What If Central Banks Go Insolvent? Another Crisis Contagion?

What do countries like Iceland do, where the Central Bank does not have liquidity to bailout it's financial institutions? The ability of a Central Bank to financially bailout depends on it's Forex Reserves. In the case of Iceland, the country's bank assets are 10 times it's GDP. It's short-term debt is 6 times Iceland's reserves. Clearly, in the event of a crisis, Iceland's Central Bank is in no position to bailout it's local institutions.

The Russian puzzle!

Apparently solvent nations can be on the brink of solvency! Russia's central bank has reserves of approximately $550 bn while the country's private sector has raised a debt bill of approx $450 bn. In the event of a bearish trend in oil prices, the forex reserves could be depleted swiftly and render the Central Bank incapable of a bailout.

The same is true of other emerging economies - BRICs (Brazil, Russia, India, China) nations.

Central Banks are central to the issue...

The external economy of any nation is it's foreign trade leading to precious foreign exchange inflows which is stored in the nation's Forex Reserves owned by the Central Bank. The domestic economy of a nation is composed of local private institutions which cater to domestic consumption as well as exports that contribute to the nation's GDP.

When a country's economy opens up to foreign investment, foreign institutions bring in capital inflows in the form of FDI (long term) and FII (short term) investments. FDI is Foreign Direct Investment which is usually in the form of green-field projects and similar long-term capital intensive investments in energy, power, infrastructure etc... FII on the other hand, is Foreign Institutional Investment which is dominantly short-term in nature. These are typically investments in public equity, private stakes etc... In the event of a liquidity scare or adverse economic scenarios, the FIIs will be the first to pull out their investments leading to extremely high and swift capital outflows. Therefore, FII is akin to short-term debt for a nation as it is a claim on the nation's Forex Reserves and needs to be restricted to manageable levels as a percentage of Forex Reserves. In an overheated economy, the FIIs are a very high percentage of GDP / Reserves.

The other source of Forex Reserves is the exports of a nation. The trade balance of a country is the Net calculation of exports less imports. If a nation imports more than it exports, it's forex reserves would be depleted at a very high rate.

Many emerging economies have exploded too swiftly leading to very high short-term capital flows in addition to a spurt in domestic demand which in turn leads to deterioration of Net exports (adversely impacting Forex Reserves). Typical in such nations, there is a lot of liquidity leading to high credit-offtake, which in turn leads to inflationary pressures. This prompts monetary action from the Central Banks in order to squeeze liquidity, causing an increase in domestic interest rates, thus pressurising domestic consumption.

In a tight-liquidity and high interest-rate regime, many home-owners end up with negative equity as their mortgages are larger than the value of their property (due to declining real estate prices in such a regime).

How to preempt the next financial crisis wave?

In the current global scenario, there is a serious risk of continued bank defaults within nations, followed by adverse change in capital flows across nations, leading to a series of country-wide defaults in various countries. If solutions to these problems are not foreseen now, we could very well enter a global financial depression ! Each country must enforce regulations on the banking and financial system and follow a multi-pronged approach in order to pre-empt the next wave of financial terror.

• The country's banking system must be adequately capitalised. All banks must conform to Capital Adequacy and Liquidity norms. Banks must set aside contingency capital in accordance with the risk of their portfolio. Exposure of banks to high-risk assets such as real-estate must be dis-incentivised with a higher risk-rating.
• The monetary policies should be geared towards a lower interest-rate regime. This move will be a significant measure in the direction of re-affirming consumer confidence as well as reducing default-risk on the loan portfolios. This will also bring back inflows which have dried out owing to the recent global liquidity crisis. Reduction in interest rates also pumps in more liquidity into the banking and financial system.
• Fiscal expansion towards addressing local demands on energy & infrastructure as a percentage of GDP would divert funds towards long-term and sustainable growth of the economy.