The Reserve Bank of Australia is currently very close to a negative capital position, and if the exchange appreciates marginally or yields go up slightly, may well show negative equity on June 30 and in the 2021/22 Annual Report.
The negative equity position will be entirely due to unrealised valuation losses from the holdings of Australian bonds, which will offset the valuation gains from the exchange rate depreciation compared with the level at the start of the financial year.
Negative equity might sound like a significant event, but the RBA had already flagged that this could happen and that it would not affect its ability to operate as a central bank.
“The Board is mindful that valuation losses in any given year could be large enough to exceed the balance in the RBRF and result in a negative equity position. Such an outcome, if it were to occur for these reasons, would not affect the Reserve Bank’s ability to operate effectively or perform any of its policy functions,” the RBA said in its 2021 annual report.
The RBA is in a unique position compared with its global counterparts. It doesn’t have an indemnity arrangement with the Commonwealth to cover losses for the bonds it bought to provide monetary policy easing to the economy since the pandemic.
This means the RBA must cover all the realised losses and show the unrealised losses on the balance sheet, thus wiping out all its reserves and capital.
The Reserve Bank of New Zealand, for example, pays any gains it makes or gets indemnified by the Crown each month for its bond holdings bought under the Quantitative Easing program.
The RBNZ also shows the unrealised valuation losses in the balance sheet as indemnity and can thus avoid showing a negative equity position.
CB-Intel’s estimate is the RBA’s unrealised valuation losses – based on the market value of bonds -- are currently close to A$30 billion caused by the sharp rise in bond yields in recent months. At the start of the financial year, the RBA’s net asset position was $23 billion.
Unrealised valuation losses are, in some sense, paper entries, and in the RBA’s case, based on its announced plan to not sell its bond holdings, these losses would never be realised.
The RBA has another problem. Its realised gains are diminishing because of the rising cash rate, and when the cash rate moves closer to 1.0 per cent, the RBA will start incurring losses because the rate on the Exchange Settlement balance will rise along with the cash rate.
CB-Intel’s rough estimate is the average earnings from bonds held by the RBA is 0.8 per cent to 1.0 per cent. Already, the RBA has been making a loss since May 4 on a portion of the funds it lent under the Term Funding Facility at 0.1 per cent.
This financial year the RBA would still be able to pay dividends to the Commonwealth, but it might choose to be prudent and retain it on its balance sheet as reserves. However, in the next few years, a dividend is unlikely as long as the cash rate remains above 1.0 per cent, and depending on how high interest rates go, the government will have to infuse some capital into the RBA.
Governor Philip Lowe said in February he thinks of the balance sheet from a profit point of view, which means he focuses on the realised profits or losses.
Lowe did say the other way to look at the balance sheet is from a market value accounting angle.
“And when you use market values, it telescopes all the future gains or losses into today. So, you're going to see quite large swings, possibly some large losses in capital losses in the Reserve Bank's balance sheet, because the market pricing telescopes all the future things into today,” Lowe said.
He reminded the RBA is a very well capitalised institution, but as losses come through, there would be smaller dividends to the government for a number of years.