Economy
The Self-Financing Game of Thrones: Hungarian central bank royalty in war of words
The Self-Financing Programme of the National Bank of Hungary was unveiled in April 2014 and expanded in Summer 2015. The programme has made a successful contribution to reducing the external vulnerability of Hungary's national economy, and to a healthier public debt structure. These welcome changes are now recognised by several international organisations, investment banks and commercial banks active in Hungary. On the other hand, certain monetary policy experts - who are fortunately now represent a minority opinion - have been disputing the results of the programme, especially by exaggerating the costs and risks taken by the central bank and belittling the benefits. This bias is reflected in the recent comments of [former NBH Governor] György Surányi.
Speaking in a recent panel discussion at the Budapest Economic Forum, György Surányi welcomed the reduction in external vulnerability and declining trend of foreign currency debt, however he criticised the NBH's Self-Financing Programme for resulting in an "open interest rate position" at the NBH, and also because it restrains corporate lending.
In this article, I would like to point out several faults in that the line of reasoning.
The aim and results of the Self-Financing Programme
When evaluating a programme, it makes sense to begin with an overview of its declared objective, as this is the basis for assessing whether the measures taken have been effective. Regarding the NBH's Self-Financing Programme, the task is quite simple, as the NBH has made it clear on several occasions that the aim is to reduce the country's external vulnerability. The programme seeks to attain that goal by transforming the central bank's policy tools, whereby it channels commercial banks' liquidity away from the central bank and towards acceptable forms of collateral available in the market - which, given the specific features of Hungary's securities market, primarily means government bonds.
Doing so does not affect the aggregate amount of receivables of the banking sector from the state as a consolidated entity (including all government accounts and the NBH), it only changes the structure of banking sector assets. Further, increased demand for government bonds from the banking sector makes it possible for the state to finance foreign currency debt payment through increasing forint bond issuance.
It is no longer dubitable that the Self-Financing Programme has proved to be effective in achieving the desired goal of reducing vulnerability. The stock of forint bonds held by commercial banks has increased by some HUF 1,500 billion since the launch of the programme in 2014; as a result, the ownership share of the domestic banking sector in Hungary's public debt has climbed almost to 35%. With that, the banking sector is currently the largest player in the forint government bond market, having relegated foreign investors from first to second place. Within the stock of forint-denominated government bonds held by commercial banks, the average time to maturity has increased from less than 3 years to about 4 years over the past 1.5-year period, significantly reducing the replacement cost risk of Hungary's public debt. The share of foreign currency liabilities within Hungary's total government debt has fallen from a peak of around 50% to less than 35%.
What this means is that a decrease in gross external debt is reducing the risks and costs of government debt financing, along with the country's external vulnerability. A shift towards forint issuance helps bring down the ratio of foreign currency liabilities within public debt, whilst increased demand for government bonds makes financing cheaper. The lower amount and healthier structure of external debt help reduce the country risk premium, something that could further contribute to lower financing costs. By improving financial stability, the programme could contribute to a more efficient monetary policy, and have a carryover effect resulting in more sustainable economic growth.
Costs for the central bank, benefits for the national economy
One typical misunderstanding that arises when evaluating the programme is that the costs of the programme and benefits associated with it do not necessarily present themselves at the same place. The tools that ensure the success of the programme are created and operated by the central bank; therefore, the latter bears the costs and potential risks. At the same time, the risks should be assessed in relation to the benefits, and the latter mostly appear at the level of the national economy. As discussed above, the programme has triggered or supported several positive trends that can be described as significant even at the macroevonomic level. However, in order to achieve these, the NBH's active participation was necessary, something that entailed undertaking or taking over certain risks.
That is, the risk-return analysis of individual central bank policy tools should not be performed in isolation, but rather, by considering the programme as a whole, and their contribution to the programme. One such important yet often overlooked consideration, when evaluating the interest rate swaps provided by the central bank to support self-financing, is that while on the one hand the central bank takes over a certain interest rate risk from banks, on the other hand the shrinking of the central bank's balance sheet that is a natural consequence of the Self-Financing Programme offsets the higher interest cost.
It is an undeniable fact that the Self-Financing Programme and the central bank's IRS transactions alter the NBH's interest rate risk profile. The floating interest in an IRS is a liability-side component outside of the balance sheet, whilst fixed interest receipts essentially mean an asset-side exposure. That is, the interest rate position opened by means of an IRS transaction increases the interest rate risk of the central bank in and of itself. However, this effect should not be evaluated in isolation from the other effects, because the interest rate risk borne by the central bank is determined by two factors: the level of interest rate risk to the balance sheet entries (the time to maturity of the assets shown in the balance sheet) and the value of the assets carrying said interest rate risk.
In the course of the Self-Financing Programme, the need for sterilisation decreases, which counteracts the central bank's increased liability-side interest rate risks resulting from IRS transactions. As of September 2015, the 3-month deposit replaced the 2-week deposit as the NBH's key policy instrument, which means that on the liability side short maturities still present the greatest risk, as liabilities get quickly repriced.
Compared with the situation prior to the Self-Financing Programme, the only change to the liability side of the NBH balance sheet is that as a result of the IRS transactions, the earlier 2-week risk has been partly converted into 6-month risks, whereas the remaining 2-week deposit is transformed into 3-month deposits. Thus, the impact on NBH in the event of a potential short-term yield increase remains essentially unchanged - in fact, due to the longer liability-side maturity it could be even slightly lower than it would have been without launching the Self-Financing Programme.
On the asset side of the NBH balance sheet, the time to maturity of receivables has increased due to the long-maturity fixed-interest leg of the IRS's, in comparison with the "sans Self-Financing Programme" scenario. At the same time, it is important to highlight the difference between interest rate risk and interest rate cost, as floating interest payments on the liability side could actually mean higher interest costs in the event of a yield increase - in contrast to fixed-interest assets which in a similar scenario only get repriced, and potential losses are not realised until the transaction is closed. Assuming that the participant banks, in keeping with the ethos of the programme, intend to hold on to the IRS deals with the central bank and Hungarian government bonds until maturity, there is no essential difference in the interest rate cost in the scenarios with or without the programme.
The benefits of the Self-Financing Programme are realised on the macro level and exceed the quantifiable costs borne by the central bank. The benefits created by the programme, apparent in the NBH balance sheet and at the national economy level, are measured against the direct cost of the interest rate swaps. The central bank's IRS transactions come at a lower cost to banks compared to those available in the market, the reason for which is that these transactions are different from market transactions. The IRS deals offered by the central bank are available on condition that banks increase their stock of collateral acceptable to the central bank (primarily, government bonds) by at least the same amount as the IRS transactions of which they have availed themselves. At the same time, this cost has been less than 0.5% on average for the transactions so far.
It makes sense to compare this amount to the decrease in NBH debt service arising from the "shrinkage" of the NBH balance sheet thanks to the programme, which in turn helps reduce sterilisation costs. At the current key policy rate, assuming near-zero yield on foreign currency reserves, the sterilisation cost that can be thus saved is more than 1%. This cost is currently at a historic low, the cost of keeping reserves was significantly higher in previous years.
Only structural change to receivables from consolidated state accounts
Since the launch of the Self-Financing Programme, both short and long yields have decreased. Some of the IRS deals made by the central bank in the past have turned a profit for the NBH thanks to the decline in interest rates, something that has created a buffer to cover costs in case of a minor increase in yields. Looking forward, the Self-Financing Programme will contribute to a decrease in long yields as well as help stabilise yields at a low level; that is, the programme in and of itself reduces the risk of a yield hike. As a result of quantities, the direct impact of the Programme will be a downward pressure on yields. As for the macro level, reduced external vulnerability is another factor that will lower long yields, and at the same time help reduce the risk of a potential crisis scenario.
The increased resilience of Hungary's national economy and government bond market is clearly shown by the fact that while non-residents have sold significant amounts of forint bonds starting from Spring 2015, the selloffs did not result in a significant increase in yields; in fact, yields on the 3-year to 5-year horizon even decreased somewhat. This landmark victory has resulted from the market stabilising impact of demand from the banking sector for government bonds.
One additional factor that helps reduce the interest rate risk is that the NBH's room for interest rate manoeuvre has become greater recently. Judging from market expectations, the key policy rate of the NBH could remain unchanged in the next two years, in line with the NBH's forward-looking interest rate policy communication. At an unchanged base rate, there is no loss resulting from interest rate swap value fluctuations. In recent times, various measures have been approved that help widen rooom for monetary policy manoeuvre. The conversion of retail foreign currency loans into forint debt, together with the Self-Financing Programme, reduces external vulnerability, and therefore has a similar impact on the strength of an interest rate policy response to potential external shocks. The resilience of the government bond market and the foreign currency market has improved; external shocks of a given size have triggered smaller yield hikes and currency weakening than before. The carryover effect of currency rates on consumer prices has also diminished recently, something that has added even more room for interest rate policy manoeuvre.
The programme does not curb corporate lending activity, as it modifies only the form of receivables from the state as a consolidated entity by reallocating financial assets from the central bank to government accounts. As a result of getting "kicked out" of the two-week instrument, banks have purchased government bonds worth HUF 1,500 billion so far, which is significantly less than the sterilisation need. The only scenario in which monetary policy tools could theoretically restrict banks' lending capacity would be one in which the latter altogether purchase a larger quantity of government bonds than the amount moved from the two-week instrument. This is not the case, however; even after banks are done with their shopping in the government bond market, there is still a significant amount invested in the 3-month central bank deposit, thus banking sector liquidity is not adversely affecting lending activity.
Summary
The NBH practice is in line with the global trend whereby several other central banks have taken significant risks by more actively utilising their balance sheets. Ever since the onset of the global financial crisis, it has been typical of central banks to assume a more active role in the economy, utilising new policy tools in order to achieve traditional or more recently adopted policy objectives. Several of the developed world's central banks have significantly expanded their balance sheets, have carried out quantitative easing to meet monetary policy goals. For instance, by adopting an asset purchase programme in early 2015 the European Central Bank has sought to meet an inflation target; more exactly, to enable economic growth without posing a risk to the inflation target. At the same time, by these purchases the ECB is undertaking a significant interest rate risk. Since the announcement of the programme, the central bank of the eurozone has acquired government bonds worth more than EUR 300 billion, the majority of which are fixed-interest bonds with a very long term to maturity - 8 years on average.
All in all, the Self-Financing Programme of the NBH has been a major step to mitigating the external vulnerability of Hungary's national economy. Meanwhile, thanks to the shrinking of the central bank's balance sheet, the programme does not introduce additional risk, and the benefits it provides outweighs the costs.
In this article, I would like to point out several faults in that the line of reasoning.
- First, it is a technical mistake to separate costs and benefits, since the welcome reduction in external vulnerability is mainly the result of the very same Self-Financing Programme that is the subject of criticism.
- Second, the risks resulting from interest rate swap transactions are adequately offset by the shrinking of the NBH's balance sheet.
- Third, the programme has no impact on corporate lending, as it modifies only the form of receivables from the consolidated state, re-allocating the stock of financial assets from the central bank to government accounts.
The aim and results of the Self-Financing Programme
When evaluating a programme, it makes sense to begin with an overview of its declared objective, as this is the basis for assessing whether the measures taken have been effective. Regarding the NBH's Self-Financing Programme, the task is quite simple, as the NBH has made it clear on several occasions that the aim is to reduce the country's external vulnerability. The programme seeks to attain that goal by transforming the central bank's policy tools, whereby it channels commercial banks' liquidity away from the central bank and towards acceptable forms of collateral available in the market - which, given the specific features of Hungary's securities market, primarily means government bonds.
Doing so does not affect the aggregate amount of receivables of the banking sector from the state as a consolidated entity (including all government accounts and the NBH), it only changes the structure of banking sector assets. Further, increased demand for government bonds from the banking sector makes it possible for the state to finance foreign currency debt payment through increasing forint bond issuance.
It is no longer dubitable that the Self-Financing Programme has proved to be effective in achieving the desired goal of reducing vulnerability. The stock of forint bonds held by commercial banks has increased by some HUF 1,500 billion since the launch of the programme in 2014; as a result, the ownership share of the domestic banking sector in Hungary's public debt has climbed almost to 35%. With that, the banking sector is currently the largest player in the forint government bond market, having relegated foreign investors from first to second place. Within the stock of forint-denominated government bonds held by commercial banks, the average time to maturity has increased from less than 3 years to about 4 years over the past 1.5-year period, significantly reducing the replacement cost risk of Hungary's public debt. The share of foreign currency liabilities within Hungary's total government debt has fallen from a peak of around 50% to less than 35%.
What this means is that a decrease in gross external debt is reducing the risks and costs of government debt financing, along with the country's external vulnerability. A shift towards forint issuance helps bring down the ratio of foreign currency liabilities within public debt, whilst increased demand for government bonds makes financing cheaper. The lower amount and healthier structure of external debt help reduce the country risk premium, something that could further contribute to lower financing costs. By improving financial stability, the programme could contribute to a more efficient monetary policy, and have a carryover effect resulting in more sustainable economic growth.
Costs for the central bank, benefits for the national economy
One typical misunderstanding that arises when evaluating the programme is that the costs of the programme and benefits associated with it do not necessarily present themselves at the same place. The tools that ensure the success of the programme are created and operated by the central bank; therefore, the latter bears the costs and potential risks. At the same time, the risks should be assessed in relation to the benefits, and the latter mostly appear at the level of the national economy. As discussed above, the programme has triggered or supported several positive trends that can be described as significant even at the macroevonomic level. However, in order to achieve these, the NBH's active participation was necessary, something that entailed undertaking or taking over certain risks.
That is, the risk-return analysis of individual central bank policy tools should not be performed in isolation, but rather, by considering the programme as a whole, and their contribution to the programme. One such important yet often overlooked consideration, when evaluating the interest rate swaps provided by the central bank to support self-financing, is that while on the one hand the central bank takes over a certain interest rate risk from banks, on the other hand the shrinking of the central bank's balance sheet that is a natural consequence of the Self-Financing Programme offsets the higher interest cost.
It is an undeniable fact that the Self-Financing Programme and the central bank's IRS transactions alter the NBH's interest rate risk profile. The floating interest in an IRS is a liability-side component outside of the balance sheet, whilst fixed interest receipts essentially mean an asset-side exposure. That is, the interest rate position opened by means of an IRS transaction increases the interest rate risk of the central bank in and of itself. However, this effect should not be evaluated in isolation from the other effects, because the interest rate risk borne by the central bank is determined by two factors: the level of interest rate risk to the balance sheet entries (the time to maturity of the assets shown in the balance sheet) and the value of the assets carrying said interest rate risk.
In the course of the Self-Financing Programme, the need for sterilisation decreases, which counteracts the central bank's increased liability-side interest rate risks resulting from IRS transactions. As of September 2015, the 3-month deposit replaced the 2-week deposit as the NBH's key policy instrument, which means that on the liability side short maturities still present the greatest risk, as liabilities get quickly repriced.
Compared with the situation prior to the Self-Financing Programme, the only change to the liability side of the NBH balance sheet is that as a result of the IRS transactions, the earlier 2-week risk has been partly converted into 6-month risks, whereas the remaining 2-week deposit is transformed into 3-month deposits. Thus, the impact on NBH in the event of a potential short-term yield increase remains essentially unchanged - in fact, due to the longer liability-side maturity it could be even slightly lower than it would have been without launching the Self-Financing Programme.
On the asset side of the NBH balance sheet, the time to maturity of receivables has increased due to the long-maturity fixed-interest leg of the IRS's, in comparison with the "sans Self-Financing Programme" scenario. At the same time, it is important to highlight the difference between interest rate risk and interest rate cost, as floating interest payments on the liability side could actually mean higher interest costs in the event of a yield increase - in contrast to fixed-interest assets which in a similar scenario only get repriced, and potential losses are not realised until the transaction is closed. Assuming that the participant banks, in keeping with the ethos of the programme, intend to hold on to the IRS deals with the central bank and Hungarian government bonds until maturity, there is no essential difference in the interest rate cost in the scenarios with or without the programme.
The benefits of the Self-Financing Programme are realised on the macro level and exceed the quantifiable costs borne by the central bank. The benefits created by the programme, apparent in the NBH balance sheet and at the national economy level, are measured against the direct cost of the interest rate swaps. The central bank's IRS transactions come at a lower cost to banks compared to those available in the market, the reason for which is that these transactions are different from market transactions. The IRS deals offered by the central bank are available on condition that banks increase their stock of collateral acceptable to the central bank (primarily, government bonds) by at least the same amount as the IRS transactions of which they have availed themselves. At the same time, this cost has been less than 0.5% on average for the transactions so far.
It makes sense to compare this amount to the decrease in NBH debt service arising from the "shrinkage" of the NBH balance sheet thanks to the programme, which in turn helps reduce sterilisation costs. At the current key policy rate, assuming near-zero yield on foreign currency reserves, the sterilisation cost that can be thus saved is more than 1%. This cost is currently at a historic low, the cost of keeping reserves was significantly higher in previous years.
Only structural change to receivables from consolidated state accounts
Since the launch of the Self-Financing Programme, both short and long yields have decreased. Some of the IRS deals made by the central bank in the past have turned a profit for the NBH thanks to the decline in interest rates, something that has created a buffer to cover costs in case of a minor increase in yields. Looking forward, the Self-Financing Programme will contribute to a decrease in long yields as well as help stabilise yields at a low level; that is, the programme in and of itself reduces the risk of a yield hike. As a result of quantities, the direct impact of the Programme will be a downward pressure on yields. As for the macro level, reduced external vulnerability is another factor that will lower long yields, and at the same time help reduce the risk of a potential crisis scenario.
The increased resilience of Hungary's national economy and government bond market is clearly shown by the fact that while non-residents have sold significant amounts of forint bonds starting from Spring 2015, the selloffs did not result in a significant increase in yields; in fact, yields on the 3-year to 5-year horizon even decreased somewhat. This landmark victory has resulted from the market stabilising impact of demand from the banking sector for government bonds.
One additional factor that helps reduce the interest rate risk is that the NBH's room for interest rate manoeuvre has become greater recently. Judging from market expectations, the key policy rate of the NBH could remain unchanged in the next two years, in line with the NBH's forward-looking interest rate policy communication. At an unchanged base rate, there is no loss resulting from interest rate swap value fluctuations. In recent times, various measures have been approved that help widen rooom for monetary policy manoeuvre. The conversion of retail foreign currency loans into forint debt, together with the Self-Financing Programme, reduces external vulnerability, and therefore has a similar impact on the strength of an interest rate policy response to potential external shocks. The resilience of the government bond market and the foreign currency market has improved; external shocks of a given size have triggered smaller yield hikes and currency weakening than before. The carryover effect of currency rates on consumer prices has also diminished recently, something that has added even more room for interest rate policy manoeuvre.
The programme does not curb corporate lending activity, as it modifies only the form of receivables from the state as a consolidated entity by reallocating financial assets from the central bank to government accounts. As a result of getting "kicked out" of the two-week instrument, banks have purchased government bonds worth HUF 1,500 billion so far, which is significantly less than the sterilisation need. The only scenario in which monetary policy tools could theoretically restrict banks' lending capacity would be one in which the latter altogether purchase a larger quantity of government bonds than the amount moved from the two-week instrument. This is not the case, however; even after banks are done with their shopping in the government bond market, there is still a significant amount invested in the 3-month central bank deposit, thus banking sector liquidity is not adversely affecting lending activity.
Summary
The NBH practice is in line with the global trend whereby several other central banks have taken significant risks by more actively utilising their balance sheets. Ever since the onset of the global financial crisis, it has been typical of central banks to assume a more active role in the economy, utilising new policy tools in order to achieve traditional or more recently adopted policy objectives. Several of the developed world's central banks have significantly expanded their balance sheets, have carried out quantitative easing to meet monetary policy goals. For instance, by adopting an asset purchase programme in early 2015 the European Central Bank has sought to meet an inflation target; more exactly, to enable economic growth without posing a risk to the inflation target. At the same time, by these purchases the ECB is undertaking a significant interest rate risk. Since the announcement of the programme, the central bank of the eurozone has acquired government bonds worth more than EUR 300 billion, the majority of which are fixed-interest bonds with a very long term to maturity - 8 years on average.
All in all, the Self-Financing Programme of the NBH has been a major step to mitigating the external vulnerability of Hungary's national economy. Meanwhile, thanks to the shrinking of the central bank's balance sheet, the programme does not introduce additional risk, and the benefits it provides outweighs the costs.
