way of expensive election promises. However, this independence does not mean that the political system, through Parliament, cannot change the focus of the Riksbanks activities. And if Parliament wants to influence the Riksbanks terms of reference, it can do this by changing to the law, which is probably more effective than changing the financial circumstances of the Riksbank. Thus protection for the central bank must always have its limitations. On the other hand, it is important that any such changes to the Riksbank take place in a transparent process. However, it is not only the protection of the central bank from the political system which must be taken into account in any discussion of the financial position of a central bank. In certain circumstances weak finances could, in an extreme case, lead to the central bank not conducting monetary policy in the best possible way, instead being influenced by the need to protect its own finances, when determining interest rates for example. In this case it is more a matter of protecting society from a central bank not carrying out its task in the best possible way. This may be a reason for ensuring that the financial position of the central bank is never too weak. This reason is linked to the political task given to the central bank and so has nothing to do with independence from the political system. This will be developed in the following section. What is unique about financial independence in a central bank? Judgement of the Commission: A central bank is financially independent in the long- term if its net worth is positive, i.e. if the discounted future income flows net of costs are positive. Since the seigniorage is more than enough for the Riksbanks revenues to exceed its costs, own capital in the Riksbank could in principle be zero. When assessing and analysing the financial strength of an organisation it is easy to attach a great deal of weight to the size if its own capital. This is probably because of how financial strength is analysed and regulated in a limited company. When assessing the long-term survivability of a limited company it is natural to compare the size of the equity capital to the variation in financial results and the extent to which there is a risk of major losses. A limited company goes bankrupt if it cannot pay its creditors, or is liquidated when the value of the equity capital has decreased by more than the threshold values prescribed in the legislation on limited companies. However, the Riksbank is not a limited company and there are no legal obstacles to the Riksbank having negative own capital. This is not in itself unique or strange. For example, depending on how the value of the property is reported, tenant-ownership associations can have negative own capital, but still be financially stable and have long- term survivability. If there are no legal restrictions in the form of bankruptcy legislation, financial survivability is about the extent to which an economic actor can pay its maturing obligations to its creditors. it is relevant to ask whether there are situations in which the Riksbank risks not being able to pay its overdue accounts, i.e. The Riksbanks position in this respect is unique because it is the legal issuer of banknotes and coin, and can in principle always generate legal tender in Swedish krona. Thus the Riksbank can always pay its costs by issuing new banknotes. In a system such as however, all new banknotes that are created will eventually be exchanged by the Riksbank again, unless the demand for cash has grown. From a purely practical point of view a bank withdrawing banknotes from the Riksbank will see a reduction in the size of its account with the Riksbank, or a debt if the account balance is negative. The banks receive interest on the money they have deposited in this account, and must pay interest when they have a deficit in the account. So when a bank withdraws cash from the Riksbank it forgoes the interest on a corresponding amount. This works in the same way as when private individuals withdraw money from their bank accounts – when the money ends up as cash in their wallets no interest is paid on it. When banknotes are redeemed with the Riksbank an interest-bearing liability arises corresponding to the amount exchanged. So the Riksbank has higher interest costs. In this situation a central bank which does not have the funds to pay its costs must issue still more banknotes, banknotes which will eventually be redeemed with the central bank again, transformed into an interest-bearing liability and increase the costs of the central bank even more. This leads to a situation for the central bank where it is faced with accelerating borrowing. The central banks liabilities will grow and so will its interest costs. Despite this, the central bank will always be able to pay its costs by issuing new banknotes. This argument, while theoretically correct, is not relevant in practice. A modern central bank does not fulfil its obligations using banknotes. In this situation the main risk is if the financial position of the central bank is so weak that it takes into account the effect on its own profits of monetary policy decisions. When the central banks interest-bearing liability increases there is reason to hold down interest rates to reduce its costs. rates may be set lower than is appropriate for fighting inflation. Though the risk of this is small, it should be mentioned, as confidence in the central bank is so important for its monetary policy task of fighting inflation. Above all there is a risk of a credibility problem arising if the central bank can and needs to influence its own finances by setting interest rates. There are examples of countries where the weak financial position of the central bank has led to questions being asked the execution of its monetary policy.TPF FPT So far the discussion has shown that, when assessing the financial position of a central bank, it is neither relevant to look at the reported size of the own capital, nor the ability to pay an outstanding liability. An alternative way is to discuss what makes a central bank financially independent in the long-term, without taking into account whether it can always pay its liabilities. If it is clear that the central bank has the ability to fund its operational activities in the long-term, confidence in it should not be affected by its reported financial position. An organisation should be seen as financially independent in the long-term if it has a positive net worthTPF FPT, i.e. a positive net worth is achieved if the discounted future income flows net of costs and expenses are positive. If the balance sheet reports the actual worth TPF FPT of assets and liabilities, then own capital corresponds to net worth. The problem with the reporting of central banks is, as discussed in Chapter 1, that the actual value of seigniorage, or more accurately the right to issue banknotes and coin, is not reflected in the balance sheet. The interest-free credit constituted by seigniorage is reflected in the balance sheet as outstanding banknotes and coin. Banknotes and coin are reported as a liability in nominal value terms. However, this liability does not entail interest costs. The idea behind the net worth argument is that as long as the central bank has a positive net worth, there is no reason to worry about its actual financial position. The central bank can carry out the activities with which it is tasked and there is no reason to take its finances into consideration when implementing monetary policy. This is long-term financial independence. In the opinion of this Commission, net worth is a good starting point to look at how a central banks financial position can affect its activities. In 2006 the Riksbanks operating costs were million. Currency in circulation was billion. If the volume of currency in circulation continues as it is and assuming that the Riksbank can obtain an average risk-free return of 3.5 percent annually by investing this, seigniorage is annually worth approximately billion. Because the expected return from seigniorage widely exceeds operating costs, it is clear that the Riksbank has a net worth even without any own capital. As was pointed out above, there 13TP PT For a discussion of such examples, see , P. (1997): Do Central Banks ? IMF Working Paper WP/97/83 and , P. (2002): Financial Strength, Transparency, and Policy Credibility. IMF Working Paper WP/02/137 14TP PT The use of the net worth approach when assessing the capital need of national central banks is developed in Capitalizing central banks: A Net Worth Approach by , Working Paper from the , WP/05/15, 2005. 15TP PT Here, actual worth means all values marked to market, even intangible values that often do not appear in accounts for example. However, as far as possible the international financial reporting standards, IFRS, aim for actual or realistic worth in the balance sheet. is also a certain risk that the Riksbank can make losses and there is also a risk that currency in circulation can decrease in volume. These issues will be dealt with later. So, in the opinion of this Commission, own capital could in principle be zero without the Riksbanks financial position undermining its ability to fulfil its tasks. The Riksbank would have a positive net worth even with some degree of negative own capital. However, negative own capital could affect confidence in the central bank in other ways. This will be discussed in the following section. Confidence factors for a financially weak central bank Judgement of the Commission: Both currency in circulation and own capital can be considered cost-free capital and can contribute to the funding of the Riksbanks operational activities creating financial independence. However, it is possible that confidence in the central bank could be called into question if the reported own capital was negative, despite currency in circulation being more than enough to provide continued financial independence. In the previous section it was shown that a central bank with a large volume of currency in circulation, low operating costs and relatively limited risk of losses does not really need own capital. Although in principle a central bank such as the Riksbank can fulfil its tasks with some negative own capital, the way that this is perceived by external parties, with regard to confidence in the Riksbank, needs to be discussed. As discussed above, the reason that confidence could be damaged if the Riksbank has negative own capital, or was considered financially weak for any other reason, is that this could raise suspicions that it has considerations other than those of pure monetary policy when setting interest rates. Parties with insight into the workings of the central bank will not suspect this because, in line with the discussion in the previous section, the risk of financial problems is small. But it cannot be assumed that all parties will have such insight. It is notoriously difficult to assess how confidence can be affected in hypothetical situations. For example, confidence can be affected by the expectation or suspicion that a certain situation will influence behaviour, even if this expectation is not correct. Those countries with problems of confidence of this nature have mainly been developing countries with major financial problems. One exception is . In 2002, its central bank was damaged by market speculation that the monetary policy was being influenced by a to avoid losses.TPF FPT Although this speculation did occur it is hard to assess the degree to which it actually affected the ability of the central bank to fulfil its task. Loss of confidence need not be based in well-grounded suspicions that a central banks behaviour is being influenced. The mere fact that it is difficult to explain that a central bank can have negative own capital without this causing problems, may influence the central banks decision-makers to strongly avoid a negative own capital situation arising. There are indications that central bank decision-makers are, in certain cases, influenced 16TP PT (2002), ibid. by the banks financial situation, despite the fact that they really should not have any reason to be.TPF FPT It is also difficult to explain that currency in circulation normally has other economic properties than those of other liability items, and in certain respects can be considered equivalent to own capital. At the same time this Commission feels that it is unreasonable to allow the fear of a hypothetical crisis of confidence go too far. It should be pointed out that the situation for the Riksbank looks different to that of countries where problems of this sort have occurred or where there has been speculation about problems. Internationally the Riksbank is a comparatively open central bank, with scrutiny of and public access to most of the Riksbanks decisions and assessments. The Riksbank is open about the factors that govern its deliberations when setting interest rates and there is a lively public debate associated with these deliberations. Of course this means that it would be difficult for the Riksbank to take account of factors that have nothing to do with inflationary developments. The decision-makers governing the Riksbank are probably more likely to be influenced negatively by such suspicions, than the way negative own capital would affect its operations. In addition, the risk of confidence issues should diminish if the Swedish legislation stresses that negative own capital is fully possible, which could be done in conjunction with the legislation arising out of this Commission. Besides, confidence issues and how they affect the assessment of the Riksbanks capital structure must be seen in the light of the argument for independence, which is discussed above.