In recent weeks, there has been an interesting discussion in the media about the potential role of the Czech National Bank’s foreign exchange reserves as a source of funding for public investments. The fact is that the CNB’s foreign exchange reserves are relatively large: they fluctuate around the value of three trillion crowns and, coincidentally, are similar in size to the current amount of public debt.
It is therefore only natural that at a time when public finances are going through a painful recovery, questions arise as to whether and possibly how they could be involved for the benefit of public finances. Why should the central bank “sit” on the reserves and watch in comfort as they grow thanks to the income from them, while the other branches of the state have tight budgets?
The answer needs to start with what foreign exchange reserves are not. The label “reserve” can lead to the idea that it is a kind of reserve sum saved by the side in case of emergency, similar to how you can have a reserve set aside in the family budget. Indeed, some countries have such funds in which funds are accumulated, usually from mineral wealth or from past investments – such as the Norwegian Government Pension Fund, whose assets correspond to about 1.5% of the value of all listed stocks in the world. And such a fund can (and does) more or less support the budget. But the foreign exchange reserves of the CNB are not a fund of this type.
The current high volume of foreign exchange reserves arose somewhat as a by-product of the past monetary policy, when the central bank bought foreign currency for many reasons. The reasons for purchases of foreign currency were diverse and sometimes debatable: whether it was a so-called exchange rate commitment (i.e. the de facto artificial weakening of the koruna between 2013 and 2017), or the purchase of a net inflow of European funds. What is significant, however, is that together with the purchased reserves, the CNB’s debt to the banking sector also grew. The central bank bought reserves for newly issued crowns, which it immediately withdrew from the market by offering commercial banks to actually deposit them with it.
In simple terms, it can be said that our foreign exchange reserves are actually bought on debt, which today has quite a lot of interest. It is clear from this that, in addition to revenues, the holding of reserves also has its costs. Foreign exchange reserves are simply an integral part of the central bank’s balance sheet, not something that the CNB only manages in the same way as when an investment company manages (separately from its assets) funds entrusted to it by investors. They are therefore a profitable asset, but there is an interest-bearing debt against it.
But the fact is that while debt bears short-term interest, reserves can be invested in longer-term and riskier instruments, so on average they should earn more than what the interest costs on the reserves are. So couldn’t at least this difference in revenue and costs help the public finances? The answer is yes: that’s how the system is currently set up anyway.
Losses must be paid first
According to the law, the CNB pays its own costs through its activities (not only personnel, but also costs for the production and administration of currency), fills its reserve funds and transfers everything in excess to the government. Actually, this is a kind of dividend. However, this only applies if the CNB does not have accumulated losses from previous years. However, this is precisely its current situation: it is no secret that as a result of the appreciation of the koruna against reserve currencies and currently also as a result of high interest costs to fight inflation, the CNB has accumulated a significant loss. Therefore, until the central bank compensates this loss with its future profits (and it must be said that this will be a long shot), one cannot reasonably hope that it will contribute to the state budget.
It is certainly true that the greater the CNB’s income from reserves, the sooner the loss will be covered, and the sooner and the bigger the “dividend” the bank could pay to the government. So should the bank strive for the highest possible yield? Even a central bank cannot avoid the choice that all other investors must face: the dilemma between return and risk.
The CNB’s investment horizon is long and the volume of reserves (in relation to our needs) is high, which would speak in favor of more profitable, and therefore riskier, instruments such as shares. On the other hand, the reserves continue to have their reserve function in the sense that the bank must be able to use them in sufficient quantity if it gets the impression that it is necessary to stabilize the exchange rate of the koruna or for other monetary policy purposes. It is not so much that the riskier instruments are illiquid, because the shares included in the world stock indexes can be sold easily. Rather, the point is that the moment when the bank would want to use the reserves would be precisely the moment when the world’s stock markets would be falling, and the sale of shares would thus come at the most inopportune moment. This could happen, for example, when we were faced with a major foreign crisis, as we saw with the outbreak of the war in Ukraine.
In short, for the bank, as for every investor, not only the average return has its value, but also its stability (or, conversely, instability) over time. However, the choice between risk and return cannot be definitively optimized by any formula because it touches on preferences. The CNB must therefore constantly evaluate and possibly reevaluate this choice, with the fact that it is fully aware that its results are ultimately part of the public sector.